Strategies for identifying and measuring risk can help treasury personnel develop
a sound diversification policy f1y10yp
Before a risk profile can be managed it must be identified. What is considered
high risk by one entity may be considered the normal course of business by another
entity. Appetite for risk-taking will vary not only between industries but also
between management styles.
Once risk parameters have been identified a measurement system must be introduced.
"A man who travels a lot was concerned about the possibility of a bomb
on board his plane. He determined the probability of this, found it to be low,
but not low enough for him; so now, he always travels with a bomb in his suitcase.
He reasons that the probability of two bombs being on board would be infinitesimal."
Quote by John Paulos.
The man has taken a strategic approach to risk management: He has identified
the risk(s), their nature, location and probability.
Likewise, a business or financial institution must balance its risk profile
between financial risk and business risk. Senior management must decide how
much business risk it can absorb and how much financial risk is appropriate.
Senior management also has the responsibility of selecting the best mix between
financial risk and business risk.
Business risk can be defined as risk arising from uncertainty about outlays
and operating cash flows, without regard to how investments are financed. Financial
risk is inherent in the movement of interest and foreign-exchange rates. It
also includes the risk of liquidity or the inability to refinance debt.
Corporations will always absorb some incidental exposure. It occurs in the light
of competitive pressure. An example would be sales contracts denominated in,
say, exotic currencies, which are difficult to hedge and often fluctuate wildly.
Another more dynamic situation is the challenge of designing a pricing structure
to shift some risk from the end user. For example, the price of electricity
could be linked to the movement of the price of tin for a tin-producing entity.
Thus, if the price of tin decreased in the marketplace, the energy supplier
would lower the price of electricity to assist the tin producer in times of
reduced revenue streams. During the cycle, when the price of tin is firm and/or
rising, the cost of the electricity will increase accordingly.
Reducing incidental exposure will increase the predictability of results. From
an analyst's perspective, reduced exposure is likely to enhance value for the
company, which will be reflected in its share price. In the absence of a market
view or a trend pattern developing, management should hedge against incidental
exposure.
Mismanagement of incidental exposure can lead to an escalation of risk which
eventually will impact on the core business exposure. Core business exposures
are those that will directly impact on the business, are well known to the shareholders
and often commented upon by analysts.
An airline company, for example would have the price of oil per barrel as core
exposure. Management, investors and analysts alike would all be aware what impact
an increase of US$2.00 per barrel would have on the cash flow projections of
the airline company, should the company be unhedged.
A further illustration would be the impact of volatile interest rates on the
cash flows of a highly geared/leveraged company. If the company did not have
fixed rate funding, rising interest rates could have a devastating impact on
its expense base.
Changing the core business exposures may lead to results difficult for investors
to predict. This in turn may lead to investors liquidating their holdings or
potential investors holding back. For the company to simply hedge these exposures
may not be appropriate. Untimely hedging is likely to result in the creation
of a competitive advantage to the competitor(s) and a loss of profit for the
company.
With regard to core exposure on-going analysis and management is required to
determine the optimal result.
Least Risk Strategy
The least risk strategy is unlikely to be a no risk strategy, except for the
most basic of business units.
The least risk strategy for a fund manager may be to invest in the terms of
the ratios dictated by a certain performance index. On the other hand, the least
risk strategy of a pension fund unit of a large corporate entity may be to simply
keep all monies in financial instruments not exceeding a tenor of ninety days.
It often transpires that the least risk strategy of a corporate entity is in
the parameters of the strategic plan which they chose to implement. However,
in most instances the strategic plan that is implemented is indicative of the
amount of risk the company is willing to absorb - both business and financial.
Whatever the least risk strategy is defined to be for a specific business unit
or entity, it will allow for a useful benchmark. Management will only deviate
from the least risk strategy if there is a change in the business environmental
conditions, or through competitive pressures or a change in market view.
A change in the business strategy will inevitably create a change in the risk
profile. To assist management to measure and compare risk profiles the alternative
strategies can be compared to the least risk strategy. This will determine whether
the potential gain will justify the risk to be taken and it will also identify
which of the alternative strategies would be implemented.
Thus the success of decisions to deviate from the benchmark can be measured
retrospectively.
Diversifiable Risk and Undiversifiable Risk
It would be appropriate to determine how much risk can be diversified, if any
at all.
As we are aware, when an investor increases the number of shares in a portfolio,
the overall risk of that portfolio declines. At first, the decline is rapid
and eventually tapers off to market risk.
The diversifiable portion of an investment portfolio of an investment portfolio
is termed unsystematic risk. The systematic risk of a portfolio is that portion
of the total risk which cannot be eliminated through diversification. This is
the market related risk and arises from general economic conditions that are
experienced by all investors.
