Increasing Inflation, Increasing Need for Integrated Financial Risk Framework
Annual inflation rate in US has reached 8.6% in May 2022, which is a highest rate in 41 years. Similarly, inflation is peaking at record high in the euro area with the annual inflation rate of 8.1% in May 2022. An integrated financial risk framework helps treasurers to understand the impact of inflation on other financial risks and the interactions between these risks.
The main causes for global increase in inflation are supply chain constraints coupled with strong demand and labor shortages, which indicates cost-push inflation. Given geopolitical instability resulting from war in Ukraine with strict sanctions imposed to Russia and continued lockdowns in Asia due to the coronavirus, global supply chain disruptions are likely to persist. Therefore, inflation in both US and EU area is expected to remain well above 2%, which is a target for both Fed and ECB, for as long as the supply chain constraints are present.
Increase in interest rate volatilities
Besides the obvious impact of high inflation on prices and consequently contracting consumer purchasing power which we are all facing, Treasurers need to understand the impact of inflation on other financial risks and the interactions between these risks. Inflation targeting is the most widely used tool for making monetary policy decisions. The US and the UK have already started implementing contractionary policies through raising interest rates and reduced government spending. Similarly, it is expected that ECB will start raising policy interest rates after the second quarter of 2022. Consequently, there has been a steady increase in interest rate volatilities and the trend lines indicate permanent increase in the interest rates volatilities for the upcoming period. Interest rates have a direct relationship with foreign exchange rates which is explained by interest rate parity. Similarly, there is also an observable increase in volatility in foreign exchange rates that is further heightened by supply-demand shifts for particular currencies. For example, the USD/EUR exchange rate shows steadily increasing volatility over the first two quarters of 2022.
Understanding the impact of inflation
With regards to the liquidity risk, it is important to understand P&L impact of the rising price levels, combined with the increased volatilities in interest rates and FX rates. For example, production companies may experience rising costs of goods sold while at the same time they might also experience increasing pressure on the sale prices due to FX rate movements.
Some important questions to ask are: What can be done to limit price increases on the supply side? Please, also refer to the article on the commodity risk management “Challenges to Treasury’s role in commodity risk management”. Can the price increases on the supply side be passed on to the customers? And, if so, what will be the overall impact on the profitability or EBITDA of the company?
Key financial metrics
The above outlines the added value of having an integrated framework for financial risk management. The starting point is for Treasury to establish what are the key financial metrics that need to be managed with regards to the firm’s overall financial performance. The basic distinguishment can be made between statutory accounting, management accounting and economic/competitive view on the firm’s performance. Statutory accounting view is focused on the accounting measures such as debt ratio, interest coverage and reported earnings. Economic view is focused on cash flows and metrics such as free cash flows are the focus. While accounting view tends to be more important for large publicly listed companies with credit rating obtained from credit rating agencies, economic view tends to be essential for privately held companies that are primarily finance though debt.
VaR modeling and scenario analysis
Once the key financial metrics are determined, the firm needs to develop thorough understanding of the financial exposures, correlations between the risk categories and their impact on the financial metrics of the company. Advanced financial modeling, such as Value at Risk (VaR) models, could be used to incorporate different types of financial risks and accommodate for the relationships and interdependencies between different risk categories. VaR models allow for the modeling of risks with imperfect correlations between one and another and allow modeling of multitude of possible outcomes. Next to the VaR models, it is also advisable for the firm to perform scenario analysis and stress testing where impact of economic downturn could be further modeled and analyzed. While VaR models provide output as a maximum dollar amount to be lost over a specified horizon at given confidence interval, scenario analysis provides a dollar amount expected to be lost under a specified scenario. Scenario analysis also allows for the Treasury to exercise an expert judgement in the definition of the potential scenarios and stress tests. Measuring the impact of the financial risks helps the firm to define its risk bearing capacity and indicate capital buffer required to withstand a specified period of the financial distress. For the organizations with imposed financial covenants, it is also important to execute prospective covenant testing including all relevant risk categories.
After the potential impact of financial risks is measured, it is a role of the Treasury and the Board to define the risk appetite for the firm. Risk appetite can be defined as amount and type of risk that a company is able and willing to accept in pursuit of business objectives. Financial risk management or enterprise risk management teams should support Treasury and the Board with the definition of the company-wide risk appetite.
Finally, financial risk management policy and policies for the individual risk categories are formulated based on the risk appetite statement. These policies need to have stated objectives for managing of the financial risks, clearly set risk limits and clearly formulated hedging strategies.
Integrated financial risk management framework requires significant effort, highly skilled resources and technological support. On the other hand, there are number of significant benefits that can be achieved, including:
- Integration of risk organization – top-down integrated framework that accounts for relationships and interdependencies of various risks.
- Integration of risk transfer – better risk reporting as holistic view of all risks can be taken and allowing only hedging of the residual risks that remain after factoring in for the diversification effect.
- Integration of business processes – optimization of business performance through business decisions such as capital allocation, investment evaluation and efficient allocation of resources (reducing risks and taking on most profitable risks).
Sources:· tradingeconomics.com/united-states/inflation-cpi Euro Area Inflation Rate - April 2022 Data - 1991-2021 Historical - May Forecast (tradingeconomics.com) SRVIX (cnbc.com) 5.4/5.5 Interest rates Implied volatility - 5. Market risk - ESRB Risk Dashboard - ECB Statistical Data Warehouse (europa.eu) Bloomberg