Module 22 — Financial Risk: Market, Credit & Liquidity

Market risk (FX, interest rate, commodity), credit risk management, liquidity risk frameworks, and stress testing. The CFO's toolkit for protecting the balance sheet.

Learning Objectives

Quantify FX, interest rate, and commodity risk exposures
Design credit risk management frameworks for receivables and counterparty risk
Apply liquidity risk metrics: LCR, NSFR, cash runway
Conduct stress tests and reverse stress tests
Communicate financial risk to the board in quantified terms

1. Market Risk — FX Exposure

Three Types of FX Risk

Type	Definition	Example
Transaction Risk	Risk from specific future foreign currency cash flows	Paying USD supplier invoice in 90 days
Translation Risk	Risk of P&L/balance sheet changes when consolidating foreign subsidiaries	Dubai subsidiary earnings translated to PKR
Economic Risk	Long-term impact of FX on competitive position and future cash flows	PKR depreciation making Pakistani exports cheaper

Measuring FX Exposure

Net exposure by currency: Sum of all currency inflows minus all currency outflows for each currency
Natural hedge ratio: % of FX inflows that offset FX outflows in the same currency
Sensitivity analysis: Impact of 10%, 20%, 30% PKR depreciation on P&L and net assets

FX Risk Reporting

Currency	Payables (PKR)	Receivables (PKR)	Net Exposure (PKR)	Natural Hedge %	Unhedged Exposure
USD	2,000M	800M	(1,200M)	40%	(720M)
EUR	500M	200M	(300M)	40%	(180M)

FX Policy — Key Parameters

Maximum unhedged exposure per currency (PKR or %)
Mandatory hedging threshold: any exposure > X days or PKR amount requires hedge
Approved instruments: forwards, options (and which types), cross-currency swaps
Authorization levels: what can treasury manage vs what requires CFO/board approval

2. Market Risk — Interest Rate Risk

Fixed vs Floating Rate Risk

Floating rate risk (most common): Borrowing at KIBOR + spread — rising rates increase interest costs directly.

Fixed rate risk: Locked in at high rates if market rates fall; opportunity cost.

Duration and interest rate sensitivity:

Interest Rate Sensitivity = Net Floating Rate Exposure × Rate Change
Example: PKR 5bn floating rate debt × 1% rate rise = PKR 50M additional annual interest cost

Interest Rate Risk Hedging

Interest rate swaps: Swap floating for fixed — pay fixed, receive floating; converts floating exposure to fixed
Interest rate caps: Maximum rate protection while retaining benefit if rates fall
Cross-currency interest rate swaps: Swap both currency and interest rate basis simultaneously

KIBOR and SBP Policy Rate Exposure (Pakistan Context)

SBP policy rate is the anchor for KIBOR
Pakistan experienced rapid rate cycles: 8% → 22% (2022–2023) → easing (2024–2025)
CFOs must model KIBOR sensitivity for every new borrowing and existing floating exposure
Covenant headroom should be stress-tested at KIBOR +400bps in budgets

3. Market Risk — Commodity Risk

Commodity Price Exposure Types

Input commodity risk: Raw material prices (cotton, steel, crude, wheat)
Output commodity risk: Product prices denominated in commodity markets
Energy price risk: Gas and electricity costs for energy-intensive industries

Pakistan Commodity Risk Context

Textile sector: Cotton price, yarn price, polyester price
Cement: Coal and fuel price (historically imported)
Food processing: Wheat, sugar, palm oil
Power sector: Furnace oil, natural gas, coal — fuel mix changes with policy

Commodity Hedging — When It Makes Sense

Physical commodity hedging via futures and swaps requires:

Sufficient volume to make hedging cost-effective
Liquid futures market for the commodity
Management capability to monitor positions
Board-approved hedging policy

4. Credit Risk

Credit Risk Framework

Customer credit risk (trade receivables):

