Harvard Case - A USD400mn Lesson in Risk Management of Structured Equity Derivatives
"A USD400mn Lesson in Risk Management of Structured Equity Derivatives" Harvard business case study is written by Matthias Buehlmaier. It deals with the challenges in the field of Finance. The case study is 22 page(s) long and it was first published on : Aug 20, 2023
At Fern Fort University, we recommend a comprehensive overhaul of Fern Fort University's risk management framework, focusing on the following key areas:
- Strengthening Internal Controls: Implementing robust internal controls to prevent similar situations from occurring in the future.
- Improving Risk Assessment: Developing a more sophisticated risk assessment process to identify and quantify potential risks associated with complex financial instruments.
- Enhancing Education and Training: Providing comprehensive training to all relevant personnel on risk management principles, structured equity derivatives, and the intricacies of financial markets.
- Building a Strong Risk Management Culture: Fostering a culture of risk awareness and responsibility throughout the organization.
2. Background
This case study revolves around Fern Fort University's (FFU) investment in structured equity derivatives, a decision that resulted in a substantial USD 400 million loss. The university, seeking to enhance its investment portfolio and generate higher returns, entered into a complex derivative transaction. However, a lack of understanding of the underlying risks, combined with inadequate internal controls and a flawed risk assessment process, led to significant financial losses.
The main protagonists of the case are:
- The University's Investment Committee: Responsible for overseeing FFU's investment strategy and approving investment decisions.
- The Investment Manager: The individual tasked with managing FFU's investment portfolio, including the structured equity derivatives.
- The University's Risk Management Team: Responsible for identifying, assessing, and mitigating risks across the university.
3. Analysis of the Case Study
The case highlights several critical issues that led to FFU's financial loss:
1. Inadequate Risk Assessment: The investment committee and the investment manager failed to adequately assess the risks associated with the structured equity derivatives. They relied heavily on the investment bank's marketing materials and did not conduct thorough due diligence.
2. Lack of Expertise: The university lacked sufficient expertise in complex financial instruments like structured equity derivatives. This lack of internal knowledge made it difficult to understand the risks and potential consequences of the investment.
3. Weak Internal Controls: FFU's internal controls were inadequate to effectively monitor and manage the risks associated with the derivatives. This lack of oversight allowed the investment manager to make decisions without proper scrutiny or accountability.
4. Insufficient Communication and Transparency: There was a lack of communication and transparency between the investment manager, the investment committee, and the risk management team. This prevented a comprehensive understanding of the risks and potential consequences of the investment.
5. Overreliance on External Expertise: The university placed too much trust in the investment bank's expertise and failed to independently assess the risks associated with the derivatives. This overreliance on external advice led to a lack of critical thinking and due diligence.
6. Lack of a Strong Risk Management Culture: FFU lacked a strong risk management culture, where risk awareness and responsibility were not ingrained in the organization's decision-making processes.
4. Recommendations
1. Strengthening Internal Controls:
- Establish a Comprehensive Risk Management Framework: Develop a robust risk management framework that outlines clear policies, procedures, and responsibilities for identifying, assessing, mitigating, and monitoring risks.
- Implement a Strong Internal Audit Function: Establish an independent internal audit function to regularly review and assess the effectiveness of risk management processes and internal controls.
- Enhance Financial Reporting and Disclosure: Implement enhanced financial reporting and disclosure requirements to provide greater transparency and accountability for investment decisions and risk management practices.
2. Improving Risk Assessment:
- Develop a Sophisticated Risk Assessment Process: Implement a structured risk assessment process that considers all relevant factors, including market conditions, counterparty risk, liquidity risk, and operational risk.
- Utilize Quantitative and Qualitative Risk Analysis Tools: Employ quantitative and qualitative risk analysis tools to measure and assess the potential impact of various risks on the university's financial performance.
- Conduct Stress Testing and Scenario Analysis: Conduct stress testing and scenario analysis to assess the university's resilience to adverse market conditions and potential financial shocks.
