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Risk management in isolation is risky: to avoid unintended consequences of their decisions, treasurers need to apply the same partner-with-the-business mentality for risk management as they do for other activities and not treat it as an isolated treasury function.

The adage that "hindsight offers 20/20 vision" can be applied to certain treasury and risk-management activities. Overall, risk management, financial or otherwise, carried out in isolation has the potential to spawn unwanted, unintended consequences that are far easier to detect retrospectively. That's certainly the way to characterize the case of South African Airways Ltd. (SAA) and the impact of its widely publicized currency hedging losses in 2003 and 2004.

The airline's troubles began when its treasury group executed a simple and widely accepted hedging strategy of locking in future long-term currency exposures with forward contracts (purchase U.S. dollars/sell SA-rand for future delivery).

Specifically, the objective was to fix the rand-dollar exchange rate on future dollar-based jet fuel and long-term aircraft purchase contracts to avoid the risk of a further decline in rand value. In managing this one specific risk--currency risk, per se--SAA failed to see, ignored or was otherwise not knowledgeable enough to foresee the future unintended consequences of its actions.

The law of unintended consequences is understood to suggest that each cause has more than one effect, and will include unforeseen effects. Less a law or rule itself, it should be viewed as a call to decision-makers to exercise caution.

In SAA's situation, the hedging strategy had its intended impact: locking in the exchange rate on future non-rand purchases. It should have achieved a primary value-added objective of risk management and, thus, allowed management to plan. This can be referred to as a "first-order effect," or an intended consequence. But, the hedge, or future commitment of the forward contracts, had other, unintended consequences, referred to as "second-order effects."

In the case of SAA, these second-order effects impacted two areas: its financial position, referred to as the "accounting impact," and its purchasing strategy, the "business impact."

* Unintended Consequence #1: Accounting Impact. The accounting impact, was a result of SAA's newly adopted hedge accounting requirements of the time: AC133, Financial Instruments: Recognition and Measurement (according to South African generally accepted accounting principles (GAAP)), which required the airline to carry its derivatives on its balance sheet at fair value and mark to market the change in the derivatives' value over time, either through earnings or equity, depending on the qualifying hedge relationship.

At the time, the rand's value against the dollar--which had been in a persistent decline--reversed and appreciated substantially, causing the forward contract's fair value to erode. As a result, the adjustment to the forward contract's declining fair value eventually impacted the company's net equity position as the unrealized losses were carried through to earnings.

Note that regardless of whether the unrealized losses were carried through earnings or reserved in equity as an adjustment to other comprehensive income, the impact would have been the same: erosion in the entity's equity component. Now, one might assume to the contrary, that the ability to "park" the derivatives' fair value adjustments in equity would have been harmless.

But, the write-down in equity, which came amid other negative, non-hedge-specific write-downs and an erosion of earnings at the time, forced the airline into technical insolvency, since the net impact violated certain debt-equity ratio covenants. This forced SAA to take actions to recapitalize to avoid a call on certain debt. (Notably, SAA was in a highly leveraged position at the time.)

As a result of this unanticipated impact to equity, and thus its debt covenants, the airline was pressured to realize the marked-to-market losses of the forward contracts--i.e., buy the contracts back--in order to avoid the risk of potential further erosion to equity had the rand continued to appreciate. Thus, the unrealized loss became a significant cash impact, requiring recapitalization of the airline from its parent company.

* Unintended Consequence #2: Business Impact. Another, less evident potential consequence of SAA's hedging strategy concerns the obligation it was trying to protect--its future commitments to purchase aircraft. These were firm commitments, which at the time were viewed as having a high probability of occurring. As such, they would typically satisfy the criteria of selecting forward contracts as a hedge in order to lock in the future rand-dollar exchange rate.

However, the aircraft purchase contracts were apparently very long-term in nature, spanning up to 10 years--according to "Hedging Is Not Riskless," by Prof. Pablo Triana, in AFP Exchange, Nov. 29, 2007. In an industry where 10 years can be an eternity, who knows what the business will look like over time?

In the early-to-mid part of this decade, post-9/11, airlines suffered through a barrage of financial troubles. These caused many to file for bankruptcy or seek solutions outside of courts to alleviate the strain of financial commitments, including contracts for the future purchase of aircraft. The result was that many airlines had some success in renegotiating, eliminating and/or deferring some of their obligations to their primary aircraft vendors, thus maintaining some level of flexibility in these contracts.

However, with its choice of hedging a risk in these future commitments with forward exchange contracts, SAA eliminated any potential flexibility, at least outside of bankruptcy proceedings. Regardless of whether SAA was able to eventually negotiate a deferral or other reprieve to honor such obligations in its weakened financial state, in light of its forward currency contracts, the company would have had no choice but to honor the financial commitment to purchase dollars/sell rand.

Thus, by the choice of its hedge instrument, SAA changed the nature of its business risks, essentially, eliminating any flexibility. This would have been another, significant unintended consequence of its risk management activities--although the impact of this never materialized, since the forward contracts had to be prematurely unwound in light of the accounting impact.

In reality, the declining U.S. dollar's value had other, concurrent negative impacts on the airline's balance sheet at the time as well, including a write-down of other asset values and an impact on international revenues.

