The Cost of Risk
Financial institutions often place an explicit cost on risk to ensure it is being taken prudently. For example, a bank may require that a transaction that risks $100 million in bank capital must earn at least $25 million in present value. This cutoff percentage (25%) can be called a risk-adjusted return on capital, or RAROC.
Bank capital is affected by market risk (changes in market prices), credit risk (default risk and counterparty performance risk), and operational risk (people, processes, and systems). Any activity that increases risk should not be voluntarily undertaken without earning a commensurate return. The logic is as simple as net present value: if money were free, people would squander it more. When risk is free, it is also squandered. Nonbanks also need measures of the cost of risk, although the measures may be different.
The risk-based performance measurement process is designed to ensure that managers take risk prudently, by reflecting the cost of risk in assessments of their performance, and thereby affecting their compensation.
Measuring and Reporting Risk
If risk is the threat of an adverse outcome, that threat should be measured against the corporation’s business objective. If the business objective is to “maximize shareholder value,” then the logical risk measure is the potential reduction in share price. If the business objective is to “maximize earnings while keeping an investment grade rating,” then the appropriate risk measures are “earnings at risk,” a probabilistic statement of how bad earnings can get, and the probability of a ratings downgrade.
Many corporations report their risks in terms of value-at-risk or, worse, Greek letters such as sigma (standard deviation) and delta (sensitivity to a pricing benchmark). Best practice firms report their risks not only in financial terms that senior managers can understand easily, but also in terms that map directly into financial goals.
A company’s treasury usually has the best opportunity to manage risk, since it deals mostly with issues related to interest rates and foreign exchange. A treasury risk policy that requires 100% hedging may be at odds with corporate objectives. For example, a large corporation with little debt probably does not need to worry about whether its debt is financed on a fixed or floating basis. Since floating debt is usually cheaper, it may be better not to hedge. The same thing is true of foreign exchange. If the risks are small relative to the company, the question should be asked if hedging is necessary.1 If the risks are large, hedging may be justified.
Other treasuries trade quite a lot within their hedging boundaries, creating a pocket of speculative activity within the firm. Unless the firm can demonstrate a core competence in trading foreign exchange, this does not usually contribute positively to corporate objectives.