Definition of Risk – Part 3

 

*/By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc./*

What is the definition of risk?  This is the question that we started to
explore in Part 1.  There I claimed that there were two basic, yet very
different definitions of risk;

The first definition is:

·        "Risk is the possibility of adverse events that prevent an
organization from achieving its goals"

A second definition is:

·        "Risk is the possibility of events that prevent an
organization from achieving its expected outcomes"

In Part 1 I gave one illustration of how the choice of the definition changes
how an entity should measure risk.  In Part 2 I argued that the choice of
definition determines whether an entity decides to use options or forward
(swap)[1] [1] type contracts to hedge its financial risks.  In this
installment I will put forward an argument that the definition of risk
determines how the risk management function should be evaluated.

Throughout most of the 1990's, CIBC and Wharton conducted a survey of risk
managers to determine risk practices of corporations.  One of the questions
concerned whether or not the Treasury function was a cost centre or a profit
centre.  The responses changed significantly depending on current events in
the market.  For instance after the P&G and Gibson Greetings debacles in the
mid 1990's the popularity of operating the Treasury function as a profit
centre quite understandably declined.

Relating the survey to our current question of the definition of risk, it
becomes quite obvious that if the firm is choosing to define risk as only
"downside" or "bad" risk, then the Treasury function should in most
cases be operated as a cost centre.  Thus a simple and relevant evaluation
metric is "losses prevented / cost".  Losses prevented of course is more
easily said than measured, but one obvious way to do this is retroactively
(perhaps on a quarterly or annually basis) calculate the realized cash flow
of the firm and subtract from it the cash flows that would have occurred
without any Treasury interaction.  Hopefully a firm that is serious about
risk management will be able to calculate to a reasonable degree the cost of
its risk management activities (which includes not only the direct costs of
its hedges, but also indirect costs such as the management time and energy
spent on developing and implementing a strategy).

If the definition of risk includes both the upside and the downside risk,
then the evaluation measure becomes "(losses prevented plus opportunities
achieved) / cost".  This gives a much fuller and complete picture of the
value of the risk management function.  The opportunities achieved should
include direct opportunities such as new markets that were entered because
the risks could be managed to indirect value added through financial
engineering that either lowered the cost of capital or created incentives
that allowed for new customers.[2] [2]

At this point I would like to make it emphatically clear that I am not
advocating that the Treasury function should ever undertake speculation. 
Rarely has that ever turned out well in the long run for a non-financial
corporation.  If the corporation wants to speculate then it should become a
hedge fund – which implies a whole different set of operating competencies
as well as risk competencies.   The point is that by accepting that risk
has both a good component as well as a bad component, and by actively
managing both the good risk as well as the bad risk, there are potential
advantages for the corporation.

This concludes this set of three articles on the "Definition of Risk". 
I have tried to argue that there are two different definitions of risk and a
firm needs to make a conscious decision as to which definition of risk it
will operate under as the choice of definition affects the risk measures
used, the hedging tools selected as well as how the Treasury and Risk
Management function gets evaluated.

------------------------------------------------------------------------------
[1] [3] Swaps can be shown to be economically equivalent to a series of
forward contracts.  Therefore this analysis uses swaps and forwards
interchangeably.

[2] [4] An example of reducing the cost of capital would be a corporate
financing that embedded a structured note that provided investors a method to
invest in a commodity while laying off a risk for a corporate.  Hull (John
C. Hull, "Futures, Options and Other Derivatives", 7th edition, Pearson,
Prentice Hall, 2009) provides an example of Standard Oil issuing bonds where
the coupon was a function of oil prices.  This structured note allowed
investors to invest in oil, while allowing Standard Oil to hedge some of its
oil price risk in a win-win solution.  An example of using risk management
to incent new customers is residential fuel companies that give customers an
alternative payment structure that caps the price of fuel over the winter
months.

 


[1] #_ftn1
[2] #_ftn2
[3] #_ftnref1
[4] #_ftnref2

Definition of Risk – Part 2

 

*/By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc./*

What is the definition of risk?  This is the question that we started to
explore in Part 1.  There I claimed that there were two basic, yet very
different definitions of risk.

The first definition is:

·        "Risk is the possibility of adverse events that prevent an
organization from achieving its goals"

A second definition is:

·        "Risk is the possibility of events that prevent an
organization from achieving its expected outcomes"

In Part 1, I gave one illustration of how the choice of the definition
changes how an entity should measure risk.  In this installment I will argue
that the choice of definition determines whether an entity decides to use
options or forward (swap)[1] [1] type contracts to hedge its financial risks.

