Defining Ways to Measure and Manage Risk

In managing a business, the CEO and other C-level executives develop plans and programs that will generate profitable growth. In developing these growth plans, there are always elements of risk that may create problems for the company and may prevent them from achieving its goals. These companies have to deal with risks and impact on several levels and via several classes of risk. Each class of risk has different significance. 

For example, companies may face risks in the following areas:

• ·        Business risk
• ·        Technology risk
• ·        Competitive risk
• ·        Regulatory risk
• ·        Environmental risk
• ·        Political risk
• ·        Financial risk.             

In some cases, there are norms for measuring risk. Norms, however, aren’t necessarily appropriate or available for all settings or purposes. Over time, I will cover each of these risk areas and provide prescriptions and tools for handling them in various blogs and whitepapers. In this blog, I want to cover one area of risk which is in the area of financial risk.

One of the most common risk measures in the financial services space is volatility of returns, usually quantified as the standard deviation of returns over a specific time period. Short term risk and long term financial risk are both measured by volatility. We can look at this in terms of two specific time frames: daily volatility and long term volatility. The return volatility, σ, for 100 days works out to be 10 times the volatility for one day. More concisely:

            σ₁₀₀ = (√100) _* σ₁ = 10 _* σ₁

We need to be careful here, as there is an implicit assumption that those daily return values follow a normal distribution. (You recall that bell-shaped curve that describes a normal distribution from statistics class, right?) This often isn’t too unreasonable as an assumption in “normal times” for many financial returns. But it may well be reasonably heroic in unusual times like those of today. Let me share an example from one company with which I worked.

For a number of years, I worked as head of risk management and chief compliance officer for a globally regulated firm that managed currency risk (a component of financial risk) for institutional investors from all over the world. This company used “risk of loss” as the metric of financial risk. The natural follow-on questions are how does one define risk of loss and how does one measure it accurately?

The definition of risk of loss is exactly what the words say: by being exposed to the risk, one will lose in the event the outcome is adverse. Conversely, one will gain when the outcome is favorable.

In order to measure risk of loss, one has to be able to measure and quantify two components:
            (i) exposure to the risk, and,

            (ii) the probability of occurrence of adverse moves.

In the context of currencies, exposure is simply the difference between the value of the underlying assets in local currency terms (e.g., the Yen value of a portfolio of Japanese stocks) and the magnitude of any hedge currently in place.

More concretely, suppose a manager has an international portfolio of stocks for a US pension fund. The value today of the Japanese investments is, say, JPY 10 billion, or about USD 90 million if the exchange rate yen is roughly JPY 111 = USD 1.

An equity portfolio manager typically does not forecast changes in exchange rates but rather attempts to outperform the Japanese equity market by selecting stocks expected to outperform the market. In order to protect the USD value of the portfolio, that equity manager might elect to hedge most of the currency exposure. By so doing, the risk level and impact of currency risk can be reduced. For example, the equity manager can sell forward say, JPY 9 billion to reduce the currency exposure by 90%. This means that if JPY increases relative to USD, the portfolio will only gain translation value on 10% of the portfolio as the manager, by dint of the passive hedging tactic, locked in the lower value with the hedge, i.e. the hedge will incur a loss. Conversely, if JPY falls relative to USD, the portfolio will only lose on the 10% exposed to currency movements.

The risk and impact may be charted as follows. This figure shows the initial risk-impact (H,H) and how, through the hedging tactic, “sell currency forward” the risk and impact both are reduced to a more tolerable and acceptable level, (M,M) as indicated by the direction of the arrow.

Now for the second part: How can one accurately assess the probability of an adverse outcome? To do this the firm had a model for the daily returns of currencies. The model did not, however, assume that currency returns follow normal distributions. Rather the model assumed a more flexible distributional form which allowed for skew in the distribution of currency returns. By doing this, the model could accurately assess the likelihood of adverse exchange rate movements. Given this assessment, which was updated daily, exposures to each of the currencies in an international portfolio could be adjusted to keep the probability of loss in an acceptable range. This allowed for the exposures to be adjusted in order to take advantage of favorable changes in exchange rates and reduce exposures when adverse movements occurred.

Rather than passively hedge a portfolio’s foreign currency exposure for some period of time, exposures could be actively managed. This was all made possible by choosing a more appropriate risk measure – here, risk of loss – and then actively managing the foreign currency exposures as described above. Overall the result of the hedging program tended to add value relative to a passive hedging program.

This is but one type of risk management as this blog focused on a financial, i.e. currency, risk. It shows that one must think carefully, and even creatively, about the risk metrics that one uses in a particular setting. While a risk metric may be definable and calculable, it may serve no useful purpose and potentially blind those using it to very real risks or even opportunities to add value. 

C-Level Partners helps companies grow their revenues and improve margins while managing risks and impacts. We believe these components must be designed as complements as part of a total growth system. If you would like to discuss your company’s specific business issues feel free to contact me on bnewton@clevelpartners.net. And if you like this blog and find it useful, please like it and share it with others.

The Regulation Conundrum Resolved

The misalignment in regulation: A conundrum resolved.

