This is the risk radar that investors switch off when they buy a company based on perceived reputation. Reputation is used instead as the proxy for risk management. Thus, many investors went into Enron, Worldcom or Equitable Life because they were regarded as good pedigree companies. Long-Term Capital Management, adorned with a Nobel prize-winner on board, had a total market exposure estimated at $1250 billion against its capital of $800 million.
Many people just want rapid profit, but they do not have a clue about real risk management. Setting an investment project goal with a risk limit is essential; it is not an optional extra. A predefined project by RAMP methodology has goals, expected performance and variance reporting. This puts adverse CEO spotting back on the project agenda.
Finding the company on our corporate AEW radar can warn us that the company is about to “blow”. This organic-based system uses both figures and mathematical techniques, but is more about the manner in which human beings operate. The forensic evidence can be tracked down in audit trails. There are scents given off by CEO sharks associated by red flags alarm signals for indicating weak banks.
There are essential tools to identify weak banks using early warning techniques. This subjects the supervisor’s data on the bank to a stress testing process, of the bank’s expenses, asset quality of portfolio and their funding. Then we can derive a better risk-discounted picture of the earnings, capital and solvency. This is followed by qualitative (note not quantitative) modelling:
Qualitative data
Management/board of directors have oversight administration deficiencies; the oversight committee may not be empowered, or it is too chummy with the CEO.
Risk management has deficiencies in resourcing, empowerment and skills.
Strategic mistakes have been made by the board into the market.
Quantitative data
Performance-related rise in declared profits, asset value, sales.
Aggressive growth and expansion strategies.
Sudden and major deterioration in earnings.
Basel II recognises that such operational risk weaknesses cause big problems for the investors. Its AEW10 system also focuses on warning signs in:
Board management quality.
Effectiveness of policies, procedures and planning.
Execution of risk management controls and audits.
Quality of MIS systems and reporting processes.

However, the danger is that individuals and corporations might not understand the value or operation of the investments being sold. It sounds like another Millennium Dome. This makes for a bad investment project. Under RAMP methodology, there are minimum criteria for a successful and desired result:
Clearly stated and understood objectives.
Defined scope of the project investment.
Clear responsibilities and project ownership of these parties.
Estimated budget for the project.
Defined end-state for the project.
Milestone date of project end.
Under extremely unclear financial engineering or complex business lines where none of the above conditions exist, then a successful outcome is very unlikely. Thus, clients may be occasionally oversold derivative products and inappropriate investment strategies. It is not just the banks and investment funds who have lost. The main losers are the humble private investors.

Investor risk is perceived as fear or underperformance, notably in losing the value of the original investment. Substantial benchmarking occurs, notably in the comparison of returns against inflation, stock-market and other industrial yardsticks. Similar executive peer-group pressure and benchmarking lead them to see who gained the highest award from the remuneration committee. Not all CEOs are intent on removing value from the company, a fine minority contribute by increasing investor wealth whether in share price or earnings per share.
The hazard remains that many CEOs are executive recruitment failures. They create negative shareholder return and blacken the name of the company. Reputational risk emerges as one of the more obscure risks, while being costly too. An incompetent executive seems to be excusable in the markets, certainly if we believe the newspaper accounts; being crooked is not. Either way, CEO tenure is usually short term, so CEOs may adopt the attitude: “Better clean up the company assets before they boot me out.”
We have seen that the Board of Directors is not always an adequate counter to the ego of the CEO and the wish for more M&A and self-aggrandisement. Non-executive directors, who are enlisted in a cabal to add to the existing yes-men on the Board, can never serve to deter the company from embarking on an unacceptably risky course. We need an essential set of conditions for successful corporate guidance.
An appropriate range of multidisciplinary skills
Power to ensure effective implementation of decisions
Ability to undertake effective assessments of the soundness of decisions associated with projects
Suitably qualified and dedicated support staff for the collection and analysis of data
Otherwise, we are condemned with the dire corporate leadership that has steered so many companies on the rocks.
An incompetent or crooked CEO underperforms colleagues and rivals. The bottom line is either the profit level or the share price. They fail on both scores. Failure should destroy their reputation in the industry. While the CEO can inflict great damage upon the company, reputational risk decrees that the executive can be punished with the embarrassment of being summarily ejected. By then it may be too late. There are two subrisks operating here – stemming from:
an inept executive;
a crooked executive.
What to do? Risk management becomes an empirical business study in corporate control.
We have seen how risk comprises:
hazard;
catalyst;
result.
We come back to the risk of a shark attack described in previous posts. The shark has a large dorsal fin that alerts us to its impending attack. We have already detailed an AEW warning system to alert us to the adverse CEO choice.
There are various risk management techniques to shed light upon a dark corporate operational area. These can include more effective interviewing to bring unsuitable executive candidates under the spotlight. Another is to undertake a management review of the control structure for recruiting key staff. Redesign the audit processes to block potential fraudulent financial statements passing the accounting process.
Compare this risk management arsenal against the risk of a fraudulent CEO. Fraud needs conditions:
1. motivation;
2. opportunity;
3. rationalisation.
We deploy risk countermeasures:
1. Anti-fraud motivation measures – better training of staff and recruitment, screening and interviewing of new applicants, monitor HR performance at work plus instigate an effective ethics programmes.
2. Anti-fraud opportunity measures – better staff monitoring, accounts screening, external audits, limit IT systems access and raise security physical access limits.
3. Anti-fraud rationalisation measures – raise chances of detection, raise punishment levels to act as deterrent, lower expectations of profit.
Risk management is really about a logical sequence of tasks to protect the business investment. The enterprise risk management strategy or life-cycle could be outlined as the series of tasks.
I. Risk detection.
II. Risk countermeasures.
III. Risk monitoring.

