Risk management in isolation is risky: to avoid unintended consequences of their decisions, treasurers need to apply the same partner-with-the-business mentality for risk management as they do for other activities and not treat it as an isolated treasury function.

• Author: Stowe, David W.
• Position: TREASURY

The adage that "hindsight offers 20/20 vision" can be applied to certain treasury and risk-management activities. Overall, risk management, financial or otherwise, carried out in isolation has the potential to spawn unwanted, unintended consequences that are far easier to detect retrospectively. That's certainly the way to characterize the case of South African Airways Ltd. (SAA) and the impact of its widely publicized currency hedging losses in 2003 and 2004.

The airline's troubles began when its treasury group executed a simple and widely accepted hedging strategy of locking in future long-term currency exposures with forward contracts (purchase U.S. dollars/sell SA-rand for future delivery).

Specifically, the objective was to fix the rand-dollar exchange rate on future dollar-based jet fuel and long-term aircraft purchase contracts to avoid the risk of a further decline in rand value. In managing this one specific risk--currency risk, per se--SAA failed to see, ignored or was otherwise not knowledgeable enough to foresee the future unintended consequences of its actions.

The law of unintended consequences is understood to suggest that each cause has more than one effect, and will include unforeseen effects. Less a law or rule itself, it should be viewed as a call to decision-makers to exercise caution.

In SAA's situation, the hedging strategy had its intended impact: locking in the exchange rate on future non-rand purchases. It should have achieved a primary value-added objective of risk management and, thus, allowed management to plan. This can be referred to as a "first-order effect," or an intended consequence. But, the hedge, or future commitment of the forward contracts, had other, unintended consequences, referred to as "second-order effects."

In the case of SAA, these second-order effects impacted two areas: its financial position, referred to as the "accounting impact," and its purchasing strategy, the "business impact."

* Unintended Consequence #1: Accounting Impact. The accounting impact, was a result of SAA's newly adopted hedge accounting requirements of the time: AC133, Financial Instruments: Recognition and Measurement (according to South African generally accepted accounting principles (GAAP)), which required the airline to carry its derivatives on its balance sheet at fair value and mark to market the change in the derivatives' value over time, either through earnings or equity, depending on the qualifying hedge relationship.

At the time, the rand's value against the dollar--which had been in a persistent decline--reversed and appreciated substantially, causing the forward contract's fair value to erode. As a result, the adjustment to the forward contract's declining fair value eventually impacted the company's net equity position as the unrealized...