A Tale of Two Supermarkets

 

*/By Stephen McPhie, CA/*

*/Partner, RSD Solutions Inc./*

/(Repost of blog from January 24, 2011)/

Over the last couple of months I have heard two separate stories of customers
of two different large supermarkets being injured while shopping.  Both
customers happened to be elderly ladies. 

Lady A slipped and fell and twisted her ankle.  The injury was not serious
but the Supermarket arranged a cab home for her.  The store manager phoned
the next day to ask how she was getting on and promised to send a £25
shopping voucher, which he did.

Lady B was struck from behind by a large trolley used to replenish the
shelves and which was being pushed by an employee.  She was treated by the
store's first aid person and advised to go to hospital.  She did this and
required 5 stitches.  Her shoes were blood soaked and ruined.  She could
not wear shoes for a month and needed several follow doctor visits costing
cab fares each time.

Several letters from Lady B's family following no further communication
from the supermarket elicited only vague sympathy and the claim that the
employee pushing the trolley was pushed by another customer and thus denial
of liability.  They did eventually send a £25 shopping voucher as a
"gesture of good will" with the hope that the lady will not stop shopping
at their store.  The family are now engaging a compensation lawyer.

The prompt and caring action by the fist supermarket cost little and resulted
in a happy customer who will tell all her friends how nice the manager was to
phone and how well she was treated.

The story is not over yet for the second supermarket, but it faces not only
the possibility of significant compensation and legal costs, but also
potentially bad publicity.  There is also the risk that the bad publicity is
magnified if the media take up the story.

So what are the lessons for risk management?  They would seem obvious for
most, but in this case one large organisation appears to have been totally
blind to them.  Identifying the possibility (or, for supermarkets, the
likelihood) of such accidents and a protocol for dealing with them promptly
costs little but can turn the situation to their advantage.  There may be no
strict legal liability but even a few hundred dollars could prevent losing a
customer, possibly several, and bring positive publicity.

/UPDATE September 2013 – The supermarket in Lady B's case ended up
settling for several thousand pounds plus Lady B's legal fees.  Had they
offered something like £200 in the first case it probably would have been
accepted./

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".

One Forty-Thousandth

 

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

*/Follow us on Twitter/* [1]

I took a bit of a break last week to get away and try to squeeze a little bit
more summer out before it is gone for good.  As part of that I had a nice
leisurely stay at my sister's cottage.  Like all good cottages (and
doctor's offices) she has a stack of old magazines, which in my brain dead
state of mind I started to peruse.

While looking through one magazine that was five or six years old (maybe
older, maybe newer) I came across a car ad for a mid-priced car that had as a
header in bold letters "1/40,000 of a second".  It was an ad touting how
accurate the clock in the car was.  Now I am not so thick as to miss the
point that the ad is trying to get across – namely if they spend that much
effort on getting the clock to such a fine degree of accuracy, how well must
the rest of the car be put together.  However the rest of the ad gave no
indication of how well the rest of the car actually was put together.  The
entire ad focused on the clock! 

Now I don't know about you, but I really do not care if the clock in my car
is accurate to within one forty thousandth of a second or four seconds. 
Furthermore I can't tell the difference and neither can you.  Thus this
car company is wasting its time, and its energy on telling time.  Its energy
and its focus is totally misdirected.  Very accurate, but misdirected.

Now that I am back from my mini-vacation I cannot help but wonder how much
risk management is like that car company.  That is, how much risk management
is putting a lot of energy and effort into measuring some aspect of risk to a
very precise degree, when in reality it is focusing on the wrong things?


[1] https://twitter.com/rsdsolutions

Football – The Other One

 

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

*/Follow us on Twitter/* [1]

I just read a brief review of a new book that looks at the mathematics of
football – soccer that is for those of us on the west side of the
Atlantic.  The name of the book is The Numbers Game, and it is by academics
David Sally and Chris Anderson.  I have not read the book, but apparently
they conclude that it is the weakest player on a soccer squad that is more
significant to the success of the team than its strongest player. 

This is a somewhat counterintuitive result as the focus of any team is always
on the superstars.  The media sports pundits are always debating which
superstar will outperform and bring their "A game" to the big match. 
The bit players – the role players – barely get mentioned.  However as
the analysis apparently shows it is the role of these bit players to make a
play – or not – that are most significant in determining the outcome.

I suspect the same is true in risk management as well.  We focus on the big
risks – the superstar risks – and frequently underplay the role and
importance of the bit player risks.  However it is often how the "bit
player" risks "perform" that determine success or failure for the
organization.


[1] https://twitter.com/rsdsolutions

Cerebral Leaps

 

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

*/Follow us on Twitter/* [1]

In an article in the September 27, 2013 edition of the Report on Business
magazine, published by the Globe and Mail newspaper, there is a fascinating
article on the Bank of Canada's Governor Stephen Poloz.  The article is
written by journalist Kevin Carmichael.  It is one of the few articles that
have emerged that has provided a bit of a personal insight into the still
relatively new Governor.

The wide ranging article covers several issues, but there was one comment
made that just popped out at me, and one that I thought was rather
refreshingly honest for a public figure to make.   In talking about the
actions of the bank of Canada during the 2008 financial crisis, Poloz
comments,  "We were fighting fires, but it was not a cerebral leap
forward."

How often are we honest enough to admit to ourselves, much less others, that
we are simply fighting fires, rather than making "cerebral leaps"
forward?  How often do we confuse the two activities?  How much focus, time
and energy do we put on fighting fires versus "cerebral leaps" forward? 

What would the current state of risk management and risk regulation be if
more risk managers, executives and regulators put more focus on "cerebral
leaps" and less on fire firefighting?


[1] https://twitter.com/rsdsolutions