Q&A—Corporate Financial Risk
Q&A: Managing Corporate Financial Risk
Prudent business leaders seek to minimize the impact of risk from all sorts of macroeconomic events: oil price fluctuations, the Canadian dollar’s rapid decline in value, the Euro’s volatility and Russian geopolitical concerns. But most business leaders seek help minimizing risks like these after the fact —even though they know they should address risk at exactly the opposite time.
Identifying risks that go beyond the headlines, long before obvious problems are looming, is key, says Bob Tull, managing director and global head of financial risk management at Fifth Third Bank. Bob Tull and his team are responsible for evaluating the financial impact of interest rates, foreign currency and commodity movements on businesses. They use this insight to help clients mitigate risk.
We asked how Tull helps his clients identify risk and mitigate it.
Q: What kinds of conversations are you having about risk?
A: We discuss the impact of both well-known and lesser-known current events. There is what we call “headline risk” and then there are the risks that lie beneath the headlines.
Q: How do you scope out risk?
A: We get a good understanding of everything our client’s company is involved in. Some clients know they have certain risks, but they don’t realize other risks. We want to help them confirm risks they see and identify potential flash points they may not be aware of.
A second thing we do is identify their risk tolerance and help them create policies and procedures around it. There is market-driven cost to any sort of hedge you put on protecting against a future event. Just because you have a risk, doesn’t mean you need to or can afford to hedge it.
Q: How do you determine whether a hedge is financially viable?
A: We create a “shock analysis” to help identify our client’s risk tolerance. For instance, what if a currency or a commodity moves 5 percent, or 20 percent? Is it meaningful? How much will it cost to mitigate?
Sometimes a client will say, “I’ve got a pretty high tolerance.” Clients may believe that they have a high tolerance for volatility or risk until they see an analysis that truly paints a picture of the potential impact. That is when we see that their tolerance isn’t as high as they may have originally thought.
Q: What does hedging against risk cost?
A: The cost is based on the asset class we’re protecting, the volatility of that asset class, the underlying risk and the duration of time the client is looking to hedge. Assessing risk is a dynamic process, and once the hedge is implemented, it is reviewed frequently to determine how effective it is. As market conditions change, that hedge may need to be restructured. For instance, when we’re attempting to hedge against an event with a long time frame, there’s far greater uncertainty. That means we get more volatility and higher cost with that hedge. The longer the duration of the hedge, the greater the cost associated with it.
Q: What are some risks you bring to clients’ attention?
A: We will look at their operations and try to identify risks that exist from a currency standpoint. We will also examine commodity input and output as well as the impact the interest rate environment has on both their debt and their current and future expected cash flows. We will look at their global operation and assess what currency risks may be apparent. This would include direct foreign exchange risk and indirect economic risk that occur when a client pays or receives U.S. dollars from their importing or exporting activities. Many companies believe that if they do business exclusively in U.S. dollars, they have insulated themselves from currency risk. But that is not always the case — there are underlying risks that exist even in those scenarios.
From a commodity standpoint, we will help companies identify various inputs and outputs in their business practices. We will help make them aware of risk that they may not have fully realized or quantified.
For instance, with interest rates at historically low levels, there can be an impact on the company’s cash and use of cash, as well as its longer-term debt structure and debt cost. If beneficial, we’ll help the company take advantage of the current interest rate environment to assist in keeping their cost of capital at a competitive level over the next three to five years.
Q: What are some strategies for hedging those risks?
A: There is no one strategy. Specific strategies are determined by risk appetite, organizational structure and product suitability for the underlying risk.
Q: Can you give an example of how you helped hedge a systemic risk?
A: Sure. One of our clients had direct exposure to oil and the Canadian dollar. The client received payments in Canadian dollars but also had fuel usage costs. When oil prices were high, there was an increased cost to the business, but the strength of the Canadian dollar created additional value for the company’s accounts receivable. The Canadian-dollar receivables were key to the company’s cash flow.
As the Canadian dollar broke parity with the U.S. dollar, we created a graph that showed the correlation between oil prices and the Canadian dollar. While the company was concerned about the high oil prices, we determined that the best value for the company was to hedge the Canadian-dollar receivables, since the impact of a weakening Canadian dollar would be more significant to the company than dropping oil prices. We used a program to hedge the Canadian dollars in the company’s accounts receivable over an 18-month period. When oil declined and the Canadian dollar weakened substantially, the company received the benefit of its higher accounts receivable value due to the hedging strategy we put in place. And it was also able to benefit directly from lower oil costs.
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