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Section ISection I

Identifying and understanding Identifying and understanding GAIL’s risk exposureGAIL’s risk exposure

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Overview

1. Analyzing GAIL’s risk exposure

2. Tools for quantifying risk

3. Impacts of risk on corporate performance – and how risk management can improve results

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1. Analyzing GAIL’s risk exposure

To put it simply and directly, if the bosses do not or cannot understand both the risks and rewards in their products, their firm should not be in the business.

William J. McDonough, PresidentFederal Reserve Bank of New York

"A Regulatory Perspective on Derivatives"

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Inputs Outputs

Decisions

Operational environment

prices

marketingupstream investments

supply decisions

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AN EXPLANATION OF RISK, FROM CONTINGENGY ANALYSIS (www.riskglossary.com)

Risk has two components: uncertainty, and exposure. If both are not present, there is no risk.

If a man jumps out of an airplane with a parachute on his back, he may be uncertain as to whether or not the chute will open. He is taking risk because he is exposed to that uncertainty. If the chute fails to open, he will suffer personally.

In this example, a typical spectator on the ground would not be taking risk. They may be equally uncertain as to whether the chute will open, but they have no personal exposure to that uncertainty. Exceptions might include:

•A spectator who is owed money by the man jumping from the plane

•A spectator who is a member of the man's family

Such spectators do face risk because they may suffer financially and/or emotionally should the man's chute fail to open. They are exposed and uncertain.

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AN EXPLANATION OF RISK, FROM CONTINGENGY ANALYSIS (www.riskglossary.com)

A synonym for uncertainty is ignorance. We face risk because we are ignorant about the future. After all, if we were omniscient, there would be no risk. Because ignorance is a personal experience, risk is necessarily subjective. Consider another example:

A person is heading to the airport to catch a flight. The weather is threatening, and it is possible the flight has been cancelled. The individual is uncertain as to the status of the flight and faces exposure to that uncertainty. His travel plans will be disrupted if the flight is cancelled. Accordingly, he faces risk.

Suppose another person is also heading to the airport to catch the same flight. This person has called ahead and confirmed that the flight is not cancelled. Accordingly, she has less uncertainty and faces lower risk.

In this example, there are two individuals exposed to the same event. Because they have different levels of uncertainty, they face different levels of risk. Risk is subjective.

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Virtually every entity in today's world is exposed to economic risks. Some of these risks are unavoidable, some can be avoided with good management. Likewise, some risks are, in one way or another, insurable, others are not.

The character of risks is not always evident. E.g., the costs of drilling rigs and oil field services are not “external”, but are correlated with hydrocarbons prices – so they can be managed through long-term fixed-price or price-indexed contracts with service providers, or through hedging.

Risks can be managed with foresight. Damage can be controlled with hindsight. Your choice.

Coopers and Lybrand, L.P.Advertisement in The Wall Street Journal,

December 7, 1995

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The Universe of RiskThe Universe of Risk

IntegratedRisk

Hazard Risks

• Well-developed risk management practices and supporting industry

• Risk finance traditionally through insurance, but recently through captives and capital markets products as well

Financial Risks

• Well developed risk management practices and supporting industry

• Risk financing through derivatives

Strategic Risks

• Demand projections often have little credibility

• Operating costs often are underestimated

• Unforeseen capital costs can cause major problems

• No risk finance or other risk transfer methods

Operational Risks

• Developing risk management field

• Some risk financing in business interruption insurance; risk transfer through PEOs; business interruption services

• Customer/industrychanges

• Creditdefault

• Financial market risks

• Interest rate changes

• Currency/foreign exchange fluctuations

• Liquidity,cash flow issues

• Marketdemand

• Operating costs

• Key managers

• Information systems

• Supply chain

• Accounting/control systems

• Natural disasters

• Workers compensation

• General liability/legal risks

• Property damage

• Unexpected capital costs

• Business interruption

Source: Mercer Management Consulting

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Source: Goldman Sachs

Market risks: normally hedgeable

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Source: Goldman Sachs

Operational risks: usually not hedgeable, but manageable.

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Risk impact has different components:

• Margin risk: the company’s profit margin is at risk because of a mismatch between the cost and revenue sides

• Budget risk: the risk of exceeding previously set budget targets

• Cash flow risk, creating liquidity squeezes and hindering investments

• Performance risk: the economic environment can become prohibitively difficult.

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The major sources of risk

• Business risk (production, human, political….)

• Market risk (direct or indirect)

• Credit risk (default by a counterparty)

• Operational risk (human errors, system failure, inadequate procedures and controls)

• Liquidity risk

• Legal risk

• Model risk: inadequate model, or inadequate use of a model.