Credit assessment before extending terms — financial analysis, trade references
Credit limits — maximum outstanding balance per customer
Credit insurance — protects against debtor insolvency (EXIM Bank for export)
Monitoring: aging report, debtor days trend, top-10 concentration
Collection: escalation protocol at 30/60/90 days past due

Expected Credit Loss (ECL) — IFRS 9:

ECL = Probability of Default (PD) × Exposure at Default (EAD) × Loss Given Default (LGD)

Three-stage model:

Stage 1: Performing — 12-month ECL
Stage 2: Significant credit deterioration — lifetime ECL
Stage 3: Credit-impaired — lifetime ECL + stop accruing interest revenue

Counterparty credit risk (treasury):

Bank limits: maximum deposit/derivative exposure per bank counterparty
Rating requirements: minimum credit rating for approved bank counterparties
Diversification: no single bank > 30% of total treasury balances

Credit Concentration Risk

Metric	Definition	Typical Threshold
Single debtor concentration	Largest debtor / Total receivables	< 20%
Top 5 debtor concentration	Top 5 debtors / Total receivables	< 50%
Sector concentration	Largest sector / Total receivables	< 40%

5. Liquidity Risk

Liquidity Coverage Ratio (LCR) — Basel III

LCR = High Quality Liquid Assets (HQLA) / Net Cash Outflows over 30 days ≥ 100%

For non-bank CFOs: ensure sufficient liquid assets to cover 30-day cash outflows in a stress scenario.

Net Stable Funding Ratio (NSFR) — Basel III

NSFR = Available Stable Funding / Required Stable Funding ≥ 100%

Addresses structural liquidity — ensures long-term assets are funded with stable long-term liabilities, not short-term funding.

Cash Runway

Cash Runway = Available Cash + Undrawn Credit Facilities / Monthly Cash Burn

Minimum 3–6 months runway as policy. Below 2 months = crisis-level liquidity risk.

Liquidity Ladder — 12-Month Cash Flow Forecast

Build weekly/monthly cash flow forecast showing:

Operating cash inflows and outflows by period
Debt service schedule — principal and interest
Committed CAPEX payments
Net surplus/(deficit) by period
Available headroom from credit facilities

Liquidity Stress Testing

Stress scenarios to test:

Revenue shock: 30% revenue decline for 3 months
Customer default: Loss of top 3 customers simultaneously
Credit line withdrawal: Bank withdraws revolving credit facility
Combined stress: Revenue shock + credit line withdrawal simultaneously

6. Stress Testing and Reverse Stress Testing

Stress Testing Mechanics

Identify key financial risk variables (FX, interest rate, credit loss rate, revenue)
Define stress scenarios — adverse but plausible (e.g., 1-in-10 year event)
Apply stress to financial model — P&L and balance sheet impact
Assess: can the entity absorb the stress? Are covenants breached? Is liquidity adequate?
Identify mitigating actions available

Reverse Stress Testing

Instead of asking "what happens if X goes wrong?" ask: "What would need to go wrong for the business to fail?"

This surfaces non-obvious scenarios where multiple modest risks combine to produce catastrophic outcomes. Regulatory expectation for significant financial entities.

Board Stress Test Presentation

Show:

Base case → Stress case → Available headroom
Key assumptions that drive the stress outcome
Management actions that would be triggered under stress
Residual risk after actions

Self-Assessment

Your company has USD 10M in payables due in 6 months and USD 4M in receivables due in 4 months. The current PKR/USD rate is 280. Calculate the net USD exposure and the P&L impact if PKR depreciates to 310 by the payment date. What hedge would you put in place?
Design a credit risk framework for a Pakistani trading company with PKR 3bn in trade receivables across 150 customers. Cover: credit assessment, limits, monitoring, and IFRS 9 ECL staging.
KIBOR rises from 15% to 20%. Your company has PKR 4bn in floating rate bank loans (KIBOR + 150bps) and PKR 2bn in fixed rate bonds (15% coupon). Calculate the impact on annual interest cost and assess whether existing EBITDA provides adequate interest coverage at the stressed rate.