However, the point of SAA's intended objective, to mitigate the impact of potential future currency swings, had significant, unintended consequences on the company's financial position, as well as on its flexibility to manage future obligations to suppliers. In this case, hedging with forward contracts changed the nature and risks of the business, turning long-term currency risks into a near-term, potential financial catastrophe.

Thus, if the primary value-added benefits of hedging are to allow management to plan and/or mitigate the potential for financial distress, the company failed on both counts.

Avoiding, Mitigating Unintended Consequences

So, how does an entity avoid or mitigate the unintended consequences in implementing its risk management strategy? Should hedging be avoided altogether, and thus employ a "head-in-the-sand strategy"? Not necessarily, since hedging offers real value. But hedging should not be done in isolation.

There are several factors to consider in carrying out the appropriate risk management strategy; for example:

* Avoid risk management silos. Enterprise risk management (ERM), the main premise of which is to view an entity's risks within a portfolio or across the organization, has continued to gain acceptance at non-financial corporations. In analyzing a portfolio of risks, it is imperative to not only catalog specific risks, including their likelihood and impact, but, as importantly, to consider the interaction among such risks--i.e., the second-order effects and beyond. Can you eliminate all consequences? Not likely, but ERM is about eliminating surprises, not necessarily all risks.

Most ERM programs typically report up to a single person or a committee, which has the advantage of raising the awareness of the portfolio of risks at a single point. In spite of this, however, risks still tend to be managed in quasi-silos, as each business manager still has the responsibility for managing his or her own risks within the ERM framework.

Hence the crucial interplay of risks across the entity may tend to get overlooked, or less emphasized.

* Dust off your crystal ball. Prospective scenario analysis, or stress-testing pro-forma financials amid various potential operating environments, (i.e., a scenario matrix), will uncover many initially missed assumptions. In SAA's case, the accounting consequence would likely have been averted, or at least anticipated, had the company analyzed prospective scenarios. The unfortunate issue in SAA's case, however, is that the accounting requirements were very new and untested, which further clouded its crystal ball.

* Move into the 21st century. Utilize a capable risk management system. This mitigates the burden to derive future scenarios, derivative fair values and prospective accounting implications. Such systems, available from third-party vendors, continue to gain in popularity amid the increasingly complex accounting requirements for derivative securities and hedging activities--FAS 133 in the U.S., or IAS 39 for international accounting.

The systems are packaged either as stand-alone, in an application service provider (ASP) environment, or installed within other financial or cash management systems, and typically tie into an entity's general ledger system.

* Play the matching game. Reduce the impact a hedge has on the business's underlying cash flows by matching the flexibility, or contingency of the underlying hedge instrument's risk, with that of the hedged item. For example, consider matching a forward contract--which is a future obligation with basically no flexibility--to that of certain future underlying obligations one is attempting to hedge.

On the other hand, an option, which is the right to buy (a call option) or sell (a put option) an asset at a pre-determined price (the option's strike price) in the future, is better suited for hedging risks that are contingent, or in which some amount of flexibility is needed. Matching the contingency, or flexibility of the hedge instrument, helps ensure an entity maintains the needed flexibility or potentially enhances it.

* Shorten your stance? Consider alternative hedging strategies over time, such as rolling shorter-term forward contracts or other instruments. Sure, SAA would not have locked in the predictability of exchange rates for as long, but it would have mitigated the potential accounting impact of marking-to-market such long-term forward contracts. Furthermore, over time there's more of an opportunity to change the business' operating strategy to adjust to risks. All of this needs to be considered against the pros/cons of longer-term or other hedging strategies.

* Build bridges. Nothing takes the place of understanding the business, and, as importantly, the impact that risk management activities may have on operating conditions. For help here, follow the "3-Cs" of an effective risk management strategy: calculate, check your assumptions and communicate.

This step cannot be overemphasized. The more senior management, internal accounting and/or other operating management understand about the nature of the risks being managed and the selected strategy chosen to address them, the more complete feedback they can provide as to how the business's financial position or operating strategy could be impacted, heading off potential second-order effects.

As a strategic treasurer, you are a partner to the business, understanding the operating environment and meeting the financial needs of the entity consistent with the business strategy. Risk management activities should be carried out with that same partnership mentality, and not as an isolated treasury function.

DAVID W. STOWE, CFA, is a Treasury and Risk Management Consultant, and CRAIG A. JEFFERY is Managing Director, both with Atlanta-based Strategic Treasurer LLC (, a treasury-consulting firm specializing in general treasury, financial systems, working capital and financial risk management.


** Risk management, financial or otherwise, that is carried out in isolation can produce unintended consequences. For a business, such consequences can be financial and business-related.

** The law of unintended consequences suggests that each cause has more than one effect and will include unforeseen effects.

** Enterprise risk management's (ERM) purpose is to view an entity's risks within a portfolio or across an organization. It won't eliminate all risk and consequences, but it will help eliminate surprises.

** Hedging offers real value, and should not necessarily be avoided. However, to mitigate unintended consequences of a hedging strategy treasurers need to use a partner-with-the business mentality and not view it as an isolated treasury function.
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Title Annotation:TREASURY
Author:Stowe, David W.; Jeffery, Craig A.
Publication:Financial Executive
Date:Mar 1, 2008
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