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For example: the For example: the LNG Value ChainLNG Value Chain

All links of the chain are capital intensive All links of the chain are capital intensive businessesbusinesses

~ $0.5-1.0bn ~ $3 bn~$0.1s bn~ $0.5bn~ $2 bn

LNG

ReceivingTerminal

Buying & Receiving

GasLNG

GasDistribution

Distribution

Shipping

Shipping

GasField

Development

Gas

Liquefaction

Upstream Projects

PowerGeneration

TownGas

End-Users

Source: ExxonMobil

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For risk analysis:

-identify the critical processes and components (go for the « doctrine of no surprises »)

- understand their risk implications

- identify the resultant cash flow risks (« cash flow at risk »)

- identify the wider corporate risks.

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Risk:

Inability to meet demand

Fluctuating demand for transport: with strong demand, both gas prices and transportation costs pipeline charges are high.

Risk mitigant:

Store large quantities of gas near market

Derivatives, cash reserves

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Urea

Coal

Henry Hub

Crude oil

LIBOR

YenUS$ Exchange rates

Total

Individual risks

Aggregaterisks

Total risks

Interest rates

Commodities

Analyzing price risks: starts with « what is the impact of a 1$ price change on company profits?

And then, look at correlation…

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One should also consider risk by business unit; e.g., at 1% probability:

1 2 3 4 5 6 7 8

loss

Business units

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And you can compare this with the units’ shares in expected profit and allocated capital….

1 2 3 4 5 6 7 8

lossprofit

capital

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1 2 3 4 5 6 7 8

lossprofit

capital

The company’s major unit is underperforming….

Doing very well

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Return on capital employedAverage return Standard Risk adjusted Worst caseon capital deviation return on cap. at 95%

Current businesses

1.

2.

Potential new businesses

3. 11.4 % 9.8% 1.1% -2.2%

4. 9.3 % 6.3% 1.4% 0.2%

Source: Goldman Sachs

What new business will you invest in?

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2.Key tools to quantify risks2.Key tools to quantify risks

You take risks in whatever you do. But if you understand, measure and account for them, that should keep you out of trouble.

Dennis Weatherstone, Chairman and CEO, JP MorganBusiness Week, October 31, 1994

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Risk management is not to ensure that losses do not happen,but to ensure that losses are kept within

« acceptable limits »

As such, it is a top management and Board responsibility.

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Using models to assess risksUsing models to assess risks

The use of a formal model can help company treasurers, and The use of a formal model can help company treasurers, and other managers, to get a clearer idea of the extent to which the other managers, to get a clearer idea of the extent to which the company is exposed to price risk. These models can be used for company is exposed to price risk. These models can be used for the company as a whole, and also, for particular instruments the company as a whole, and also, for particular instruments (e.g., one complex derivatives contracts), or group of instruments (e.g., one complex derivatives contracts), or group of instruments (e.g., the total exposure of one division). There are four major (e.g., the total exposure of one division). There are four major types of models, which are often used to complement each other:types of models, which are often used to complement each other:

asset/liability analysisasset/liability analysis value-at-risk (VAR)value-at-risk (VAR) stress-testingstress-testing Risk-Adjusted-Return-on-Capital (RAROC)Risk-Adjusted-Return-on-Capital (RAROC)

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Too large a proportion of recent "mathematical" economics are more concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.

John Maynard KeynesThe General Theory of Employment, Interest and Money, 1936

Mathematical risk quantification has become a pseudo religion that pacifies our insecurity. Models have become sacred pagan gods, but God's wrath can change.

Randall PayneRisk Professional, September, 1999

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How does one determine « acceptable limits »?

What maximum loss is the company willing or able to withstand in a given period, at a given confidence level.

Two issues:

• Expected loss: the company has to build this into the pricing of its products.

• Unexpected losses: the company has to ensure that it has the « economic capital » to deal with these.

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Quantifying « unexpected losses »:

The sum for each of the company’s operations, corrected for correlations/portfolio effects, of the following:

Probability of default

X

Exposure at default

X

Loss given default

So, good data are essential. « Garbage In, Garbage Out »

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Measuring economic capital is an art rather than a science.

Still, there are tools for quantification. And even an idea of the economic capital that needs to be put aside to ensure survival of certain activities within a certain confidence interval allows senior management/the Board to:

• allocate capital along business lines

• screen proposed new transactions/counterparties/ business lines (is the Risk Adjusted Return on Capital high enough?)

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The traditional approach to analyzing a company’s risk exposure is The traditional approach to analyzing a company’s risk exposure is Asset/Liability Analysis. This approach works as follows:Asset/Liability Analysis. This approach works as follows:

1. A hypothetical scenario is selected that describes how 1. A hypothetical scenario is selected that describes how various financial variablesvarious financial variables - commodity prices, interest - commodity prices, interest rates, inflation, etc. - might evolve over an extendedrates, inflation, etc. - might evolve over an extended horizon.horizon.

2. This scenario is used to simulate the cash flows and the 2. This scenario is used to simulate the cash flows and the accounting value of assets and liabilities as they would accounting value of assets and liabilities as they would develop over time, assuming that the scenario becomesdevelop over time, assuming that the scenario becomes reality.reality.

