Chapter 16: Managing Risk in an

Organization

Paris-based Natexis Banques Populaires has announced

that it has made “significant losses” in its equity derivatives
trading business due to poor risk control and failures in its
valuation models.

Risk, January 2003, p. 8

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d Risk Management, 6th ed.
Important Concepts in Chapter 16
 The differences between the practice of risk management
by end users and by dealers
 Principles of effective risk management in an organization
 Accounting for derivatives
 How some organizations lost money using derivatives
 Responsibilities of senior management

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d Risk Management, 6th ed.
The Structure of the Risk Management
Industry
 End Users
 Firms that engage in derivatives transactions to manage
their risk.
 Mostly non-financial corporations, but also pension
funds, mutual funds, U.S. state and local governments,
foreign governments, endowments, and other private
organizations.
 In corporations the treasury department is usually
responsible for derivatives transactions.

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d Risk Management, 6th ed.
The Structure of the Risk Management
Industry (continued)
 Dealers
 Financial institutions that make a market in derivatives.
They stand willing to take either side of a derivatives
transaction.
 They typically hedge their risk and earn a profit off of
the difference between their buying and selling prices.

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d Risk Management, 6th ed.
The Structure of the Risk Management
Industry (continued)
 Other Participants in the Risk Management Industry
 consultants, including accounting, management
consulting, and personnel search
 software firms
 law firms

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d Risk Management, 6th ed.
Organizing the Risk Management Function in
a Company
 Good risk management requires a sound organization
structure that begins with responsibility at the top.
 Dealers usually have an independent risk manager who
reports to the CEO, has access to relevant information, and
authority to block or initiate certain transactions.
 Corporate risk management should also be centralized but
is often decentralized.
 Many corporations run the treasury as a profit center,
which is not conducive to sound risk management.

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d Risk Management, 6th ed.
Organizing the Risk Management Function in
a Company (continued)
 Separation of front office from back office.
 Legal counsel, accounting, and auditing are critical, but
accounting and auditing do not substitute for risk
management.
 Risk management is a continuous process requiring regular
evaluation and comparison to objectives.
 See Figures 16.1 and 16.2, p. 586 for examples of typical
dealer and corporate end user organization charts.
 Under enterprise risk management, the management of all
risks is under a single area of responsibility.

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d Risk Management, 6th ed.
Risk Management Accounting

 The concept of hedge accounting: accounting in which

gains and losses on derivatives are tied to gains and losses
on hedged instruments.
 In the U. S., the Financial Accounting Standards Board
(FASB) has prescribed the appropriate methods of
accounting for derivatives with FAS 133, Accounting for
Derivative Instruments and Hedging Activities. Global
standards are prescribed by the International Accounting
Standards Board (IASB) with their IAS 39.
 In general, derivatives are marked to market and must
appear on financial statements

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d Risk Management, 6th ed.
Risk Management Accounting (continued)

 Fair Value Hedges: The firm is hedging the market value

of an asset or liability. The gain/loss on the derivative as
well as the instrument being hedged is recorded and
reflected in current earnings.
 Example: Firm holds security and hedges with a
derivative. Before the end of the hedge, the security
loses $100,000 in value and the derivative gains
$96,000. It does the following entries:

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d Risk Management, 6th ed.
Risk Management Accounting (continued)

 Debit Derivative 96,000

 Credit Unrealized Gain on Derivative 96,000

Debit Unrealized Loss on Security 100,000

 Credit Security 100,000
 This affects net income as well as the balance sheet.
Income decreases by $4,000. Assets decrease by
$4,000.
 These hedges must be properly justified, and carefully
documented to be eligible for accounting this way.

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d Risk Management, 6th ed.
Risk Management Accounting (continued)

 Cash Flow Hedges: The firm is hedging the risk of a

future cash flow. The derivative is marked to market and
shows on the balance sheet but the gain/loss shows up in a
temporary account, Other Comprehensive Income (OCI),
which is an equity account. At the end of the hedge, OCI
is closed out, and any balance adjusts the amount recorded
to the cash flow being hedged. Also gains/losses must be
separated into “effective” and “ineffective” components.