In this blog we have discussed many aspects of forward contracts and forward markets. We will conclude the post (and each of the following posts, which cover futures, options, and swaps) with a brief discussion of the role that these markets play in our financial system. Although forward, futures, options, and swap markets serve similar purposes in our society, each market is unique. Otherwise, these markets would consolidate.
Forward markets may well be the least understood of the various derivative markets. In contrast to their cousins, futures contracts, forward contracts are a far less visible segment of the financial markets. Both forwards and futures serve a similar purpose: They provide a means in which a party can commit to the future purchase or sale of an asset at an agreed-upon price, without the necessity of paying any cash until the asset is actually purchased or sold. In contrast to futures contracts, forward contracts are private transactions, permitting the ultimate in customization. As long as a counterparty can be found, a party can structure the contract completely to its liking. Futures contracts are standardized and may not have the exact terms required by the party. In addition, futures contracts, with their daily marking to market, produce interim cash flows that can lead to imperfections in a hedge transaction designed not to hedge interim events but to hedge a specific event at a target horizon date. Forward markets also provide secrecy and have only a light degree of regulation. In general, forward markets serve a specialized clientele, specifically large corporations and institutions with specific target dates, underlying assets, and risks that they wish to take or reduce by committing to a transaction without paying cash at the start.
Forward contracts are just miniature versions of swaps. A swap can be viewed as a series of forward contracts. Swaps are much more widely used than forward contracts, suggesting that parties that have specific risk management needs typically require the equivalent of a series of forward contracts. A swap contract consolidates a series of forward contracts into a single instrument at lower cost. Forward contracts are the building blocks for constructing and understanding both swaps and futures. Swaps and futures are more widely used and better known, but forward contracts play a valuable role in helping us understand swaps and futures. Moreover, as noted, for some parties, forward contracts serve specific needs not met by other derivatives.

As derivative markets develop, options (and even some other types of derivatives) have begun to emerge on such underlyings as electricity, various sources of energy, and even weather. These instruments are almost exclusively customized over-the-counter instruments. Perhaps the most notable feature of these instruments is how the underlyings are often instruments that cannot actually be held. For example, electricity is not considered a storable asset because it is produced and almost immediately consumed, but it is nonetheless an asset and certainly has a volatile price. Consequently, it is ideally suited for options and other derivatives trading.
Consider weather. It is hardly an asset at all but simply a random factor that exerts an enormous influence on economic activity. The need to hedge against and speculate on the weather has created a market in which measures of weather activity, such as economic losses from storms or average temperature or rainfall, are structured into a derivative instrument. Option versions of these derivatives are growing in importance and use. For example, consider a company that generates considerable revenue from outdoor summer activities, provided that it does not rain. Obviously a certain amount of rain will occur, but the more rain, the greater the losses for the company. It could buy a call option on the amount of rainfall with the exercise price stated as a quantity of rainfall. If actual rainfall exceeds the exercise price, the company exercises the option and receives an amount of money related to the excess of the rainfall amount over the exercise price.
Another type of option, which is not at all new but is increasingly recognized in practice, is the real option. A real option is an option associated with the flexibility inherent in capital investment projects. For example, companies may invest in new projects that have the option to defer the full investment, expand or contract the project at a later date, or even terminate the project. In fact, most capital investment projects have numerous elements of flexibility that can be viewed as options. Of course, these options do not trade in markets the same way as financial and commodity options, and they must be evaluated much more carefully. They are, nonetheless, options and thus have the potential for generating enormous value. Again, our emphasis is on financial options, but readers should be aware of the growing role of these other types of options in our economy. Investors who buy shares in companies that have real options are, in effect, buying real options. In addition, commodity and other types of options are sometimes found in investment portfolios in the form of “alternative investments” and can provide significant diversification benefits. To this point, we have examined characteristics of options markets and contracts. Now we move forward to the all-important topic of how options are priced.