3. The process is repeated for other scenarios in order to 3. The process is repeated for other scenarios in order to consider a range of future outcomes.consider a range of future outcomes.

Asset/liability analysisAsset/liability analysis

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The actual variables The actual variables incorporated into scenarios will incorporated into scenarios will depend on the assets and depend on the assets and liabilities considered. For liabilities considered. For example, an oil refinery might example, an oil refinery might use asset/liability analysis to use asset/liability analysis to analyze the likely profitability analyze the likely profitability of an expansion programme. of an expansion programme.

A scenario might project paths over the next ten years for A scenario might project paths over the next ten years for swap interest rates, currency exchange rates, and swap interest rates, currency exchange rates, and refinery margins. Likely, the scenario would reflect refinery margins. Likely, the scenario would reflect reasonable relationships between these variables. A reasonable relationships between these variables. A sophisticated analysis might make other assumptions as sophisticated analysis might make other assumptions as to how the refiner would alter its risk management to how the refiner would alter its risk management behavior in response to changing market conditions.behavior in response to changing market conditions.

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Asset/liability analysis is a flexible methodology that allows Asset/liability analysis is a flexible methodology that allows the user to test interrelationships between a wide variety of the user to test interrelationships between a wide variety of risk factors including: market risks, liquidity risks, actuarial risk factors including: market risks, liquidity risks, actuarial risks, management decisions, uncertain product cycles, etc. risks, management decisions, uncertain product cycles, etc.

It has the It has the shortcomingshortcoming of being of being highly subjectivehighly subjective. It is up . It is up to the users to decideto the users to decide what are appropriate scenarios. The what are appropriate scenarios. The user must also analyze the results and determine their user must also analyze the results and determine their significance. significance. Accordingly, asset/liability analysis is not so Accordingly, asset/liability analysis is not so much a measure of risk as it is a tool which supports the much a measure of risk as it is a tool which supports the analysis of risks.analysis of risks.

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Asset/liability analysis is slowing being supplanted by more Asset/liability analysis is slowing being supplanted by more objective statistical measures of risk. This is happening for objective statistical measures of risk. This is happening for two reasons: two reasons:

As markets become more liquid, market valuations are As markets become more liquid, market valuations are becoming available for a greater range of assets and becoming available for a greater range of assets and liabilities. This facilitates statistical risk liabilities. This facilitates statistical risk mmeasurement.easurement.

Advanced technology is making possible many forms of Advanced technology is making possible many forms of advanced statistical risk measurement that were not possible advanced statistical risk measurement that were not possible in the past.in the past.

There will, however, always be illiquid assets or liabilities for which There will, however, always be illiquid assets or liabilities for which market values are unavailable, so there should be a continuing role for market values are unavailable, so there should be a continuing role for some forms of asset/liability analysis.some forms of asset/liability analysis.

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Value-at-Risk (VAR)Value-at-Risk (VAR)

In other words, this approach:In other words, this approach:

1.1. Calculates the dispersion of prices, interest rates, and other Calculates the dispersion of prices, interest rates, and other assets which are important for the company around their trend.assets which are important for the company around their trend.

2.2. Then calculates for example the standard deviation of prices Then calculates for example the standard deviation of prices etc. etc. 68% of the time, the asset prices fall within the average plus or 68% of the time, the asset prices fall within the average plus or minus one standard deviation - e.g., the average oil price is minus one standard deviation - e.g., the average oil price is 3030 US$/barrel, and the standard deviation is 5 US$, then 68% of the US$/barrel, and the standard deviation is 5 US$, then 68% of the time, the oil price will be between time, the oil price will be between 2525 US$ and US$ and 3535 US$ a barrel. US$ a barrel.

3.3. A monetary value is then given to the negative results: e.g., A monetary value is then given to the negative results: e.g., how large will the company’s loss be if the price is how large will the company’s loss be if the price is 2525 US$ a US$ a barrel? This monetary value is a “Value-at-Risk” at this 16% barrel? This monetary value is a “Value-at-Risk” at this 16% risk level. Normally, these values are also calculated for other risk level. Normally, these values are also calculated for other risk exposures (e.g., 10%, 5%, 1%).risk exposures (e.g., 10%, 5%, 1%).

The Value-at-Risk (VAR) approach provides The Value-at-Risk (VAR) approach provides a a measure that indicates how measure that indicates how much money a company could lose by holding a position for a specific much money a company could lose by holding a position for a specific period of time, given a certain confidence interval (logic: the company has period of time, given a certain confidence interval (logic: the company has to hold enough capital to cover, say, 84%, or 99% of possible losses).to hold enough capital to cover, say, 84%, or 99% of possible losses).

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What is the likelihood of prices falling below certain levels? And what is the corresponding loss?

