When an amount of money greater than the capital of Barings was transferred to the futures exchange in Singapore to cover margin payments, logic suggests that an alarm should have sounded. After all, margin call "outs" mean losses on the futures contracts.
The extraordinary returns that Orange County earned in its investment funds and treasury operations should have triggered warning signals as well.
But the sirens didn't go off in either case, apparently because neither organization had in place a comprehensive approach to the management of financial price risk: the risk of a significant unexpected loss in an enterprise caused by the movement of prices in key financial markets.
To avoid the kinds of problems encountered by Barings and Orange County, as well as more mundane problems with poor hedging results, an organization should have a conceptual framework that will not allow significant financial price risks to go unnoticed.
Banks will find such a framework useful in managing their own financial risks. They will also find it useful in helping customers look at and understand theirs. That understanding will translate into valuable transaction opportunities and will also help improve the bank's understanding of the customer's credit.
A comprehensive approach to financial price management includes six fundamental steps:
*Identify risk. Understand where and how financial price risk arises in the operation of the organization as well as in the economic environment in which it functions.
*Measure risk. Take the care and time to quantify how much of each type of risk the firm faces. In both the identification and measurement steps, care must be taken to understand how the risks relate to each other and how those relations affect the measurement.
*Develop strategy. Look at the nature and size of each risk and decide whether to take some action (using on-balance-sheet or off-balance-sheet techniques), do nothing, or, in some cases, take more risk.
*Identify tools. If off-balance-sheet action is the strategy, the correct tool must be selected from a tool kit which includes futures, forwards, swaps, options, or, in the case of exotic risks, exotic derivatives.
*Execute strategy. Carefully implement the strategy using the tool selected. At this step, there are issues related to credit risk, documentation, accounting, and operations which must be considered
*Monitor strategy. Regularly compare the performance of the strategy to the risk itself to make certain that the combined result is acceptable.
This process is not a recipe for hedging but rather a way of thinking about the environment in which the organization functions and how it operates.
Today, many organizations regularly fail to implement some of the critical steps in this process.
A great many organizations omit the first three steps. They expose themselves to unexpected results because they have missed some offsetting positions within the organization.
Still other organizations implement the first five steps reasonably well but then fail to monitor the results that they achieve. As the nature of the underlying risk changes over time, they slowly drift away from the results that they had hoped to achieve.
However, there are signs of progress. Some firms are beginning to integrate their traditional risk management functions, which deal with classic insurable risks such as fire and loss of business, with financial price risk management and the rapidly developing credit derivatives market which offers a form of credit risk insurance.
These are the first steps toward an enterprisewide approach to thinking about risk which will offer many organizations exciting possibilities for improved financial performance.
Mr. Cunningham is managing director of Gnosis Inc., a Chicago derivatives training and consulting practice. Mr. Feldman is a managing director of Learning Insights, a Chicago publisher of interactive training programs for finance practitioners.