By Brian Newton

Do we need regulation? Is regulation good or bad? I feel the answer is usually “good” as long as customer needs are met and company initiatives are aligned. Additionally, the answer as to whether regulations are good or bad usually depends on the perspective of the constituent: government, consumer and company. Each likely has a different view. Regardless of the view, regulations exist and successful companies can and should deal with them using a solid business framework and by doing so we can realign business objectives with the regulation – more or less.

I will share a brief retrospective of one major regulation and then provide some thoughts and prescriptions for resolving the misalignment. Consider the Food, Drug and Cosmetic Act, under which over half of all items purchased in the US are regulated. (The following 2 paragraphs are drawn largely from the FDA website.)

The 1938 Food, Drug, and Cosmetic Act was a watershed in US food policy. Largely through the efforts of women’s groups which pioneered policies designed to protect the pocketbooks of consumers, food standards were enacted to ensure the ‘value expected’ by consumers.

The 1938 Act eliminated the ‘distinctive name proviso’ and required instead that the label of a food ‘bear its common or usual name’. The food would be misbranded if it represented itself as a standardized food unless it conformed to that standard. The law provided for three kinds of food standards: 1) standards or definitions of identity, 2) standards of quality, and 3) standards regulating the fill of container. Regulators had the authority to set standards ‘whenever in the judgment of the Secretary such action will promote honesty and fair dealing in the interests of consumers’.  That is a rule under which companies must operate.

The objective of the FDA is to ensure only quality products that are clearly described in their labels are available and consumers are thereby able to make informed decisions as to whether they want to purchase the product. In the case of drugs, labels also must describe any contraindications as well as possible side-effects so that the patient and healthcare professional are able to make an informed decision. What’s not to like about this?

Here’s the rub. Making quality products costs more. Whether it is high quality ingredients for foods, drugs, whatever, those ingredients cost more than lower quality ingredients. And properly labeling any product so that it is possible for the consumer to make an appropriate purchase decision, costs more than simply saying the product is, say, bread.

With real incomes declining in the US over the past 30+ years, the only way for companies to increase profits has been to reduce costs or provide less content for the same price (as long as the size was disclosed). Many more tasks have been automated and machines now perform those tasks. So labor costs have been reduced. Yet, if the size of the market is not increasing, other input costs must be reduced for profits to rise. One option: switch to lower quality inputs. Rather than all meat being used in dog food, one could include “meat by-products”. Since dogs, and many dog-owners, don’t read labels, the reduced cost of producing the dog food (without a commensurate price reduction) means higher profits for the producer. Other options exist that can grow the market through line extensions, new market development or broadening the eco-system. Yet many companies don’t consider these options for new routes to revenue and margin.

Okay, this is a simple example. However, it draws from an Econ 1 lecture by Prof. Richard Sutch at UC Berkeley for whom I was a teaching assistant. He was calling into question the use of price controls that Richard Nixon’s administration had imposed in the early 1970’s. His example was from a label of the cat food he had been using up until the price controls were imposed. Once the controls were in place, his cat stopped eating the food. (No, the cat really did not know about the regulations nor was he conversant in the rules, but the taste was different and this was a finicky cat.)  Eventually Prof. Sutch inspected the label. He found that new, lesser quality ingredients were now part of the cat food! Price increases may be limited and often result in a reduction in quality in order to increase profits. For human and pet food, as well as drugs, this is why the FDA exists – i.e., to ensure the foods and drugs provided for consumers (and their pets) in the US are of appropriate quality.

You may be wondering why I am writing this at all. After all consistently producing a quality product is exactly what a firm should do to build and maintain a strong reputation that consumers will recognize and value, and therefore purchase that firm’s products. So meeting the regulator’s requirements is simply good long-term business strategy. This begs the question: What’s missing?

Well, the management of many firms is often less interested in building and maintaining a firm’s reputation. Why would I say this? Firms’ managers, especially those in public companies, are compensated by short term bonus plans. If the firm increases profits, or more usually earnings per share (EPS), then senior management is paid a larger bonus. Ah yes, that old, very short-term, philosophy as emphasized by Wall Street. Indeed, it is not annual numbers but rather quarterly numbers that are the focus!

You know that regulations exist and given the explanation above, companies have to conform. Certainly they do. But let’s take a different view and let me offer some options that a company can implement to meet their business needs while aligning with the regulations.

1.   Strong leadership building a culture that keeps companies focused on doing the right things for customers.

2.   Company leaders can change the compensation structures to be more balanced between short term and long term goals.

3.   Keep customers happy, satisfied, and in the long run the company and consumers both win.

4.   Company leaders can set strategies to grow the market through line extensions, new market development or broadening the ecosystem.

5.   Understand the regulatory environment and see if there are ways to use the regulations to the company’s advantage. Sounds simple but often this is not easy to do. Companies must accept the fact that regulatory constraints exist and focus on those factors within their control.  In doing so, the companies must effectively manage their risks.

I don’t have the definitive answer to alignment yet these above prescriptions, among others, can be used to help companies focus on the right strategies and tactics. Let’s keep the dialog open and let me know if you have a contrary view. If your company or organization would like to discuss regulatory effects on your business and look at palatable options to engender change, please feel free to contact me at bnewton@clevelpartners.net.