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In other words, VAR forces a company, or the manager In other words, VAR forces a company, or the manager of a portfolio, to make a public statements along the of a portfolio, to make a public statements along the following lines:following lines:

   ““With the strategy followed so far, we have made With the strategy followed so far, we have made nice profits. nice profits.  However, if we continue in this  However, if we continue in this manner, there is a chance of one manner, there is a chance of one out of 20 that in out of 20 that in the coming year, we will lose at the coming year, we will lose at lleasteast ……10million...100 million …1 billion US$….”10million...100 million …1 billion US$….”

And implicit in this is that “it can be even worse”.And implicit in this is that “it can be even worse”.

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The three most common softwares are:The three most common softwares are:

The most popular is RiskMetrics. RiskMetrics The most popular is RiskMetrics. RiskMetrics publications, as well as sets of data that can be publications, as well as sets of data that can be downloaded in order to keep the model up-to-downloaded in order to keep the model up-to-date, are available at URL date, are available at URL http:/www.riskmetrics.comhttp:/www.riskmetrics.com

There are also a number of other commercial There are also a number of other commercial softwares.softwares.

Companies often develop their own in-house Companies often develop their own in-house programmes.programmes.These softwares vary in sophistication. Some use standard These softwares vary in sophistication. Some use standard deviations (which presume a normal distribution of values), deviations (which presume a normal distribution of values), others use Monte Carlo simulation to cope with the risks of others use Monte Carlo simulation to cope with the risks of the skewed distribution of returns of certain assets (e.g., the skewed distribution of returns of certain assets (e.g., most commodity prices are skewed to the right).most commodity prices are skewed to the right).

For a portfolio of assets (e.g., exposure to oil price risk, interest rate For a portfolio of assets (e.g., exposure to oil price risk, interest rate risk, etc.), the covariance of asset prices is calculated, to arrive for the total risk, etc.), the covariance of asset prices is calculated, to arrive for the total risk for the full portfolio. risk for the full portfolio. Naturally, this quickly becomes complex, and in Naturally, this quickly becomes complex, and in practice, one needs specialized software for a VAR analysis.practice, one needs specialized software for a VAR analysis.

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Risk MetricsRisk Metrics    Risk MetricsRisk Metrics is a tool for measuring risk, based on a huge data set of is a tool for measuring risk, based on a huge data set of

volatilities and correlations between various kinds of financial volatilities and correlations between various kinds of financial instruments. instruments.

These instruments are: These instruments are:

Basic assumptions for the model are: Basic assumptions for the model are: Normality of returns Normality of returns

Forecasts of volatilities and correlations using Exponentially Forecasts of volatilities and correlations using Exponentially Weighted Moving Average Model (EWMA) which gives the latest Weighted Moving Average Model (EWMA) which gives the latest data more weight and therefore more influence in the estimation.data more weight and therefore more influence in the estimation.

fixed income fixed income (government & (government &

non-non-government)government)EquityEquity

CommoditiesCommodities

Foreign Foreign exchangeexchange

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Risk Metrics is a valuable tool in the sense that it provides a Risk Metrics is a valuable tool in the sense that it provides a standardized measure of risk. But it can become risky if the users are standardized measure of risk. But it can become risky if the users are not aware of its assumptions as well as the the limitations of the VaR not aware of its assumptions as well as the the limitations of the VaR concept in itself. concept in itself.

VaR models such as Risk Metrics can become misleading ifVaR models such as Risk Metrics can become misleading if : :

Estimation of probability distributions of prices is not adequate: Estimation of probability distributions of prices is not adequate: crashes occur in real markets much more often than a normal crashes occur in real markets much more often than a normal distribution would predict.distribution would predict.

Valuation models for the securities in the portfolio, such as Black and Valuation models for the securities in the portfolio, such as Black and Scholes are based on mistaken values. For instance, prices are Scholes are based on mistaken values. For instance, prices are usually difficult to calculate in illiquid markets or for non-continuously usually difficult to calculate in illiquid markets or for non-continuously traded assets. Then VaR will then be calculated for a portfolio whose traded assets. Then VaR will then be calculated for a portfolio whose value is wrong in the first place.value is wrong in the first place.

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Value-at-Risk – the problemsValue-at-Risk – the problems

   The Value-at-Risk approach has a number of important The Value-at-Risk approach has a number of important weaknesses:weaknesses:

- It can be tempting for some to use it as a “black box”, accepting the It can be tempting for some to use it as a “black box”, accepting the outcomes without any real understanding of the ways that these outcomes without any real understanding of the ways that these

outcomes were arrived at. This creates complacency, outcomes were arrived at. This creates complacency, and may lead and may lead to wrong decisions when market conditions change.to wrong decisions when market conditions change.

