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Market Volatility and Risk Mitigation


How trade credit replaces working capital loans. Current exposure versus potential exposure. ... designed as long as the risk presented is not adverse selection. ... – PowerPoint PPT presentation

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Title: Market Volatility and Risk Mitigation

Market Volatility and Risk Mitigation
  • Paul G. Turner, CFA May 2008
  • Presented to IECA

The goal of the presentation will be to
demonstrate the link between individual credit
assessments, the cost of credit and the cost of
capital and how each of these has an affect on
capital structure. We will then examine the
effect of market volatility on a companys risk
management program and finally look at the market
in Canada for laying off credit risk.
Why do we need to mitigate risk?
  • The easy answer...

Why do we need to mitigate risk? (contd)
  • The more appropriate answer is we are challenged
    more and more to find ways to support increased
    sales levels with the same number of buyers, and
    without increasing enterprise risk.
  • This raises three fundamental questions
  • How to determine the maximum acceptable amount of
    credit on any one counterparty
  • Is there a cost to credit and if so, how does one
    determine it and,
  • What are the cost of capital issues related to
    trade credit?

Some theoretical background
  • How trade credit replaces working capital loans.
  • Current exposure versus potential exposure.
  • Black Swans.
  • MM Proposition II and Capital Structure

How much is too much?
  • If we accept that trade credit is a necessary
    part of business, what goes into establishing the
    proper amount for any one counterparty.
  • This has become even more important as firms
    increasingly need to consider potential exposure
    as opposed to current exposure.
  • Companies that are targeting increased output,
    coupled with increasing commodity prices must now
    actively challenge assumptions with regard to
    acceptable risk levels particularly since there
    is a finite (and small) numbers of buyers for
    energy supply.

How much is too much? (contd)
  • This should not be a mechanical exercise.
  • While modeling can be helpful, the real value of
    any model is in the testing of assumptions and
    prevailing thinking.
  • So rather than provide a model, we will focus on
    the factors that should be considered in
    establishing the number.

Factors to consider financial analysis
  • Technical Analysis
  • Fundamental Analysis
  • Macro / Micro Analysis

Factors to consider portfolio considerations
  • Investment portfolio theory.
  • Timing the absolute amount is time dependant
    in other words the view will change as events
    unfold. However, positions are usually static
    for at least some time horizon.
  • Overall portfolio characteristics. The amount of
    exposure you can take on in total is limited by
    your own capital.
  • Correlation of counterparty default. This will
    have an impact on the overall level or maximum
    total exposure, and in turn the amount allocated
    to any one buyer in the portfolio.
  • Is there a difference between the credit maximum
    for physical exposure as opposed to financial
    (MtM) exposure. Again this goes to current
    versus potential exposure.

Factors to consider corporate structure
  • Ownership issues - do you want to have more
    invested in the company than the owners.
  • Capital structure considerations - what
    percentage of your working capital is acceptable
    to invest in any one company.

Factors to consider business relationship
  • Look at it from the customer side as well. How
    much do they want to be tied to any one supplier
  • Toyotas philosophy is to ensure that they only
    represent 40 to 45 of total production from any
    one supplier. In contrast, the GM - Ford model
    is to have a much larger share of the suppliers
    capacity - an issue of control. If that supplier
    then runs into difficulty, GM must take effective
    ownership of the supplier (through a bailout or
    guarantee) to ensure continued supply. Toyotas
    philosophy is to have healthy suppliers rather
    than ones they control.
  • Rules of thumb.

