Accounting for Risk, Hedging and Complex Contracts

A. Rashad Abdel-Khalik

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781136489280
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

With the exponential growth in financial derivatives, accounting standards setters have had to keep pace and devise new ways of accounting for transactions involving these instruments, especially hedging activities. Accounting for Risk, Hedging and Complex Contracts addresses the essential elements of these developments, exploring accounting as related to today's most relevant topics - risk, hedging, insurance, reinsurance, and more.

The book begins byproviding a basic foundation by discussing the concepts of risk, risk types and measurement, and risk management. It then introduces readers to the nature and valuation of free standing options, swaps, forward and futures as well as of embedded derivatives. Discussion and illustrations of the cash flow hedge and fair value hedge accounting treatments are offered in both single currency and multiple currency environments, including hedging net investment in foreign operations.The final chapteris devoted to the disclosure of financial instruments and hedging activities. The combination of these topics makes the book a must-have resource and referencein the field.

With discussions of the basic tools and instruments, examinations of the related accounting, and case studies to help students apply their knowledge, this book is an essential, self-contained source for upper-level undergraduate and masters accounting students looking develop an understanding of accounting for today's financial realities.

Part 1
Foundations

Chapter 1
Definitions of Risk and Risk Appetite

1.1 Risk and Open Systems

Not long ago, the Biologist Karl Ludwig von Bertalanffy introduced the concept of open systems.¹ At that time, no one could have imagined that this concept would extend to all activities, including those of business entities. The open system concept states that no system, person, organization, or object is completely self-contained; every system is open to “its environment”; it can affect the environment and the environment can affect it. Thus, any organization or system is impacted by elements over which the organization or the system has no control. It follows that the impact of the environment on the organization would be unpredictable, which led von Bertalanffy to conclude that uncertainty is a fact of life for every organization or system, which echoed the words of Frank Knight as he writes:

It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little.

(Knight, 1921, p. 199)

Almost a century after Knight published his book, these words remain germane. However, until very recently, the concept and impact of risk was not fully recognized in the field of accounting at large. Indeed, the standards and practice of auditing have been ahead of financial reporting in incorporating risk as both a cause and effect of certain actions. Nowadays, concerns about risk seem to have overtaken the discipline of financial reporting. It is now an essential part of accounting as a discipline to know more about risk, instruments of risk, risk orientation, measurement and reporting of risk exposures, and the extent to which the business enterprise manages and succeeds in mitigating risk.

This chapter discusses definitions of risk and specific aspects of uncertainty—volatility and exposure to loss. It provides summaries of decision makers’ disposition toward risk-taking and introduces the reader to two prominent theories of decision making under uncertainty.

However, it seems that confusion between uncertainty and risk is a persistent phenomenon. This chapter clarifies some issues related to the relationship between the two concepts, but it seems that we end up where Frank Knight took us almost a century ago: risk is the uncertainty for which outcomes and probabilities are known objectively or subjectively; it is measurable uncertainty.²

1.2 Risk and Uncertainty

In common speech, risk is defined as exposure to the chance of injury or loss or as a hazard or dangerous chance. One often hears the expression “it is not worth taking the risk.”³ This appears to be the sense in which Benjamin Graham viewed financial analysis in his well-known book, The Intelligent Investor (1973, 1986). He notes that risk is

a loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position—or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic [true] worth of the security.

Others define risk in terms of expected loss: the probability of a bad event happening multiplied by the economic value of the consequences that will occur if the identified bad event does take place.⁴

To summarize the notions that different authors have espoused, risk can be defined by reference to the joint space of outcomes and probabilities. As Exhibit 1.1 shows, it is possible to construct four combinations of probabilities, outcomes, knowledge or lack of knowledge.

1. Case A is the condition in which possible outcomes and the probability of occurrence of each outcome is known. This case is Frank Knight’s definition of risk.
2. Case B is the combination that Frank Knight defines as “uncertainty.” It is the condition in which outcomes could be enumerated, but the probabilities of occurrences of these outcomes are not known.
3. Case C is the situation in which outcomes are not identified. It is therefore not feasible to specify a probability distribution.
4. Case D is a state of indifference or complete ignorance as defined by Bayes (Jaynes, 2003). It is the condition in which neither the outcomes nor the probabilities of occurrences are known.