The large hit you will take next The large hit you will take next

will not resemble the one you took lastwill not resemble the one you took last

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-- related to this, VAR is based related to this, VAR is based on certain assumptions, on certain assumptions, which may change over time. which may change over time. In many companies, risk In many companies, risk managers are given a “Value-managers are given a “Value-at-Risk”, a risk limits to which at-Risk”, a risk limits to which they can be exposed to they can be exposed to before senior management before senior management intervenes. Such use is intervenes. Such use is sound, assound, as long as traditional long as traditional prudential controls are not prudential controls are not weakened.weakened.Traders with frequent losses hurt you Traders with frequent losses hurt you

but they are not likely to blow you up. but they are not likely to blow you up. Beware of traders who make a steady incomeBeware of traders who make a steady income

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- VAR is better as a tool to analyze the relative benefits of VAR is better as a tool to analyze the relative benefits of different business activities within a company than to analyze different business activities within a company than to analyze the risks of the company as a whole. Thus, it is a relatively the risks of the company as a whole. Thus, it is a relatively good tool to decide how to allocate capital, reorient business good tool to decide how to allocate capital, reorient business activities and so on; but, although it is frequently used for this, it activities and so on; but, although it is frequently used for this, it does not give an “overall risk measure” for the company.does not give an “overall risk measure” for the company.

-- As it was developed by and for bank operations in financial As it was developed by and for bank operations in financial markets, VAR was developed as a tool to get an estimate of the markets, VAR was developed as a tool to get an estimate of the potential losses between now and the next daypotential losses between now and the next day, or two weeks, or two weeks. . It is not necessarily a good tool for estimating longer-term risk It is not necessarily a good tool for estimating longer-term risk exposure.exposure.

-- VAR is based on the law of averages. VAR is based on the law of averages.

Never cross a river because it is “on average” Never cross a river because it is “on average” oneone meter deep meter deep

A statistician can have his head in an oven and his feet in ice, and he will say that on the average he feels fine.

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The Value-at-Risk method is based on assumed volatilities and correlations The Value-at-Risk method is based on assumed volatilities and correlations for various market variables, typically based on historical data. for various market variables, typically based on historical data. In other In other words, a VAR-model assumes that market behavior is stable, and that the words, a VAR-model assumes that market behavior is stable, and that the statistical characteristics which the markets have displayed in the past will statistical characteristics which the markets have displayed in the past will continue to drive their behaviour in the future.continue to drive their behaviour in the future. If the system is used to force If the system is used to force a bank’s or company’s traders (speculators) to go for assets with a a bank’s or company’s traders (speculators) to go for assets with a historically low VAR, it can force them to ignore the real risk of a change in historically low VAR, it can force them to ignore the real risk of a change in these historic relationships (e.g., invest in a traditionally stable currency, these historic relationships (e.g., invest in a traditionally stable currency, even if there is a high risk of devaluation).even if there is a high risk of devaluation).

Therefore, VAR does not encompass the risk that market behaviour may Therefore, VAR does not encompass the risk that market behaviour may fundamentally change. In order to provide some protection against this fundamentally change. In order to provide some protection against this “model risk”, stress testing is normally used to determine what would “model risk”, stress testing is normally used to determine what would happen if some of the critical assumptions of the VAR-model no longer hold happen if some of the critical assumptions of the VAR-model no longer hold true. true.

In effect , VAR should always be In effect , VAR should always be combined with stress-testing.combined with stress-testing.

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Stress -testingStress -testing

Stress-testing isStress-testing is a risk analysis method whereby the a risk analysis method whereby the performance of an instrument, or a portfolio of performance of an instrument, or a portfolio of instruments (including the whole of the company) instruments (including the whole of the company) under one or a handful of user-defined market under one or a handful of user-defined market scenarios is tested. Stress testing is frequently used scenarios is tested. Stress testing is frequently used to supplement Value-at-Risk measures.to supplement Value-at-Risk measures.

The major weakness of stress-testing is that the The major weakness of stress-testing is that the limited number of scenarios chosen always will miss limited number of scenarios chosen always will miss the vast majority of possible "stress" events. The the vast majority of possible "stress" events. The results should thus be used carefully. results should thus be used carefully.

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Stress –testing- an exampleStress –testing- an exampleAssume that jet fuel prices and gasoil prices are historically Assume that jet fuel prices and gasoil prices are historically closely correlated. A VAR model that incorporated this historical closely correlated. A VAR model that incorporated this historical correlation into its analysis would ignore the possibility of the correlation into its analysis would ignore the possibility of the two commodities dramatically moving against each other—more two commodities dramatically moving against each other—more specifically, it would recognize the possibility, but assign it a specifically, it would recognize the possibility, but assign it a very low probability. very low probability.

With a stress test, the risk manager could directly analyze what With a stress test, the risk manager could directly analyze what might happen if the correlation between the two commodities might happen if the correlation between the two commodities broke down. This could be done by considering two scenarios:broke down. This could be done by considering two scenarios: Gasoil increases in value relative to jet fuel by 10% over the Gasoil increases in value relative to jet fuel by 10% over the

next week.next week. Gasoil decreases in value relative to jet fuel by 10% over Gasoil decreases in value relative to jet fuel by 10% over

the next week.the next week.