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d Risk Management, 6th ed.
Risk Management Accounting (continued)
 Cash Flow Hedges (continued)
 Example: A firm plans to borrow $1 million in six
months by issuing a discount note. It buys an FRA to
hedge. Rates go down and it incurs a loss on the FRA
of $10,000. Eventually the FRA expires with a loss of
$12,000 and the note is issued at 7%, generating a cash
inflow of (1 - .07)$1,000,000 = $930,000. During the
interim, it enters the following:
 Debit OCI 10,000
 Credit FRA 10,000

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d Risk Management, 6th ed.
Risk Management Accounting (continued)
 Cash Flow Hedges (continued)
 When it takes out the loan, it enters the following:
 Debit Cash 930,000
 Credit Notes Payable 930,000

 Debit FRA 10,000

 Debit OCI 2,000
 Credit Cash 12,000

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d Risk Management, 6th ed.
Risk Management Accounting (continued)
 Cash Flow Hedges (continued)
 Debit Notes Payable 12,000
 Credit OCI 12,000
 Thus, it received $930,000 in cash and set up a liability
of $930,000. It removed the FRA from the books and
recorded a $2,000 further loss in OCI. It paid out
$12,000 to cover the FRA loss and zeroed out OCI. It
reduced the note balance to $918,000, reflecting the net
amount of cash it received.

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d Risk Management, 6th ed.
Risk Management Accounting (continued)
 Cash Flow Hedges (continued)
 This was a perfect hedge. Suppose in the interim
period the loss was $11,000 but the effective part was
$10,000. Thus, the gain/loss on the derivative does not
perfectly match the gain/loss on the hedged instrument.
It would do the following:
 Debit Current Income 1,000
 Debit OCI 10,000
 Credit FRA 11,000

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d Risk Management, 6th ed.
Risk Management Accounting (continued)
 Cash Flow Hedges (continued)
 At expiration let the loss on the FRA be $15,000, of
which only $12,000 is effective. Then we
 Debit FRA 11,000
 Credit OCI 11,000

 Debit Current Income 2,000

 Debit OCI 1,000
 Debit Notes Payable 12,000
 Credit Cash 15,000

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d Risk Management, 6th ed.
Risk Management Accounting (continued)
 Cash Flow Hedges (continued)
 We remove the FRA from liabilities and all but $1,000
from OCI. We zero out OCI and reduce Current
Income by $2,000. Notes payable goes from $930,000
to $918,000 (the Notes Payable entry above is the
same), reflecting a loss of $12,000. Of the $12,000
loss, the ineffective part is $2,000, which goes into
Current Income and combines with the $1,000 loss
already in Current Income.
 There is still some uncertainty about how firms are to
identify effective and ineffective parts of hedges.

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d Risk Management, 6th ed.
Risk Management Accounting (continued)
 Foreign Investment Hedges: Procedures for these had
been in effect for a number of years. Certain transactions
qualify for Fair Value and Cash Flow hedge accounting.
 Speculation: Gains/losses are marked to market and
recorded in current income.

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d Risk Management, 6th ed.
Risk Management Accounting (continued)
 Some Problems in the Application of FAS 133
 No clear prescription for what constitutes
effective/ineffective hedging.
 Embedded derivatives must be separated.
 No hedge accounting for bonds held to maturity.
 Difficulty of arriving at derivatives’ values.
 Does not permit macro (firm-wide) hedges.

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d Risk Management, 6th ed.
Risk Management Accounting (continued)
 Disclosure
 In the U. S., the SEC requires that firms using
derivatives present either
 Tabular information on market values and contract

terms, or
 Sensitivity analysis of potential losses, or

 Value-at-Risk

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d Risk Management, 6th ed.
Avoiding Derivatives Losses
 See Table 16.1, pp. 593-594 for a partial list of
organizations reporting derivatives losses.
 Four case studies:
 Metagesellschaft: To Hedge or Not to Hedge?
 Orange County, California: Playing the Odds
 Barings PLC: How One Man Blew up a Bank
 Proctor & Gamble: Going Up in Suds

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d Risk Management, 6th ed.
Risk Management Industry Standards
 Two organizations have established standards for the
practice of risk management:
 Group of 30 (G-30). See Table 16.2, pp. 601-603.
 Risk Standards Working Group. See
Table 16.3, pp. 604-605.

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d Risk Management, 6th ed.
Responsibilities of Senior Management
 Senior management is ultimately responsible for all
organizational activities. With respect to risk
management, these responsibilities can be summarized as:
 Establish written policies
 Define roles and responsibilities
 Identify acceptable strategies
 Ensure that personnel are qualified
 Ensure that control systems are in place

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d Risk Management, 6th ed.
Summary

D. M. Chance An Introduction to Derivatives an Ch. 16: 24

d Risk Management, 6th ed.
 Derivatives are nothing more than a tool. And just as a saw
can build your house, it can cut off your arm if it isn’t used
properly.
Walter D. Hopps
Business Week, October 31, 1994

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