Cost of credit
  • Broadly speaking, the components of the cost of
    credit can be broken down into
  • Administrative Costs
  • Human resources
  • Information tools
  • Surveillance costs
  • Legal
  • Costs of buyer default
  • Capital Costs
  • The cost of allocating capital to the risky asset
  • Opportunity costs
  • Companys own default cost

Cost of credit (contd)
  • How much capital should be allocated to Accounts
    Receivable (AR)?
  • It could be the probability of default associated
    with the AR base to arrive at an expectation of
    loss. Then the company must allocate a certain
    amount of capital to this figure, and the cost of
    credit is the cost of that capital.
  • However, this is the expected default cost, what
    about the unexpected default cost?
  • Market value approach - assessing the risk
    premium attached to owning a piece of your

Cost of credit - other issues
  • Wrong way risk - does the price fluctuation of
    the underlying commodity affect the risk of the
  • Floating versus fixed costs - do you have the
    ability to pass on the cost of credit in the
    price. If not, a deteriorating risk with your
    buyer will have a direct and negative impact on
  • Bottom line without understanding your own cost
    of credit, how can you determine the efficiency
    of laying off the risk.

Cost of capital considerations
  • Basic capital structure dictates a mix of debt,
    equity and internal funding to support the asset
  • The optimal mix is determined by many factors
  • Volatility of the asset base
  • Growth expectations
  • Tax regime
  • Timing and market expectations and,
  • Agency costs.
  • Even with bankruptcy costs, debt is a cheaper
    form of capital than equity.

Cost of capital considerations (contd)
  • Volatility of the asset base is a key
    determinant. Even in the energy sector, AR is a
    risky asset.
  • The larger the proportion of AR to the total
    balance sheet, all things being equal, the
    greater reliance the firm will place on equity
  • By mitigating the credit risk associated with AR,
    the firm lowers volatility and can reduce its
    dependence on equity.
  • Furthermore, stability in cash flows and lower
    enterprise risk reduces the equity premium
    demanded by investors.

Market volatility
  • The impact of market volatility

Risk mitigation
  • The goal of any mitigation strategy should be to
    transfer the amount of risk which best improves
    the capital allocation decision while maximizing
    stakeholder value.
  • These products are specifically designed to
    achieve these goals while providing an
    opportunity for management to protect one of the
    largest corporate assets.

Credit Insurance protects the ?rm against that
which it cannot see, not that which is
The Canadian market
  • North America is a mature market with respect to
    Risk Transfer options.
  • Primary options are Credit Insurance, Credit
    Default Swaps (CDS) and Receivable Put
  • The primary mechanism for risk transfer in Canada
    remains Credit Insurance with all the major
    global participants having a significant presence
    in Canada.
  • In the US, CDS outpaces all risk transfer options
    with a current nominal value in the range of
    USD62 trillion at YE 2007.

Risk transfer options
  • Credit Insurance
  • Generally the cheapest form of cover.
  • Flexible in portfolio design and degree of risk
    transfer - both single
  • buyer or multiple buyers acceptable.
  • Aggressive risk appetite.
  • Non-cancelable limits possible with Atradius,
    AIG, ERIS and some
  • secondary markets.
  • Strong service offering.
  • Ability to syndicate a structure to enhance limit
  • CDS Market
  • Very large market - despite its size, signi?cant
    liquidity issues of late.
  • Offers long term structures allowing buyers to
    reduce basis risk of contract tenor.
  • Complex agreements to structure.
  • Not designed for multiple counterparties.
  • Possibility to attain 100 indemnity.

Risk transfer options (contd)
  • Receivable Put Market
  • More closely related to Credit Insurance than CDS
  • Not designed for multiple counterparties,
    strictly one-off transactions.
  • Aggressive risk appetite and pricing from key
    players such as Credit Suisse and Deutsche Bank.
    This is tied to their presence in the distressed
    debt market.
  • Long term structures possible (up to 5 years with
    most common tenors in the 1 to 3 year range).
  • 100 indemnity, however, insolvency the only risk
  • Much simpler agreements to structure as compared
    to CDS.

Structural Issues
  • Because CDS and Receivable Puts are overlays on
    one buyer, portfolio structures are not possible.
    As such, these products are usually considered
    when Credit Insurance is not viable (for example
    transferring GM risk in 2005 / 2006) or when term
    structures are longer than one year.
  • CDS and Receivable Puts are designed to hedge an
    existing or potential position. Credit Insurance
    is used as a mechanism to leverage existing
    positions and increase exposures on
    counterparties to levels the company is not
    comfortable with on their own.
  • Credit insurance allows a company to structure a
    portfolio to meet the specific needs based on
    buyer risk, exposure size, concentration,
    financing requirements, etc. Basically any
    portfolio can be designed as long as the risk
    presented is not adverse selection.