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The two scenarios have nothing to do with the The two scenarios have nothing to do with the historical trading patterns of the two commodities. historical trading patterns of the two commodities. No probability is assigned to either scenario. No probability is assigned to either scenario. The risk The risk manager simply asks: "what would happen if one of manager simply asks: "what would happen if one of these scenarios came to pass?”these scenarios came to pass?”

By analyzing the impact that stress scenarios would By analyzing the impact that stress scenarios would have on a portfolio, the user can identify exposures have on a portfolio, the user can identify exposures that might not be identified by statistical risk that might not be identified by statistical risk measures. These could include risks associated with measures. These could include risks associated with cross hedges or way-out-of-the-money options. As cross hedges or way-out-of-the-money options. As with asset/liability analysis, results are highly with asset/liability analysis, results are highly sensitive to user assumptions. sensitive to user assumptions.

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Similar stress tests can be done for other « random hazards ». And the Board/management can decide on how much risk they are willing to take with respect to such hazards.

E.g., unexpected random hazard loss should not exceed 10% of profit, or reduce equity by more than 2%, or cash flow by more than 5%. (Source: AON)

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Risk-Adjusted Return On Capital Risk-Adjusted Return On Capital (RAROC)(RAROC)

RAROC is a comprehensive risk management tool; in a RAROC is a comprehensive risk management tool; in a way, VAR is one of its constituent elements. Just like the way, VAR is one of its constituent elements. Just like the VAR approach was made popular when, JP Morgan VAR approach was made popular when, JP Morgan made its RiskMetrics programme available on the made its RiskMetrics programme available on the Internet in 1994, so the RAROC approach became Internet in 1994, so the RAROC approach became accessible with Bankers Trust’s publication of the accessible with Bankers Trust’s publication of the methodology in 1997.methodology in 1997.

The VAR approach only looks at risk. It does not balance The VAR approach only looks at risk. It does not balance risk and return. The RAROC approach is meant to risk and return. The RAROC approach is meant to correct this weakness.correct this weakness.

RAROC allows to link returns and riskRAROC allows to link returns and risk

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CCreate a formal model of the risk portfolio.reate a formal model of the risk portfolio. For example, what is the For example, what is the exposure to US$ risk; what is the exposure to oil price risk? Company exposure to US$ risk; what is the exposure to oil price risk? Company risks are thus put into pre-set categories, with the correlation between risks are thus put into pre-set categories, with the correlation between categories already built in.categories already built in.

EEstimate “capital at risk”.stimate “capital at risk”. This is calculated as the amount of capital This is calculated as the amount of capital needed to cover the worst 1% of possible outcomes, given historical needed to cover the worst 1% of possible outcomes, given historical risk distribution - in the Bankers Trust model, a Monte Carlo simulation risk distribution - in the Bankers Trust model, a Monte Carlo simulation is used to identify the losses resulting from the 1% of worst outcomes.is used to identify the losses resulting from the 1% of worst outcomes.

AAttributettribute the capital at risk the capital at risk over different business units, categories of over different business units, categories of instruments, etc.instruments, etc. The model then allows to test different scenarios: The model then allows to test different scenarios: adding new positions, adopting a hedging strategy, changing asset adding new positions, adopting a hedging strategy, changing asset allocation. Sensitivity analysis is also possible, to identify the possible allocation. Sensitivity analysis is also possible, to identify the possible effect of hypothetical changes in interest rates, exchange rates, etc. effect of hypothetical changes in interest rates, exchange rates, etc.

Ste

p 1

Ste

p 2

Ste

p 3

The RAROC approach

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From an operational point of view, RAROC allows a company From an operational point of view, RAROC allows a company to segment risk into all of its components. And not in an to segment risk into all of its components. And not in an abstract way, but actually, by attributing the amount of capital abstract way, but actually, by attributing the amount of capital which is at risk in each component. This capital at risk can which is at risk in each component. This capital at risk can then be compared to the returns made by this component. then be compared to the returns made by this component.

In other words, companies can use RAROC to ensure that the In other words, companies can use RAROC to ensure that the magnitude of returns fits the magnitude of the risks it is taking. magnitude of returns fits the magnitude of the risks it is taking. If the two are not commensurate, the company can decide to If the two are not commensurate, the company can decide to allocate its capital in a more attractive manner.allocate its capital in a more attractive manner.

RAROC is a tool to help a company determine RAROC is a tool to help a company determine whether it has the right return the right mix of whether it has the right return the right mix of

assets the best possible management of assetsassets the best possible management of assets

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RAROC allows for a more efficient capital allocation, and thus, RAROC allows for a more efficient capital allocation, and thus, expected return can be improved while keeping risk constant.expected return can be improved while keeping risk constant.

