Treasury Control and Performance Evaluation Prof Ian Giddy New York University.

Treasury Control and Performance Evaluation

Prof Ian Giddy

New York University

Copyright ©1996 Ian H. Giddy Management, Markets and Linkages 3

A Corporate Foreign Exchange Application

TRANSACTIONS

FORECASTS FROM

BUSINESS UNITSCONSOLIDATION

NET POSITIONS,

BY CURRENCY

AND MATURITYVOLATILITY AND

CORRELATION

FORECASTS

VALUE

AT

RISK


FIRM'S INT'LBUSINESS

BOOKED &ANTICIPATED

TRANSACTIONS

REPORTINGSYSTEM

SCHEDULE OFFX FLOWS

PORTFOLIOANALYSIS OF

FX EXPOSURE

NETEXPOSURESIN FOREIGN

CURRENCIES

MEASUREMENTOF FX RISK BY

CURRENCY

RISKMANAGEMENT

DECISIONS

CORRELATIONDATA

VOLATILITYDATA

HEDGINGTRANSACTIONS

The VaR Management Cycle

This process can be undertaken on a monthly cycle basis, as the institution revises its estimates of future business and as new data on volatilities and correlations are acquired.


FIRM'S INT'LBUSINESS

BOOKED &ANTICIPATED

TRANSACTIONS

REPORTINGSYSTEM

SCHEDULE OFFX FLOWS

PORTFOLIOANALYSIS OF

FX EXPOSURE

NETEXPOSURESIN FOREIGN

CURRENCIES

MEASUREMENTOF FX RISK BY

CURRENCY

RISKMANAGEMENT

DECISIONS

CORRELATIONDATA

VOLATILITYDATA

HEDGINGTRANSACTIONS

The VaR Management Cycle

PERFORMANCE

EVALUATION


Performance evaluation: “the science of attribution”

Example: Why did this taxi take so long?The traffic; the driver; my lousy

instructions? How much should I tip this taxi

driver? Would I use this taxi company

again?

Why Measure Performance of Treasury?


Why Measure Performance of Treasury?

Like banks, treasurers face market risks, and must manage them

Unlike banks, exposures cannot be known with precision - so there’s no such thing as “fully hedged”

Hedging is a dynamic process Making money is not enough - must be

evaluated relative to cost and risk and capital allocated.


Nokia: “performance measurement (selective vs. full hedge) is encouraged but not required”

Ericsson: “it is something we should look at” Borealis: “no satisfactory relationship between

risk and return” Kværner’s qvestions:

Am I making money and if so, why?How does my profit or loss relate to the

risks that have been taken?

Baltic Benchmarking


What Do We Want to Measure?

Return performance (did we outperform some benchmark measure?)

Risk reductionHedged positions?Reduced earnings volatility (historical)?Reduced Value at Risk (anticipated)?

Reporting, disclosure and problem identification (have we improved our risk measurement system?)


Risk and Return

RETURN

RISK


Kinds of Trading Risk forPerformance Measurement

Corporate Risk Hedging vs Bank-within-the-Company

What Risks?Position RiskBasis RiskLiquidity RiskCounterparty Risk


Choosing the Right Yardstick: Return

Profitability - wrong! Compare with “best practice”

companies - wrong. Compare with “forward rates” Evaluate return relative to risk


TIME

EXCHANGE RATE Spot

Forward

Actual

Probabilitydistributionof actualexchange rate

Today In three

months

Unbiased Forward Rate Theory


Performance Evaluation: ExampleFARMCO: PERFORMANCE EVALUATIONOct. 1 1995

Predicted exposures Spot Forward

Expected Return Volatility Hedge

CAD -200758 1.3374 1.3405 1.0% 1.79 150000DEM 22365 1.4288 1.4165 2.5% 3.82 0JPY -15688 100.39 97.83 2.0% 3.71 10000Portfolio expected profit 1,180 Portfolio total VaR 9,337 Portfolio diversified VaR 5,210 Expected gain, relative to risk (VaR) 23%April 1 1996

Actual Exposures

Actual Spot

Actual Return

Actual Volatility Hedge

CAD -220400 1.3736 2.5% 2.1 150000DEM 24000 1.3901 1.9% 4.2 0JPY -11500 97.00 -0.8% 5.3 10000Portfolio actual profit 1,278 Portfolio total VaR 11,251 Portfolio diversified VaR 5,913 Actual gain, relative to actual risk (VaR) 22%

Adjusted gain, based on predicted exposures 788 Adjusted gain, relative to actual risk (VaR) 13.3%Adjusted gain, relative to ex-ante risk (VaR) 15.13%


Performance Evaluation: ExampleFARMCO: PERFORMANCE EVALUATIONOct. 1 1995




Actual Exposures

Actual Spot

Actual Return





What Happened?FARMCO: PERFORMANCE EVALUATIONOct. 1 1995




Actual Exposures

Actual Spot

Actual Return





How Am I Doing?FARMCO: PERFORMANCE EVALUATIONOct. 1 1995




Actual Exposures

Actual Spot

Actual Return





Key Measures of Performance

Return: (Actual return - forward premium) Return relative to risk

(the “Sharpe” ratio):Historical volatility of returnsHistorical volatility of position valueEx ante Value at Risk

RETURN

RISK


The Sharpe ratio.(actual return relative to actual risk)

The risk ratio.(actual return relative to prospective risk)

The efficiency ratio.(actual risk relative to prospective risk)

Use risk-return performance measures to evaluate individual trader performance.

Using a VaR Measure for Trading-Portfolio Performance Evaluation


Performance Measurement: Roadmap

FINANCIAL SIDE

OPERATIONAL SIDE

EXPOSURES Known Anticipated

Map exposures

Map risks

Manage risks

Measure performance Take actions to improve

performance

MARKET PRICES

MARKET VOL & CORR.

RISK MEASUREMENT VaR Worst-case scenario, etc.

RISK MANAGEMENT Hedging Investment or trading

PERFORMANCE MEASUREMENT Relative return Relative risk.

INCENTIVES ALLOCATION OF RESOURCES.


Sola Chemical

A rea T reasurer A rea C ontro ller A rea T ax A ttorney

M anagers ,A s ia

E uropeLatin A m erica

A ssistant Controller Intl

C ontro ller

A ssistant Treasurer Intl

T reasurer Tax A ttorney

F inance C om m ittee

P res identS ola U S A


Sola Chemical

Tax planning - cerntralize? FX exposure - Paper loss? Centralize to

net exposures? Transfer pricing and performance

evaluation - 2nd set of books? Sourcing funds - cheap local

opportunities lost? Other considerations?

A rea T reasurer A rea C ontro ller A rea Tax A ttorney

M anagers ,A s ia

E uropeLatin A m erica

A ssistant Controller Intl

C ontro ller

A ssistant Treasurer Intl

T reasurer Tax A ttorney

F inance C om m ittee

P res identS ola U S A


Performance evaluation: “the science of attribution”

Why did we make/lose money?The market; the FX manager; my

lousy instructions? How much should I tip this FX

manager? Would I use this method again? How good is my performance

measurement system?

Treasury Performance Measurement: Conclusion


Summary of “Value at Risk” Reporting

“At close of business each day tell me what the market risks are across all businesses and locations.”

Dennis Weatherstone, JP Morgan

Logical steps:Economic-value accounting (need market prices

or models)Market-price based performance measurementVolatilities and correlations of market pricesManagement of riskOptimization of hedging

THE END

Treasury Control and Performance Evaluation Prof Ian Giddy New York University.

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