To illustrate this point I will take a well-known example from the airline
industry – namely Southwest Airlines.  Southwest has been frequently
lauded for many of its management practices, including its risk management. 
Prior to 2009, Southwest "locked" in its fuel costs with a series of
rolling swap contracts.  As the price of oil rose, so did fuel costs.  The
hedges gave Southwest a significant competitive advantage as when fuel costs
rose, so did the value of its hedge contracts – offsetting the rise in fuel
prices.  Southwest was well hedged against the "bad" risk of rising fuel
costs.

However fuel costs then fell dramatically along with other commodity
prices.  While a somewhat welcome relief on fuel costs for most airlines,
the falling fuel costs created a real problem for Southwest.  It was
"locked-in" to long term hedges that protected against rising fuel prices
but the swap contracts also prevented Southwest from taking advantage of the
"good" risk of falling fuel prices.  There was also a secondary effect
– namely as long as the economic crisis continued, airline travel will be
distressed and consumers will be more price conscious than ever.  Thus just
when Southwest needed to be most price competitive, its "bad" risk only
hedges caused it double grief.

The morale of this story is that forward contracts are fine if the
corporation is only concerned about "bad" risk.  However if a
corporation wants to be strategically prepared in cases of both "good"
risk and "bad" risk, then options are usually a better choice.  This is
not to say that options are always the best alternative for hedging.  In
another installment I will demonstrate the well-known adage that "the only
perfect hedge is in a Japanese Garden".

We are not done though with illustrating how the definition of risk permeates
the most important risk decisions of a company.  In the next installment of
this series we will see that the definition of risk defines how the risk
management team should be evaluated.

------------------------------------------------------------------------------
[1] [2] Swaps can be shown to be economically equivalent to a series of
forward contracts.  Therefore this analysis uses swaps and forwards
interchangeably.

 


[1] #_ftn1
[2] #_ftnref1

Definition of Risk Part 1

By Rick Nason, PhD, CFA
Partner, RSD Solutions Inc.

What is the definition of risk?  What a simple question – especially for a
question that is aimed at risk professionals!  However, in working with
clients – both financial institutions and corporate clients – I am
continually struck with how few Board Members, Executives and Risk Managers
have actually taken the time to ponder this very important and influential
question.  (The answer to this question is important and influential I hear
you ask?! – well read on and I shall attempt to explain.)

There are two polar answers to the question "What is the definition of
risk?"  The first answer is;

·        "Risk is the possibility of adverse events that prevent an
organization from achieving its goals". 

A second answer is;

·        "Risk is the possibility of events that prevent an
organization from achieving its expected outcomes".   

Now with a quick reading (I confess to practicing Speed Reading myself) these
two definitions appear to be pretty similar, but a little more thought shows
that they are in fact quite different with very different implications.  The
first definition looks at one way risk – namely downside risk.  The second
definition looks at two-way risk, namely upside and downside risk.  In a
simpler way, the second definition could be stated as:

·        "Risk is the possibility that bad or good things may
happen."

You may still be saying "so what!?"  Well let's examine a couple of
implications.  The first aspect to look at is how we generally measure
risk.  One common measure of risk is the standard deviation of possible
outcomes. 




The formula above says to take each result (Ri) and subtract from it the
average result, (Ravg), then square it, divide by the number of observations
(n) minus one, and then take that result and take the square root of it.

Notice that if the average expected result is 5, (for example $5 MM of
positive cash flow), then a realized result of "15" would be considered
riskier than a realized result of "4". Furthermore a realized result of
"15" would be considered riskier than a realized result of a "-2". 
This is obviously counter to the definition of risk as "the possibility of

adverse events that prevent an organization from achieving its goals". 
For this definition the appropriate measure of risk is actually semi-standard
deviation which is rarely used in practice simply due to the fact that the
measure is not as well known as standard deviation.  Semi-standard deviation
is given by the formula:



When calculating semi-standard deviation there are two differences with
conventional standard deviation.  The first difference is that instead of
using the average result as the central point of deviation, it is the
benchmark, or objective result that is used as the point to calculate
deviations.  The second difference is that only those realized results that
are below the benchmark factor into the calculation.  Good, or above
benchmark results are not used to calculate the risk.

Therefore if you use standard deviation (or equivalently variance) as one of
your risk measures then you are implicitly assuming the second definition of
risk – although explicitly it may be the first definition that is in the
mind of Board Members and Executives.

At this point – in part depending on how well you enjoyed high-school
statistics – you may think this is all mathematical quibbling.  However
there are even more important and direct implications of the choice for the
corporation's definition of risk.  One of the crucial implications is
whether the corporation uses options or forwards (and equivalently swaps) as
its instrument of choice for hedging.  That is the topic of the next
installment of this series "What is the Definition of Risk? Part 2".