At the operational level, RAROC allows a company to evaluate whether the At the operational level, RAROC allows a company to evaluate whether the risk-adjusted return on a possible new transaction is good, compared to risk-adjusted return on a possible new transaction is good, compared to the transactions already in the portfolio, or compared to a certain objective.the transactions already in the portfolio, or compared to a certain objective.

On the other hand, as the scope of RAROC is rather broad, it requires a On the other hand, as the scope of RAROC is rather broad, it requires a more extensive approach to risk management than do other approachesmore extensive approach to risk management than do other approaches..

Most importantly, a set of clear policies from senior Most importantly, a set of clear policies from senior management (including procedures and standards) is required management (including procedures and standards) is required together with a level of organizational maturity that ensures together with a level of organizational maturity that ensures the needs of the business are not stifled by the requirements the needs of the business are not stifled by the requirements of risk tracking. of risk tracking.

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USING THE VARIOUS MODELS :USING THE VARIOUS MODELS : THE PRACTICAL ASPECTS THE PRACTICAL ASPECTS

For commodity firms, there are really two factors that enter into the decision For commodity firms, there are really two factors that enter into the decision whether or not to use these models, and if any, which ones should be used. whether or not to use these models, and if any, which ones should be used. These factors are:These factors are:

• the complexity of the modelthe complexity of the model

• the direct and indirect costs of using the model the direct and indirect costs of using the model

ComplexityComplexity

The various models are only tools, so management should understand them, The various models are only tools, so management should understand them, and their use.In all cases, the strength of the model will depend on the quality of and their use.In all cases, the strength of the model will depend on the quality of the underlying data. Using sophisticated models in environments were these the underlying data. Using sophisticated models in environments were these data are weak, or not very significant (e.g. due to government interventions) is data are weak, or not very significant (e.g. due to government interventions) is risky.risky.

CostCost

The first cost that companies should consider is the actual cost of buying the The first cost that companies should consider is the actual cost of buying the computecomputerr software. This can vary from 5,000 US$ for a simple VAR system, to software. This can vary from 5,000 US$ for a simple VAR system, to one million US$ for the complete RAROC package. Then, they should look at one million US$ for the complete RAROC package. Then, they should look at the costs of adapting this system to the company’s needs. Larger companies the costs of adapting this system to the company’s needs. Larger companies can also outsource the activity to an independent firm.can also outsource the activity to an independent firm.

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There are, of course, several other factors that will There are, of course, several other factors that will help determine which system to use. For example:help determine which system to use. For example:

compatibility with existing accountancy systemcompatibility with existing accountancy system

regulatory requirements. For example, in the United regulatory requirements. For example, in the United States of America, the Securities and Exchange States of America, the Securities and Exchange Commission has formally accepted the VAR method Commission has formally accepted the VAR method as a tool to determine how much companies might as a tool to determine how much companies might lose if their derivatives positions implode. Public lose if their derivatives positions implode. Public companies have to record this measure in their companies have to record this measure in their annual reports.annual reports.

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How does one get the necessary numbers?

Probability of default

X

Exposure at default

X

Loss given default

Market risks: historical data, corrected for current conditions.

Non-market risks: assessments by (independent) experts

Assessments by individual business units, properly checked

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The risks of quantative risk models The risks of quantative risk models

In the final analysis, it should be stressed that all of these models for analyzing and quantifying risks are just tools. However sophisticated they may be, they do not replace the normal prudential controls on the use of risk management instruments, nor do they allow management to make “automatic” decisions on the future course of action.

Operating risk is the primary reason for company losses

“Risk” cannot be measured in an objective manner. Certain assumptions always need to be made in the measurement, and these assumptions are subjective. This is not a problem as long as managers understand what are the assumptions behind this measurement, and agree with them; and if they are willing to change their assumptions on the basis of new information. However, if they take any model as an objective truth, risk models may actually increase company risk. Markets are basically unpredictable, and the unimaginable happens all too often.

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The use and abuse of « hard data »

Relying on qualitative risk assessment has its problems: it can be based on the wrong intuition, misleading, does not allow to properly identify portfolio effects, etc.

Using hard data gives a more objective basis for policy making. However, one should avoid over-reliance:

•

Data problems

Data can be bad or inappropriate

Data may give a false sense

of security

Data may act as an artificial barrier to internal disagreement

The underlying reality may change

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3. Impacts of risk on corporate 3. Impacts of risk on corporate performance – and how risk performance – and how risk management can improve resultsmanagement can improve results

Every business faces risks, much of which are unobvious, complex and dynamic. How well companies manage these risks could help separate the winners from the losers.

Bankers TrustRAROC and Risk Management, 1995

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Some still argue that risk management does not add value.

- Modigliani/Miller: corporate financing decisions do not affect corporate value.

- what the firm does could be easily duplicated by its shareholders – and they have different risk aversion levels.

