Why Robust Frameworks Matter…
At Martialis, we have a simple standard refrain: if it’s not written down it doesn’t exist.
In my mid-December blog I introduced the topic of decision-making frameworks and why they can be used to promote outcomes of higher quality in a range of fields exposed to uncertainty. I extended this into the area of hedging market risk, since financial markets are a field shrouded in uncertainty.
In today’s blog I am going to expand on this theme by presenting a catalogue of reasons why firms should carefully consider robust frameworks for managing market risk.
Charles had a framework
Working in financial markets in Melbourne in the early-1990’s I’d occasionally take a call from my entrepreneurially gifted friend Charles (a great friend to this day, but not his real name).
Since I worked in a major dealing room, Charles was always interested in what I thought of the Australian dollar exchange rate. It didn’t matter that I’d moved across from an utterly failed stint as a currency trader (FX-options) to an equally questionable time running a bond-option/swaption book, Charles wanted to know what I thought ‘Aussie’ might do (markets love their pet names); where was Aussie headed?
Charles business imported a unique brand of high-end outdoor gear and consequently had a particularly acute sensitivity to the value of the AUD/USD rate. His suppliers demanded monthly payments in USD while his sales were uniformly made in AUD, as is common among Australian businesses. Charles was “long-AUD,” in market parlance; if the Aussie fell his average cost of sales would balloon and his business would suffer accordingly.
Every so often I’d gently try to encourage Charles to ponder hedges that might help manage the obviously concerning risk. I’d find myself pricing up indicative combinations of forwards and various option structures, but I had to be careful; we were good friends and Charles needed formal advice from someone who didn’t have friendship skin in the game. That wasn’t me.
Then, in late 1995 on one of our calls, a large penny dropped for me: to the extent that Charles had a hedging framework it was that he’d simply budgeted on a low break-even exchange rate for the business. That is: all things being equal the business could survive profitably if the AUD remained persistently above USD 0.6400.
Charles had accepted a buffer based on an excessively big assumption, but not much else, and for an extended period the buffer strategy worked very well:
· Charles’ business average A$ rate for the five years to April 1998 for import goods approximated 0.7305, i.e., well above the necessary break-even.
· Through the 1996 calendar year the business enjoyed an average A$ of 0.7849.
· By simply covering payments with spot deals, Charles avoided the visually costly forward hedges that prevailed at that time (routinely 75-100 pips discount in the 1-year).
Until it didn’t.
In early 1998, with the global and Australian response to the Asian Financial Crisis, Australian term yields fell below comparable US rates and the AUD/USD dropped through 0.6400. It stayed below Charles’ business break-even for twelve months.
From April 1998 the average month-end spot rate was 0.6171, 229 basis points below Charles’ buffer, and a level which helped him decide to wind-up an otherwise successful retail business.
Despite this early-career setback, Charles managed to prosper in subsequent ventures and put the events of the Asian Financial Crisis behind him.
As my title of the December blog (The decision to do nothing is still a decision) attests: doing nothing is a decision, but could Charles outcome have been modified in the presence of a formal currency risk-management framework?
The answer is almost certainly yes, and I will mount a series of arguments as to why in the form of a high-level catalogue explaining the advantages.
Formality holds advantages (written policy matters)
It is worth considering the inverse of our axiom that what’s not written down and/or signed-off in a business doesn’t really exist, to-wit: what’s written down and signed-off matters and can matter a lot in certain circumstances.
While major firms lean heavily on formality, the establishment of well-written formal policy can matter in any business context in firms of any size and circumstance, for example in a well-defined market risk hedging program:
delineating who in a firm can hedge what, when and how;
avoiding confusion, inertia, and/or internal disputes ex-post and otherwise, and
promoting accountability, particularly decision-making accountability.
For firms exposed to market-risk that is meaningful (particularly relative to non-market factors) the presence of a written policy is crucial if the business is ever required to demonstrate that enterprise-outcomes were overwhelmingly the result of carefully geared management, not the result of unrepeatable factors or random chance.
This has proved a particularly sensitive topic in the case of businesses being targeted by an interested acquirer with the thorny question of: how did you decide to hedge or not hedge?