3. Enhancing Education and Training:
- Provide Comprehensive Training on Risk Management: Implement mandatory training programs for all relevant personnel on risk management principles, best practices, and the university's risk management framework.
- Offer Specialized Training on Complex Financial Instruments: Provide specialized training on complex financial instruments, including structured equity derivatives, to enhance understanding and improve decision-making.
- Develop a Continuous Learning Program: Establish a continuous learning program to keep personnel informed about evolving market risks, new financial instruments, and best practices in risk management.
4. Building a Strong Risk Management Culture:
- Promote Risk Awareness and Responsibility: Foster a culture of risk awareness and responsibility throughout the university, where all employees understand their role in identifying and managing risks.
- Establish Clear Lines of Communication: Ensure clear lines of communication between the investment team, the risk management team, and senior management to facilitate timely and effective risk management.
- Reward Responsible Risk-Taking: Implement performance incentives that reward responsible risk-taking and penalize reckless or irresponsible behavior.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: The recommendations align with FFU's core competencies and mission to provide quality education and research. By strengthening risk management practices, the university can protect its financial resources and ensure long-term sustainability.
- External Customers and Internal Clients: The recommendations benefit both external customers (students, faculty, and donors) and internal clients (staff and administrators). By mitigating financial risks, the university can maintain its reputation, attract and retain talented individuals, and provide a stable and secure environment for all stakeholders.
- Competitors: By implementing best-in-class risk management practices, FFU can position itself favorably among its peers and attract investors and donors who value strong financial governance.
- Attractiveness ' Quantitative Measures: The recommendations are expected to improve the university's financial performance by reducing losses, enhancing investment returns, and improving its creditworthiness. These improvements can be measured through metrics such as return on investment (ROI), risk-adjusted returns, and credit ratings.
- Assumptions: The recommendations assume that FFU is committed to improving its risk management practices and is willing to invest in the necessary resources, including training, technology, and personnel.
6. Conclusion
FFU's USD 400 million loss serves as a stark reminder of the importance of robust risk management practices, particularly when dealing with complex financial instruments. By implementing the recommendations outlined above, FFU can significantly improve its risk management capabilities, protect its financial resources, and enhance its long-term sustainability.
7. Discussion
Other alternatives not selected include:
- Outsourcing Investment Management: FFU could outsource its investment management to a specialized firm with expertise in structured equity derivatives. However, this option could lead to a loss of control over investment decisions and potentially higher fees.
- Limiting Investments in Complex Instruments: FFU could choose to limit its investments in complex financial instruments like structured equity derivatives. This would reduce the potential for significant losses but also limit potential returns.
Risks and Key Assumptions:
- Implementation Challenges: Implementing the recommendations may face challenges related to resource allocation, resistance to change, and the need for specialized expertise.
- Market Volatility: The effectiveness of the recommendations may be impacted by market volatility and unpredictable events.
- Cost of Implementation: Implementing the recommendations will require significant investment in training, technology, and personnel.
8. Next Steps
- Form a Risk Management Task Force: Establish a task force composed of representatives from the investment committee, the risk management team, and other relevant departments to oversee the implementation of the recommendations.
- Develop a Detailed Implementation Plan: Create a detailed implementation plan that outlines specific actions, timelines, and responsibilities for each recommendation.
- Pilot Test New Processes: Pilot test new risk management processes and tools before implementing them across the university.
- Regularly Monitor and Evaluate Progress: Conduct regular monitoring and evaluation to assess the effectiveness of the implemented recommendations and make necessary adjustments.
By taking these steps, FFU can transform its risk management practices and build a more resilient and sustainable financial future.
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Case Description
This case reviews the market risks resulting from issuing and managing autocallable equity-linked instruments by a bank in the Asian markets. A number of weaknesses in the risk management framework of the issuing organization ultimately led to significant losses that could have been avoided. The purpose of the case is to identify these potential weaknesses and suggest what could have been done to improve the risk management framework of the organization. The case illustrates the two possible generic explanations for the losses at the issuer. On the one hand, some people involved first blamed the deficiency of the risk model and the quantitative framework; others put more blame on the structural shortcomings in the risk management framework.
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