- risk management only eliminates short-term deviations from the longer-term trend

- managers will manage their risks (linked to their stock options, etc.), not necessarily those of the company.

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Modern commodity marketing techniques and strategies, Modern commodity marketing techniques and strategies, including market-based risk management instruments can, if well including market-based risk management instruments can, if well utilised, allow: utilised, allow: 

an improvement of marketing strategiesan improvement of marketing strategies;; the ability to avoid having to sell, or buy, for unfavourable the ability to avoid having to sell, or buy, for unfavourable

prices (that may reign during certain short periods);prices (that may reign during certain short periods);

more predictable income streams or expenditures, and in more predictable income streams or expenditures, and in general terms bring price risks to a level that is manageable;general terms bring price risks to a level that is manageable;

for the locking in of profits from certain business decisions, for the locking in of profits from certain business decisions, in areas such as production, trade, processing or in areas such as production, trade, processing or investment;investment;

the possibility to valorize inventories or unutilized the possibility to valorize inventories or unutilized production capacity;production capacity;

the ability to gain cheaper access to capital.the ability to gain cheaper access to capital.

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The market allows something which non-market The market allows something which non-market based instruments do not: based instruments do not: risk can be removed from those risk can be removed from those who do not want it and cannot afford to shoulder it to those who who do not want it and cannot afford to shoulder it to those who are seeking riskare seeking risk..Non-market based risk management instruments, such as fixed-price Non-market based risk management instruments, such as fixed-price long-term contracts, government stabilization funds, diversification etc., long-term contracts, government stabilization funds, diversification etc., also may have their place in an organization’s management policy. also may have their place in an organization’s management policy.

The use of risk management markets does not replace proper The use of risk management markets does not replace proper physical trading techniquesphysical trading techniques, in effect without proper physical trading , in effect without proper physical trading techniques , access to many risk management instruments may be very techniques , access to many risk management instruments may be very difficult , and even with access , use of risk management markets will in difficult , and even with access , use of risk management markets will in effect amount to speculation and thus , conceivably have negative effect amount to speculation and thus , conceivably have negative effects.effects.

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Expected returns

Likely loss at 1% confidence interval

Situation without risk management

Better risk/return ratio

Possible results with risk management

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Source: Goldman Sachs

For example, a company has to decide how best to allocate its capital.

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Source: Goldman Sachs

The returns on these business lines are not 100% correlated…

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Source: Goldman Sachs

The company has a range of choices, depending on its risk appetite.

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Better project/investment decisions

Note: this could also be for specific decisions – e.g. to use coal (blue line), or natural gas (red)

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Traditional methods such as discounting expected future cashflows with the company’s weighted average cost of capital may give a misleading impression on projects.

« The traditional approach will lead us to accept risky projects whose return do not justify the higher risks. Furthermore, it will cause us to reject value-adding safe projects because we are charging too high a price for risk. Finally…. it will cause management to reject hedging proposals. »

See B. Humphreys & D. Shimko, « The principles of wacky WACC », http://www.e-rcm.com/research/documents/whitepapers/wackywacc.pdf

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Less need for equity

With risk management, one can better leverage one’s own equity. It thus reduces dependence on the capital market.

Key reason: banks will perceive less risks, and thus be willing to lend more.

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With risk management, one can convert « real options » into real profits

E.g., the ability to supply gas at short notice can in itself become a revenue source – whether the gas is delivered or not.

And gas-buyers (e.g., petrochemical plants) can optimize their gas purchases (long-term offtake contracts can be combined with use of paper market tools).

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Equity funds can be freed up, e.g., for new investments, or more research

By creating a centralised risk management function, the capital deployed can be reduced. With centralised risk management, the total Value-at-Risk is reduced [in this example] from $358 million to $329 million. The firm is now able to redeploy its free capital, generating new profits.

J.F. Casanova, “Relating Risk Management to the Bottom Line” (article provided in hand-out).

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The risk of severe cash flow crises can be eliminated

Hedging and insurance reduce the likelihood that the company will encounter financial distress.

Issue: do you hedge/insure separate risks, or the overal cash flow risk?

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Clients can be offered a wider range of pricing options

They can be offered fixed prices, indexed prices, contracts with floor or ceiling prices, etc.

(As an illustration, in the USA, grain trader Cargill offers farmers 26 different ways to buy their grain… See http://www.cargillaghorizons.com/cah/cahpublic.nsf/pages/us?OpenDocument)

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There are often tax advantages to earnings stabilization

Most countries have an increasing marginal tax rate. So total taxes are higher when in year 1, revenue = 100, year 2, revenue = 200; than if revenue in both years = 150.

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And: management and the Board can concentrate on the Big Picture,

rather than trying to guess how prices will move

Over the past few years I have become increasingly convinced that one of the greatest incentives to hedge is to meet preset budgets so that management can collect their bonuses.

John RalfeRisk, June 1997