Financial Decision Making: 3 Questions Every CFO Must Ask and Answer

Posted by Peter Orr on Tue, Jul 20, 2010 @ 08:56 AM

Fork in road

Credit markets are certainly not “normal” (in any sense of the
word) but at least they’re stable enough for issuers to make some decisions. That said, keeping in mind the answers to three deceptively simple yet vitally important questions will always serve CFOs, governing boards, finance committees, and other financial decision makers very well.

Notice that these questions are not framed in terms of some specific risk metric or probability. That’s because they are intended to address decision making in a way that we (as a species) are best suited to understanding. Despite the fact that banking regulation has often focused on extremely remote events like 99.9% annualized confidence intervals i.e. events that happen every 1,000 years, it’s a well researched fact that we human types simply don’t do very well making decisions about such tiny likelihoods. We tend to overemphasize the dramatic remote risks (shark attacks and plane crashes) over the far more dangerous yet mundane occurrences (auto accidents and drowning).   

Can we make it through the worst plausible scenario?

The nature of risk management comes first in defining a plausible event or set of events to be concerned about. Without some sense for what that the downside concern is and how it will impact a corporation’s financial position, risk management doesn’t exist. Notice that this is where the entity’s level of risk aversion comes explicitly to the surface.

“Make it through” will mean different things to different entities since incentives and consequences, including political fallout, are obviously not uniform across institutions. For many, this concept is tied to liquidity access – a topic that’s found a great deal of interest over the last 18 months.

“Plausible” is also an important word here. An issuer I know, when answering this question for themselves, looked at the marks on their swaps if the entire yield curve moved to 0%. This is obviously a definable event and it gives one boundary value for their swaps; some people may consider it so implausible however that it should not be the focus in response to this question.  

How much might we gain in the best plausible scenario?

This is an important question in that if there’s very little gain expected relative to the “do nothing” scenario, absorbing the risk may not be worth it. This question wraps in it whether you want to evaluate the best scenario in terms of the individual transaction in isolation, or evaluate the overall impact against the backdrop of the entire portfolio (debt and/or investment).

The answer to this question in conjunction with the first helps determine the nature of the strategy’s distribution. A remote but large downside with a modest but likely upside is similar to a “sold option” situation. A fairly uniform upside and downside is a simple long position in some risk, etc. 

What is the breakeven?

How far do the factors that affect the performance of the instrument(s) need to move in order for the strategy to break even with the “do nothing scenario”? For instance, do you want exposure to SIFMA based variable rates as a tax-exempt borrower if you believe significant inflation will arrive eventually and you can lock in a rate at 3.75% fixed? How fast to floating rates need to rise for this strategy to break even (download model here)?

Understanding the break even helps us evaluate the likelihood that the transaction will work in your favor in a way that no other calculation really does. It allows us to directly assess a tangible, quantified event and the subjective probability that that event will occur. With that information in hand, evaluation of the best course of action is often much more clear.

For analytics that help answer each of these questions using rigorous, comprehensive decision frameworks see here.

Tags: Financial Decisions, business process, risk in finance, decision support, financial risk