Comments on pricing
  • Credit Insurance is usually the cheapest form of
    protection. In comparison to LC's, insurance is
    generally 30 to 40 their cost.
  • While single buyer transactions are becoming much
    more common in Credit Insurance, portfolio
    pricing is generally more competitive. It also
    allows the Insurer to be more aggressive in their
    risk appetite.
  • Receivable Puts are more cost effective than a
    comparable CDS instrument since most CDS products
    are laid off in another market.
  • CDS pricing is capital market driven and
    therefore can be subject to severe volatility (as
    well as liquidity concerns).

The Canadian insurance market
Insurer Rating Premium Base (YE 2006) Comments
AIG AA USD52.7 billion (total premium for all lines) Credit Insurance a small part of their overall Offers non-cancelable limits
Atradius A 1.8 billion With the recent merger with CYC in Spain, they are the largest in the world Flexible in tailoring solutions True non-cancelable policy structure
Coface AA- 975 million Newest participant to CDN market Lacking service presence in Canada Aggressive pricing
EDC AAA (backed by the sovereign) CDN90 million Sovereign rating provides policyholders preferred lending margins Strong risk appetite
Euler AA- 1.7 billion Largest number of in country risk experts Strong service presence in Canada
The product - overview
  • Credit Insurance is designed to protect the
    seller from non-payment of its buyer.
  • Can be triggered by either the Insolvency of your
    buyer or Protracted Default due to cash ?ow
  • Other risks covered include repudiation or the
    buyers non-acceptance of goods, and political
  • The premise of cover is that the Insurer can step
    into your shoes once a claim is paid. As such,
    the underlying contract must be enforceable.
  • Premiums are based on the policyholders usage,
    either through assessing a rate per dollar of
    sales, or basis points for credit exposure
  • Most policies today are losses attaching
    meaning the coverage is based on a policy being
    in force when goods are shipped, not when the
    loss actually occurs.

The product - pricing structure
  • Portfolio / single buyer approach
  • In most instances the Insurer requires a spread
    of risk through a portfolio of buyers. The
    premise is they require is a reasonable spread of
    risk taking the good with the bad.
  • They will consider a single buyer portfolio as
    long as the risk is reasonable. This is most
    often used when the exposure on a buyer exceeds
    de?ned levels of acceptance within the capital
  • Aggressive pricing today
  • Pricing re?ects the risk premium required to hold
    exposures on the basket of buyers similar to
    pricing debt instruments.
  • Can tailor risk sharing proportions (through
    co-insurance and/or deductibles) to maximize the
    value of premium dollars spent.
  • Despite the recent turmoil in capital markets,
    Insurers remain aggressive in pricing. This is
    largely due to the fact they are very familiar
    with this kind of volatility and do not
    over-react to a crisis environment. They are
    not totally reliant upon the capital markets for
    pricing structures, rather they use them as a
    guide since the time line is much longer than
    with other credit instruments.

Comments on non-cancelable limits
  • Whenever a non-cancelable policy is issued, the
    basic premise is that the credit is of sufficient
    quality that the Insurer can take a longer term
    outlook on the capacity provided. It offers the
    Insured greater protection that the Insurer will
    not withdraw cover due to a risk deterioration.
    In other words, the Insurer cannot change the
    conditions of cover to rebalance their own risk
  • It does not relieve the Insured from all
    obligations related to credit risk management.
    The Insured must continue to act in a prudent
    manner as it relates to risk assessment, most
    importantly in the event of a loss.
  • This is not to say that the limit will be
    continued irrespective of the credit risk. If
    there is specific knowledge of imminent failure,
    cover is halted going forward (it has no effect
    retroactively on shipments already made).
  • Insolvency and protracted default are covered
    risks. However, in the energy sector, protracted
    default is akin to insolvency due to the
    realities of a delay in payment.