Evidence has been piling up that a large number of Indian firms have posted losses due to exposure to derivative markets. Organizations in sectors such as pharma, information technology and steel have suffered losses.
By regulation and common sense, it is normally prudent for a company to only hedge those risks for which it has a genuine anticipated asset or liability. In many cases, companies seem to have used risk management tools to take on speculative positions without underlying transactions that really needed to be hedged.
Clearly, some companies have paid the price for not understanding the potential impact of the financial instruments they used.
Since 2008, there has been a clamour for greater oversight of the use of such products. At the same time, the previous year has seen exchange and interest rates fluctuate wildly. Despite current concerns about using complex derivative products, firms will need to continue to avail these risk management tools intelligently to control various elements of their balance sheets.
In doing this, boards and managements need to examine, more critically than they have done so far, the rationale behind their risk mitigating strategies. Although in the case of listed companies clause 49 of the listing agreement requires boards to review risk processes in the company, the jury is still out on how well this is done. Moreover, many companies that indulge in derivatives are small, unlisted entities that do not fall under the purview of clause 49.
There are simple rules that can help boards test the need for the use of risk mitigation tools. Importantly, the board needs to examine precisely what risk is sought to be controlled, and doing so requires considerable clarity regarding the financial goals of the organization. Risk management is intended to reduce the volatility of a company’s earnings. From a purist’s perspective, boards need to query the form this volatility takes and what is actually achieved by reducing volatility. One can then enquire whether the suggested risk management strategy actually achieves this.
Earnings volatility can have several undesirable consequences, the severity of which depends on the unique situation of each firm. The most common are described below.
The most common fallout of highly volatile earnings is that this increases the likelihood of financial distress, breached banking covenants and defaults on obligations. While actual default is the extreme manifestation of financial distress, there are a number of common situations where the value that a company is able to extract either from its lenders or from its customers is proportional to the likelihood of financial distress of that company.
A good example of how companies feel the pain of even the mere probability of financial distress is observed when companies issue warranties to customers, who later might have to utilize the same.
Where customers perceive a high chance of financial turmoil in a company, they would place a relatively low value on such a warranty and consequently pay less for the company’s products.
Note the manner in which customers seemed to stay away from General Motors Corp. and Chrysler Llc products as their Chapter 11 filings appeared imminent.
If by the utilization of the right risk tools one could reduce the likelihood of financial distress and consequently charge more from customers, there would be a case for the right form of hedging.
Earnings volatility can similarly cause managements to avoid taking on certain profitable investments they otherwise might have, in order to leave enough headroom between their earnings and the possible losses caused by new investments. Managements need to consider whether the use of volatility-reducing products can enable companies to take up those projects which they otherwise might not. Volatile earnings and the fear of financial distress dramatically increases an aversion to leverage. The tax shields that higher levels of debt would bring to the company can be a fallout of the good use of risk management products.
Equally, when a company’s effective tax rate increases with earnings, companies will pay lower taxes over a long period by reducing the volatility of their earnings. This would occur since the tax during years of high profits may not be offset fully during years of low profits. The shape of a firm’s effective tax curve would therefore impact the desire to reduce volatility.
It is moot whether boards consider these factors explicitly when they review the risk management strategies of their chief financial officers (CFOs). As a starting point, it is worth recalling that most hedging decisions implicitly factor in some view on how the market will move and seek to protect the company against downside risks.
The strategy used by the firm may vary based on the nature and value of downside risk. The risk of not servicing a warranty, an inability to fund a new opportunity and price uncompetitiveness are all different and need to be treated differently.
CFOs and treasurers are rarely forced to place values to these scenarios and then adapt their risk management strategies. Importantly, CFOs are often not asked why they believe that hedging a risk is better than not doing so. It is reasonable to assume that these issues do not get a lot of space in the agendas of board meetings.
Risk is the attendant of reward, the concomitant of complexity in the 21st century. Managing risk is one of the major competitive differentiators of our time. Perhaps because boards do not review this area often, even CEOs delegate the subject to finance and treasury professionals, who are often removed from the dynamics of the companies’ businesses.
Boards and CEOs can gain much by testing a company’s risk strategies against the touchstone of the above rules of thumb. Merely forcing the discipline of thoroughly asking the questions discussed above can result in some powerful insights. Boards, therefore, need to recognize that the prime drivers of risk management should be those factors that impact earnings volatility.
Where a management has recommended risk management without underlying reasons as discussed above, the board needs to take an even longer and harder look at the motivations behind the risk policy. As the results of many companies have shown, this is time well spent.
Govind Sankaranarayanan is CFO, Tata Capital Ltd.He writes on issues related to governance. The views expressed in this column are personal. Write to him at firstname.lastname@example.org