Modern risk management technique is for managers to focus on systematic risk
given that a diversified portfolio will negate unsystematic risk. This tends
to imply that we should not concern ourselves with managing unsystematic risk,
because the efforts will go unrewarded.
However, strategic management has unsystematic risk as a core focus to competitive
advantage. Take the example of a raw material supplier whose patronized by a
single large buyer. He can diversify some of this risk by implementing a marketing
strategy to increase his target market thus reducing the reliance on the single
purchaser.
Further, a multinational corporation with a variety of foreign currency receivable
would do well to hedge (diversify) this risk by converting some of itis
debt portfolio to currencies which complement itis receivable structure
rather than maintain a single currency debt portfolio.
Portfolio Diversification
As the number of different securities/shares in a portfolio increase, the risk
of the portfolio declines rapidly at first and then approaches the systematic
risk of the market.
Systematic risk measures the level of non-diversifiable risk in an economy or
specific market place.
A multinational company can be viewed as representing a portfolio of internationally
diversified cash flows originating in a variety of countries and currencies.
These cash flows are likely to be strongly influenced by foreign factors, factors
specific to the host country, factors including exchange controls, political
risk, the infrastructure and location. Therefore it would appear reasonable
to suggest that investors may be able to achieve a degree of international diversification
indirectly by investing the shares of the multinational corporations.
Effects of Exchange Rates
Studies have indicated that the US$/EURO and the US$/JPY exchange rates exhibit
nearly as much volatility as their respective stock markets.
The return on a foreign investment will depend on the performance of the principal
investment in terms of its local environment as specifically measured by its
local currency. However, a change in the exchange rate between the local currency
and the home/functional currency will also impact on the return of the investment.
Often the currency in which the foreign investment is placed will appreciate
not only against the home/functional currency but against a broad range of currencies
and concurrently the value of the shares listed on the local stock market appreciate.
This concept is due to internationalistion. For example, assume that in the
recent budget announcement a European nation has lowered the corporate tax rate
significantly, therefore allowing for greater dividend payments by corporate
entities.
Foreign investors, eager to maximize their returns will be keen to purchase
shares of reputable companies listed on the countryis stock exchange.
When a purchase order is placed with a broker payment must be made in the currency
of the country in which the investment is to occur. Consequently, the investor
must purchase the currency against the sale of his own currency. Demand for
the foreign currency form investors around the world will result in the value
of the currency appreciating. This demand side factor, will have the same impact
on the value of the value of the shares, they will appreciate as demand outstrips
supply.
Thus the relationship between share value appreciation concurrently with currency
appreciation can be attributed to international demand pressure. Obviously,
domestic demand for the scrip will have no bearing on the local currency appreciation.
Fluctuating exchange rates do indeed have the potential to reduce actual gains,
thus rendering the foreign investment more risky. However, this is not an appropriate
reason for avoiding international diversification.
The appropriate conclusion to be drawn is to assume that if the exchange rate
uncertainty was absent, neutralized or controlled effectively, the potential
gains to the overall value of the portfolio could have been greater.
Financial Risk
The four components to financial risk are interest rate risk, currency risk,
liquidity risk and credit risk.
On occasion the impact of financial risk is obvious. For example, which of the
following interest rate scenarios is the most risky for a highly geared/leveraged
business entity?
(A) When interest rates are high and forecast to go higher.
(B) When interest rates are moderate and forecast to go lower.
(C) When interest rates are low and heading lower.
Clearly scenario (A) is the more risky.
Often the strategic impact of a rising interest rate environment is not appreciated
until the consequences are of a great magnitude.
Take the case of the Building Society with a perfectly matched asset and liability
book. That is to say, the Building Society only lends ninety days floating rate
mortgages, is obliged to give the borrower thirty days notice of a rate change
and is funded by ninety day assets. The concept being, if the ninety day rates
increase, and consequently increase the Society's cost of funds this would be
offsets by raising the interest rate on the mortgage. Admittedly the Society
would have a thirty day risk in a rising interest rate market but this thirty
day notice risk would neutralize during a period of falling interest rates.
Under the above scenario the impact of rising interest rates is not identified
until the borrowers become financially restrained by a burdening interest expense
and unable to service their mortgages.
The end result for the Building Society is that the ratio of non-performing
assets on its books will increase with a negative impact on future cash flow.
The impact of such a scenario can be reduced by a pro-active hedging strategy.
By securing fixed rate funding the Society is able to reduce its cost of funds
and these gains could be set against erratic mortgage loan repayments.