Options in which the asset underlying the futures is a commodity, such as oil, gold, wheat, or soybeans, are also widely traded. There are exchange-traded as well as over-the-counter versions. Over-the-counter options on oil are widely used.
Our focus in this blog is on financial instruments so we will not spend any time on commodity options, but readers should be aware of the existence and use of these instruments by companies whose business involves the buying and selling of these commodities.

In earlier posts we covered futures markets. One of the important innovations of futures markets is options on futures. These contracts originated in the United States as a result of a regulatory structure that separated exchange-listed options and futures markets. The former are regulated by the Securities and Exchange Commission, and the latter are regulated by the Commodity Futures Trading Commission (CFTC). SEC regulations forbid the trading of options side by side with their underlying instruments. Options on stocks trade on one exchange, and the underlying trades on another or on Nasdaq.
The futures exchanges got the idea that they could offer options in which the underlying is a futures contract; no such prohibitions for side-by-side trading existed under CFTC rules. As a result, the futures exchanges were able to add an attractive instrument to their product lines. The side-by-side trading of the option and its underlying futures made for excellent arbitrage linkages between these instruments. Moreover, some of the options on futures are designed to expire on the same day the underlying futures expires. Thus, the options on the futures are effectively options on the spot asset that underlies the futures.
A call option on a futures gives the holder the right to enter into a long futures contract at a fixed futures price. A put option on a futures gives the holder the right to enter into a short futures contract at a fixed futures price. The fixed futures price is, of course, the exercise price. Consider an option on the Eurodollar futures contract trading at the Chicago Mercantile Exchange. On 13 June of a particular year, an option expiring on 13 July was based on the July Eurodollar futures contract. That futures contract expires on 16 July, a few days after the option expires.” The call option with exercise price of 95.75 had a price of $4.60. The underlying futures price was 96.21. Recall that this price is the IMM index value, which means that the price is based on a discount rate of 100 – 96.21 = 3.79. The contract size is $1 million. The buyer of this call option on a futures would pay 0.046($1,000,000) = $46,000
and would obtain the right to buy the July futures contract at a price of 95.75. Thus, at that time, the option was in the money by 96.21 – 95.75 = 0.46 per $100 face value. Suppose that when the option expires, the futures price is 96.00. Then the holder of the call would exercise it and obtain a long futures position at a price of 95.75. The price of the underlying futures is 96.00, so the margin account is immediately marked to market with a credit of 0.25 or $625.” The party on the short side of the contract is immediately set up with a short futures contract at the price of 95.75. That party will be charged the $625 gain that the long made. If the option is a put, exercise of it establishes a short position. The exchange assigns the put writer a long futures position.

As we noted in earlier posts, the currency forward market is quite large. The same is true for the currency options market. A currency option allows the holder to buy (if a call) or sell (if a put) an underlying currency at a fixed exercise rate, expressed as an exchange rate, Many companies, knowing that they will need to convert a currency X at a future date into a currency Y, will buy a call option on currency Y specified in terms of currency X. For example, say that a U.S. company will be needing €50 million for an expansion project in three months. Thus, it will be buying euros and is exposed to the risk of the euro rising against the dollar. Even though it has that concern, it would also like to benefit if the euro weakens against the dollar. Thus, it might buy a call option on the euro. Let us say it specifies an exercise rate of $0.90. So it pays cash up front for the right to buy €50 million at a rate of $0.90 per euro. If the option expires with the euro above $0.90, it can buy euros at $0.90 and avoid any additional cost over $0.90. If the option expires with the euro below $0.90, it does not exercise the option and buys euros at the market rate.
Note closely these two cases:
Eum expires above $0.90
Company buys €50 million at $0.90
Eum expires at or below $0.90
Company buys €50 million at the market rate
These outcomes can also be viewed in the following manner:
Dollar expires below €1.1111, that is, €1 > $0.90
Company sells $45 million (€50 million X $0.90) at € 1.1 1 1 1, equivalent to buying €50 million
Dollar expires above €1.1
11 1, that is, €1 < $0.90
Company sells sufficient dollars to buy €50 million at the market rate This transaction looks more like a put in which the underlying is the dollar and the exer- cise rate is expressed as €1.1 11
1. Thus, the call on the euro can be viewed as a put on the dollar. Specifically, a call to buy €50 million at an exercise price of $0.90 is also a put to sell €50 million X $0.90 = $45 million at an exercise price of 1/$0.90, or €1.11 1 1.
Most foreign currency options activity occurs on the customized over-the-counter markets. Some exchange-listed currency options trade on a few exchanges, but activity is fairly low,