Foreign Exchange Risk Management Forex Risk Management
Morning Briefing

Risk Management: Case Studies

25-Jul-2004
Case 1 - The need to define proper objectives
Case 3 - Focus on objectives; Learn from your mistakes.

Treasury Risk Management

The Colour of Money - Series on Forex Hedging

Current Issue   ::    Archives
Use a Forecast for Budgeting
28th May, 2012

Case #2

ISSUES IN CORPORATE RISK MANAGEMENT
Keep the Objective in mind. It pays
                                                       
The definition of proper Objectives is the first step in effective Corporate FX Risk Management. Get your objectives wrong and you are most likely courting trouble. We had taken this up in the Issue dated 28-Mar-04. Having set the correct objectives, the Risk Manager needs to keep them in mind after the Hedge Strategy has been implemented, so as to not be led astray by the market. It pays immensely.

A conglomerate with a Rupee Balance Sheet had a large foreign currency loan book, 85% of which was denominated in US Dollars. The balance was in D-Marks, Yen and Sterling. Circa 1994-95, the Risk Manager decided to reduce the currency concentration risk and rebalance the loan basket using Currency Swaps. The Objective was clearly defined as Risk Diversification.

It was decided to swap 10% of the Dollar loans into Yen. The Yen was chosen because interest rates were close to zero as compared to 6.50-6.75% on the USD 6-month Libor, giving a huge interest benefit. Further, the Yen was expected to weaken over a 3 year time frame. The Swap took place in Jan-95 near 100 on the USDJPY Spot.

Almost immediately thereafter, the Dollar dived against the Yen, to hit an all time low of 79.80 in April 1995. There were 3 months of intense agony. The company had never undertaken such a large forex deal. The Board was on the edge. Had the deal gone horribly wrong? The Risk Manager reminded the Board that the objective was Risk Diversification and only 10% of the loan book had been put on the line. Further, the deal had a 3 year tenor.

The market eventually turned around and the danger passed. The Swap came back into money. Now the Board was tempted to square off the trade and book whatever small profit was available. Again the Risk Manager stuck to his guns, saying the Objective was long term Currency Diversification, not short term Trading Profits. The Board backed down and the Swap was allowed to run its course.
The Yen eventually touched 120 in 1997. The company booked a huge currency and interest rate gain of almost $17 million. Those who have been in the market through that period would appreciate how difficult it must have been to steer such a trade through to its end. It is immensely commendable that the Risk Manager did not waver from the Objective, neither in bad times nor in good times.

The gains from the deal (which in itself was well conceptualized), was realized by remaining focused on the Objective.

Case 1 - The need to define proper objectives
Case 3 - Focus on objectives; Learn from your mistakes.

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