Financial risk is structurally different from other risks that companies are exposed to, since, unlike any business risk, it is not a risk that the company has chosen to carry. Which explains why management is always more nervous about this risk than virtually any other. This extra edginess often leads to excessive board oversight of financial risk management, with the CFO’s decision-making routinely second-guessed by the board.
The generalised uncertainty is compounded by the fact that opportunity losses in financial risk management are fully transparent, again, unlike in other business areas. For instance, say, the sales head of Maruti delivered sales of 260,000 cars against a target of 240,000; he would likely be applauded. The board may raise questions if, say, GDP growth were higher than forecast and sales growth did not match that, but, in the absence of any transparent method of “seeing” missed opportunities, it would be difficult for the board to really point fingers. Sales performance — indeed, performance in virtually every business area — cannot be marked-to-market, because there is no transparent market.
In financial decision-making, however, even if you outperform your target — say, you sell dollars at 49.50 against a target of 49.00 — you could be taken to task if the market, at any point, reached, say, 50. This “MTM terror” explains why few boards are fully satisfied with their financial risk management, reinforcing the micromanagement and, in some cases, making matters worse by weakening the CFO’s hand vis-à-vis that of business divisions in setting transfer prices.
The correct way to set transfer prices between business divisions and the treasury is to build the cost of risk (best estimated as the price of an at-the-money option) into budgeted purchase/sales prices. This provides an accurate measure of business margins. The difference between the forward rate and the transfer price would then be set as the treasury’s risk capital. Business division heads are usually resistant to this approach, preferring to use the unadjusted forward rate as the transfer price. What is not widely appreciated is that this route results in the company either carrying more risk (since the treasury’s risk capital has to be over and above the forward rate) or less opportunity (if the treasury’s risk capital is reduced so that it has to hedge very early).
But, what is this risk capital, you say? We are a conservative company. Our treasury is not a profit centre.
Also Read
Yes, dear.
All companies are conservative companies. They all want to carry (almost) no risk and they all want to capture opportunity gains.
The nub of the matter is that financial risk management needs a specific allocation of risk capital. Many companies shy away from this, often because CFOs, even those who fully understand the need, believe that the board would not bite, fearing that this would make the operation speculative. This belief is both ludicrous and inconsistent — companies routinely set aside capital to buy insurance to protect against other risks.
The reality is that without a specific — and articulated — allocation of risk capital you CANNOT have sound financial risk management.
Against this risk capital, the treasury should be the sole owner of financial risk. Business operations should be fully insulated from the market by the transfer price — they should not have to and should not worry about forex fluctuations. [If the transfer price — set by building in the cost of risk — is too tight for a particular business or a particular transaction, it simply means that the company cannot sustain the financial risk implicit in the transaction, and the risk should be hedged out (partially or totally) at the start.]
Of course, having provided the treasury with all this risk capital and freedom and flexibility, its performance should be measured stringently. Gains that accrue from benign market movements — eg, the steadily depreciating rupee five or six years ago — should not be credited to the treasury, and the CFO should build an objective benchmark to enable separation of these gains from those actually earned by the treasury against its allocated risk capital.
Getting boards to shrug away their constantly reinforced terror about financial risk management is a tall order. But if, as CFO, you can convince the board to put this kind of structured process in place, you will find you are consistently able to protect your margins from market fluctuations, capture a reasonable part of market opportunity, and, importantly, free up considerable amount of senior management time.
And, perhaps best of all, you will earn the undying gratitude of the chairman’s wife since he will stop unnecessarily losing sleep (or hair) over the value of the rupee.