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Balancing exposure to market forces

Is there any sure way to manage market risks?

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If every business were exposed to just one set of market forces, the life of the chief financial officer would be so much easier. Some are: mining companies, for example, can afford to focus their risk management squarely at commodity prices in their area of activity. But for most, it's a bit more complicated.

If you need finance, want to issue bonds, or have a healthy amount of cash of the balance sheet then the banking and financial markets become a key factor. As for manufacturing, the markets for both supply and demand are suddenly in play.

If you're active in more than one region, then global trade balances and local market conditions can make all the difference. No wonder market risks came in as high as sixth place in the Ernst & Young (EY) global survey of management risks.

"Globalisation has made market risks both harder to map and quicker to crystallise," says Keith Strachan, director in treasury advisory at EY.

"Look at banking. German state banks – highly conservative – invested in the US property market via securitised debt instruments that offered much-needed yield at a time of low rates. Suddenly, a market failure in the US – in residential property – spreads contagion to places that 30 years ago would have been totally insulated."

The banking market is a prime example. Eight years ago, Basel II introduced a fundamental change to the market. Then the financial crisis caused it to shift again in totally unpredictable ways.

"Now with Basel III, banks are starting to look at their business model and think about a change in their relationships with customers," Strachan says. "Many of them will exit markets and re-evaluate products."

There are new risks, too. Prior to the financial crisis, most CFOs probably didn't give much thought to the risk of a bank failing. Post-Lehman Bros - and post-bailouts - that immediately came on the risk radar. But the new top risk isn't failure – it's that proper pricing of the risk and cost of the service will massively increase prices.

Market risks can change the whole basis for a company's operations. And that leads many managers to bury their head in the sand.

"For example, we worked with the European arm of a US company," Strachan explains. "Some of its shareholders started asking last year about the potential impact of a collapse of the euro. The US management team asked their European counterparts to assess the risk – but didn't get real engagement. It was perceived as too remote an occurrence.

"The European manager's judgement might be sound. But even if they had correctly identified the probability of the risk crystallising at, say, 5 percent – that's still betting the company on being right. You can never ignore high-impact market risks, even if they have low probability."

Commodities run amok

The financial services market is suffering from a series of point-in-time corrections – related to past imbalances and new regulation. But some market risks are driven by longer-term trends.

Take commodities. There's no question they have a bearing on financial performance. According to a recent CFO Research survey, 81 percent of US finance executives claim to be suffering more volatility now – with 24 percent claiming it has hurt earnings before interest and tax by at least 0.5 percent over the past year.

"There are the cyclical issues related to current consumption and availability," Strachan says. "But a huge driver is the rapidly expanding middle class in some of the fast-growth economies, bringing new expectations about consumption. So you have meat intake soaring in China, for example, which fundamentally alters that whole market – forever."


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