C02 HOW DO FIRMS MANAGE FINANCIAL RISK?

Strategies for Risk management #

Senior management and board of directors are ultimately responsible for strategy selection, but risk manager can help in decision making process.  There are four different risk management strategies.

Accept risk : A firm should decide to accept known risk that have small impact on firm and managing it is costly. Another reason can be stakeholders desired to take the exposure to certain risk. The 3rd reason, cost can be priced (generated from the risk ) into products and passed along to the customers.

Avoid risk: sometimes the best strategy. If a business risk is not a natural part of normal business operations then it should be considered as possible risk to avoid. This will include completely stopping activity which are unnecessarily risky.

Mitigate: Known risk can be mi􀀁gated in different forms de-pending on the risk factor. Like higher interest rate on loans, enhanced  collateral requirements etc. Transfer: Risk  can be transferred to third party via insurance or investing in derivatives. Introduces third party risk because firm is relaying on third party in case, risk materializes. This option can be costly because of cost involved in insurance premium or derivatives.

Ultimate decision depends upon the cost benefit analysis. i.e cost should risk management should not exceed the benefits derived from managing it.

Relationship between risk appetite and a firms risk  management decisions #

Risk managers can proceed through a five step risk management process. Out of which first two are

 Identify risk appetite:  Refers to risk that firm is willing to retain.  Two subcomponents of this are risk willingness and risk ability. Willingness refers to firms desire to accept risk in pursuit of business goals. Ability refers to cap on risk willingness for reasons like internal risk controls and regulatory constraints. Actual risk levels should be set below the maximum capacity of the company to provide for margin of error.  Role of board of directors in setting risk appetite: Board need to clearly define the firms risk appetite and communicate the policy to stakeholders in quantitative/ qualitative manner.  There are several possibilities, including

• Explicitly stating which risk to retain, avoid or mitigate.
• Using quantitative metrics such as VaR.
• Using stress testing

Issue for the board is to determine risk appetite. The conflict here is in between goals of two major stake holders – Share-holders who wants more risk exposure to exploit upside potential of gains and debtholders who look for minimizing risk due to limited upside potential(i.e. even if firms performs well, the only payment is interest and principle). The board must insure that its goals are stated in a clear and actionable manner. This communication usually takes two forms, broad statement for external communication and second is detailed statement for internal use by risk managers.  There are several complexities board must consider, depending upon circumstances,

• Unity risk: Do the different types of risk have different appetite.
• Entrepreneurial opportunities Risk which could provide competitive edge.
• Layers of correlated risk.
• Time horizon: Hedge short term or long term.
• Possibility for risk limit tolerance bands: Are there adequately communicated tolerance bands within which man-agers can operate?
• Reputational impacts
• Risk measurements: VaR and stress testing all have value, but firm will need to deduce a metric that makes sense given their business models.

Map known risk :

Inventory of all known risks is called risk mapping which is next step after setting risk appetite. Every type of risk and its interactions in the form of correlation are considered.  The robustness of the risk mapping process will directly correlate with the level of granularity of the inputs. Business need to consider the magnitude of the exposures, the timing of the exposures, the location of the exposures, the calculation methodology., and the potential for risk netting. At minimum, this granular process should be conducted for the top 10 risk exposure for a firm, but it is best to do for all risks.

Hedging Risk Exposures Advantages and disadvantages #

Not all risks should be hedged. Some investors would prefer unhedged risks to get exposure. The primary goal of hedging is to increase financial stability and reduce the risk of financial distress. Following are some practical/ theoretical advantages and disadvantages of hedging –  Hedging Advantages in practice

One of the key reasons for hedging is the possibility of lowering cost of capital, which would lead to increased economic growth. A firm may be able to increase the debt capacity by reducing the volatility about Earning, which may result in access to lucrative investment  opportunities. Another possible cash flow impact could occur if the hedging activities smooth out revenues/ cost, such that tax liability decreases.  Stability in the firms operations signals strength to its stake-holders. Management see to  other distinctive benefits of hedging. First it makes business planning easier due to control risk. Second, it enables managers to potentially lock in strong margins.  Hedging can also be used as a crutch to meet short term performance goals. Hedging with derivatives may be cheaper than insurance .