Exhibit 1.1 Combinations of Probability, Outcome and Knowledge

		Outcomes
		Known	Unknown
Probabilities	Known	(A): Risk	(C): Not Feasible
	Unknown	(B): Uncertainty	(D): Ignorance

Many authors interpret Knight’s conception of risk and uncertainty as comparing the two situations of Case A and Case B: (A) “risk” describes situations with known outcomes and known or estimable probability of occurrence of each; (B) “uncertainty” describes situations in which the possible set of outcomes is known but the probabilities of occurrences cannot be assigned to these outcomes either objectively or subjectively. But Knight added to the confusion between risk and uncertainty by additionally noting that “measureable uncertainties do not introduce into business any uncertainty whatsoever” (1921, p. 232).⁵ Today, almost 90 years later, the distinction between risk and uncertainty continues to engender debate.

More recently, Holton (2004) notes that uncertainty about the potential outcomes that matter must be present as a pre-condition for the existence of risk. He provides the example of a person jumping off a high-flying airplane. If that person is equipped with a parachute, he/she would still be uncertain about making a safe landing after jumping. This uncertainty arises because there is a chance, no matter how small, that the parachute might not function properly. In contrast, there is no uncertainty in the landing outcome of a person jumping without a parachute from an airplane while flying at a high altitude. In this case, there is no risk in the sense of a probabilistic outcome, but there would be a loss of life with certainty.

Holton describes risk as the uncertainty that matters. Some authors consider this definition more encompassing than Knight’s distinction between risk and uncertainty. For example, human beings are constantly faced with the risk of being inflicted with cancer from consuming the chemical products inputted into the foods we eat, the water we drink, the air we breathe and the clothes we wear. In this type of environment, the probability of having cancer—the outcome that matters—is unknown, but it is not zero.⁶

Risk transferring and sharing are methods of risk reduction. The most common form of risk sharing is insurance. Insurance against risk has existed for centuries in one form or another,⁷ but it was not until the 1950s that the explicit consideration of risk in investment decision making began to take shape. It was the publications of Kenneth Arrow (1951) and Harry Markowitz (1952) that sparked the interest of academia and of finance practitioners in the role of risk in making choices (Arrow, 1951; Markowitz, 1952). As the concept of risk gained prominence, some authors referred back to Frank Knight’s characterization of risk, while others have defined it by how it is measured—as the volatility of prices or returns. One could argue that the continuation of the confusion between risk as a concept and risk as an empirical metric may have been reinforced by Markowitz’ four conditions:

1. Investors try to avoid volatile investments.
2. Investors will take on more volatility (i.e., risk) only if they are rewarded for it.
3. Volatility is induced either by general market conditions (systematic risk) or by unique characteristics of the particular business enterprise (idiosyncratic risk).
4. Because volatility involves gains and losses, the unique components of risk that are attributed to any particular enterprise would be randomized as the number of investments increases.

As a consequence of these propositions, if someone invests in relatively volatile investments or projects, she/he should expect to earn, on average, a high enough return to compensate her/him for taking on the risk depicted by the observed high volatility. In general, people want to be compensated for investing in risky projects by earning a commensurate risk premium. By the same logic, people would be willing to pay someone to take the burden of risk away from them, as is the case in insurance.⁸

The question that must be asked is whether using volatility and risk interchangeably is an acceptable generalization. To illustrate the relevance of this issue, consider the view of volatility and risk in health sciences, for example. In this context, the risk that matters is the probability of falling ill or of failing to respond to treatment. This type of risk is not necessarily a function of volatility or variability of exposure to contaminants—having a high variability among individuals’ responses to exposure to hazardous chemicals does not in itself mean exposure to risk because the range of variability might be at a level of toxicity so low that it would have no impact on health—i.e., high volatility, but low risk. On the other hand, the variability of response to hazardous chemicals could be very low, but at a high level of toxicity—i.e., low volatility, but high risk. Therefore, in this context, variability and uncertainty are factors to consider in the assessment, evaluation and measurement of the risk that matters. It is evident that this simple comparison between the environments of business and health reveals two different views of the connection between risk and volatility.

To summarize, consideration of the issues raised above might lead us to agree on four propositions:

1. Risk is exposure to loss or harm and is context specific.
2. In business transactions, risk is the probability of exposure to loss (which is parallel to, but is not the same as, the ...