Delegations define latitude
Major financial firms place a heavy reliance on trading delegations to define what dealing staff can trade. These drivers’ licence-like instruments ensure that delegated staff are appropriately equipped and have due reason to deal in instruments and markets related to their area of risk and related needs.
For non-financial firms, several considerations as to ‘delegated authority’ arise when addressing the question of should-we-hedge? These include:
Maximum and minimum hedging boundaries, and discretionary adjustments considering one-off opportunities.
Hedge ratio latitude/flexibility, e.g., fixed component, discretionary component, and boundary triggers that may result in changes to the mix.
Delegated instruments, e.g., forwards, options, more complex options, structures may be appropriate.
Timing dimensions, e.g., hedge average/maximum tenor and frequency are essential.
Stop-loss boundaries, unloved throughout financial markets, are a crucial safety device.
In keeping with financials, non-financials should clearly define delegations consistent with how they wish delegated staff to address (or not address) market risk, and a high degree of delegation-tailoring should be evident. This is particularly the case where firms are willing to provide treasury staff with wide authority to accept market risk.
Quality decision-making remains central
The nature of any hedging framework will define the point at which decision-making quality plays its obviously crucial role. For example, highly restrictive policies that codify hedging arrangements front-load the need for quality decision-making, while lowering the subsequent responsibilities of treasury staff. Policies that offer too generously wide treasury delegations place their exposure to decision-making in the hands of delegated key staff.
We have been involved with firms across the range of degrees-of-latitude, and one common theme emerges: poor outcomes can happen in the presence of both high and low degrees of staff latitude.
This is where decision-making quality can be improved:
· Hedging decisions require specialist skills, and we note that firms that leverage those with specialist skills (or hire them in when warranted) tend to avoid common pitfalls.
· Repetition holds value; thus, regular forums that challenge policy or approaches to latitude ensure that market risks aren’t quietly ignored within management considerations.
· Governance structures imposed within a framework can reduce key-individual risk and take highly consequential decisions away from individuals and exposing them to challenge with decision-making forums (these can be particularly effective when markets move dramatically in both favourable and unfavourable directions).
· Product suitability is often ignored, with firms undertaking hedges in products unsuited to their central view or need, thus quality frameworks will consider product suitability boundaries rather than pro-former fixed hedges.
Performance management and culture
Having been involved in cases where a lack of hedging framework delivered some (really) difficult financial outcomes, including among some iconic Australian firms, it’s worth noting that the very presence of a framework, even the most basic, can drive confidence and better enterprise outcomes.
Where treasury teams are delegated to act, performance management aspects of frameworks are particularly beneficial:
benchmarking rewards and/or performance management;
driving accountabilities into the right hands;
triggering reviews where performance does not meet expectations;
calibrating targets consistent with firm goals; and
ensuring hedging activity is consistent with policy.
The most important point is that well-designed frameworks reduce the risk of policy being driven by reaction, where decisions are made in settings approaching panic and where randomness can lead to poor outcomes. In Charles’ approach, his business faced an existential threat as the AUD/USD rate approached 0.6400, at which time hedges became of little practical use.
Frameworks can and should be tailored
Finally, there is no case for a one-size-fits-all mindset with market risk hedging frameworks. These can and should be designed for the situation of the firm:
prevailing or strategic circumstances, e.g., latitude and appetite for risk and/or reward, extent of offsets and market-risk correlation gains/losses;
directions and goals, e.g., ensuring market risk is or is not a significant driver of overall enterprise performance;
degree of access to specific skills to achieve latitude; and
the extent of other firm resources.
Evidence of corporate formality matters where firms seek eventual main-board listings or the attention of acquirers. In these circumstances the absence of well established (and time proven) frameworks can be a major hurdle.
They are not mandatorY
Despite their benefits, frameworks are not mandatory.
In a competitive business context, we believe this makes them even more important. Why? Because the presence or absence of well-considered policy could be argued as definitional, defining the type of firm one is running and its prevailing culture.
Frameworks are designed to ensure that the things that should be managed get managed. And remember our cautionary refrain: if it’s not written down it doesn’t exist.