Hedging Disadvantages in Theory

Modiglian and Miller argued that under assumption of perfectly competitive capital markets with no transaction cost or taxes, both firm and investor are able to perform the same financial transactions at the same cost. Meaning value of the firm will not change despite hedging. This is unrealistic in real world.

Sharpe argues that under perfect capital markets, firm should only be concerned about systematic risk. As unsystematic risk can be diversified by the investor by holding large portfolio in costless manner. Not realistic because diversification results in transaction cost.  Many believe that hedging is a zero sum game that has no long term increase on a firm’s earning or cash flows. This argument assumes under perfect market, derivatives prices will reflect all risk, however, pricing of derivatives accounts for lot of factors and is vary complex.  None of the argument above considers the existence of the significant cost of financial distress and bankruptcy.

Hedging Disadvantage in practice: 

• Management loses focus on core business which could result in loss of profit.
• Compliance expenses.
• Inherent complexity of derivative contracts. Using derivatives could shift firm into unintended risk exposure.
• Derivative pricing is not always accurate and will not reflect risk factors.

Hence hedging is not zero sum game.

Challenges involved  with hedging strategies:

• Selecting wrong risk , missing relevant risk factors could result in national values of derivative that either too high or too small.
• Market trend changes and prices of assets like commodity, foreign currency are very dynamic. Hence risk management should be dynamic as the risk variables. This is too burdensome for some firms to actively manage risk. Flawed hedging strategy may result into greater losses.
• Problems may be amplified by poor communication. The concern relates to strategy that has not been effectively communicated and to potential consequences that are not adequately disseminated to decision makers.
• Hedging requires very specific skills, knowledge and time. This can be fixed by outsourcing the hedging duties to trusted third party risk manager. One way to combat this is to build strong internal risk culture. a few suggestions to create such culture
• Regularly communicate risk goals and potential warning signs.
• Conduct training of key management staff to ensure they understand risk management goals.
• Key staff should understand the potential consequences, if risk limits are breached.
• Board of directors should be able to articulate firms top 10 Risk.

Hedging Operational and Financial Risk #

Operational risk covers firms activities in production and sales. Can be considered as income statement risk.  Financial risk relates to firms balance sheet (Asset and liabilities).

Pricing risk

Cost of input impact firms ability to conduct its business in a competitive manner. Hence, hedging cost of inputs provides stability.

Foreign Currency Risk

Goal is to control exposure to exchange rates. This impacts both future cash flows and fair value in balance sheets.  In revenue hedging firm should factor both the cost of hedging as well as revenue and exchange rate volatilities and correlations. Instruments that could be used include currency put options and forward contracts. In balance sheet exposure, the focus is on the impact of foreign exchange rate fluctuations on the net monetary assets of its foreign investments. There is natural offset in asset and liability foreign currency exposure. Sometimes hedging is cost prohibitive, so some foreign currency positions may be left deliberately unhedged.

Interest Rate Risk

The goal of hedging interest rate risk is to control the firms net exposure to unfavourable interest rate fluctuations. Interest rate swaps can be used.

Static and dynamic hedging strategies In static hedging risky positions are determined initially, and appropriate hedging instrument is used. In dynamic hedging assumption is that the underlying risky positions may change with time. Rebalancing is require to maintain effectiveness of the hedge which results in transaction costs. Also significant cost and 􀀁me is required to monitor the process. Additional hedging considerations include the following –

• Relevant time horizons for hedging
• Complex accounting implications of hedging with derivatives.
• Taxation on derivatives

The Impact of Risk Management Tools #

Firm needs to decide if its hedging strategy is a one off event or if it is part of broader risk management need, is referred to as rightsizing a risk management program. There are several risk limits that need to be understood and potentially con-trolled depending on the result of the risk mapping process. Example of this is VaR which is used for aggregated risk thresh-old. Limitation of VaR is It does not provide measure of magnitude beyond the threshold.  Many firms treat risk management as cost centre, in which goal is to minimize negative effects on the firm. Available risk management tools are derivatives contract exchange traded or OTC. Derivative contracts have different benefits/ drawbacks depending upon their trading location. Example exchange traded derivatives offer liquidity and reduce counterparty risk. But exchange contract fails to meet the exact hedging requirement due to standardization. OTC can provide exact need of the business, but need to assume counterparty risk.