Market volatility affects an organization's current activities through its impact on things such as the cost of capital, raw materials and capital assets. It also affects their future activities, including long-term employee benefits, asset value and supply chains.
Managing the effect on the immediate business activities is comparatively easy. In the short term, organizations can often be nimble in their responses, for example by choosing to accelerate or defer decisions, or changing suppliers to obtain better prices for transactions in the current period.
Protecting themselves against longer-term market fluctuations – for example, through hedging transactions – is a much more complex and complicated process since it depends on a variety of factors that include everything from the organization's risk appetite, the elasticity of its customer demand, analyst expectations and activist concerns to a sufficient understanding of market movements and the availability of various derivative financial instruments.
While effective hedging strategies may protect the organization's purchasing and financing costs from fluctuations, they cannot immunize its financial reporting from volatility that arises from fair value measurements and impairment assessments. These values take into consideration management's estimates of several market-related data points at a specific date, but since they reflect long-term trends, they will also reflect market fluctuations and lead to potentially volatile results.
Organizations should ensure that the information presented in their financial reports is clear and transparent. This includes clearly explaining the organization's exposure to different market forces. Hedging strategies should be described in plain English, clearly discussing management's objectives and the assessment of their strategies' effectiveness so readers can understand what management is trying to avoid and whether it has been successful. Discussions of the sensitivity analysis should include the significant assumptions made by management so readers can perform their own analysis using either more or less conservative assumptions.
Based on the organization's risk appetite, the board of directors should determine the risks that need to be managed by the organization and how they will be managed, and the risks that will not be actively managed. Boards should ensure that clearly articulated policies are put in place that document the types of instruments to be used, the authorized level of use, and the exposures for which they are to be employed.
It is also important for the board to ensure that the organization has the proper expertise and capabilities to enter into and account for such transactions. Hedge accounting can be complex and requires robust financial reporting systems to collect the information, and solid expertise with those instruments, to properly reflect them in external reporting.
Considerations for boards
In their oversight of the organization's market volatility risk management activities, boards need:
- a broad understanding of the market risks that impact the organization's activities
- an objective and measurable risk appetite assessment that identifies the risks for which the organization needs to design specific risk management strategies and those risks that will not be actively managed by the organization
- clear documentation of the risk mitigation strategies that may be employed, and regular assessments of those mitigation strategies' effectiveness.
- CSA Staff Notice 51-328, Continuous Disclosure Considerations Related to Current Economic Conditions (CSA)
Staff Audit Practice Alert No. 4, Auditor Considerations Regarding Fair Value Measurements, Disclosures, and Other-Than-Temporary Impairments (PCAOB, 7-page PDF file)
Staff Audit Practice Alert No. 3, Audit Considerations in the Current Economic Environment, a discussion paper (PCAOB, 33-page PDF file)
Staff Audit Practice Alert No. 2, Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists (PCAOB, 9-page PDF file)