Abstract
When an organization has cash inflows and outflows of foreign nature, the cash forecast for every currency will help during the identification of the currency exposures. The format of the estimation should allow the users to determine the balance for every currency and whether there is a growing shortage or extra money over time based on reasonable cash flows. The increasing gaps between the cash inflows and outflows may need hedging, and the cash flows that offset over time represents the issue of timing effectively. The management of foreign exchange transaction can be achieved through the offsetting transactions to reduce the exposure of currencies. However, this might involve either sources or locations for the business. That is an organization with sales of foreign currency may use suppliers with products that are priced with similar money.
Key Words: Foreign Exchange, Currency, Risk, Swaps, Organization, and credit
Introduction
The investments or finances are important for the existence of business in an economy, and this is why they contribute to the firm as well as financial risks. The risks regarding foreign exchange, commodity, interest rate, and operation, it has become imperative that companies are learning how to manage such risks properly. The management and evaluation of risks can either make or break the business. But depending on the risk tolerance level and ideas of comfort in an organization, we can know how far an enterprise is willing to fulfil and explore its objectives. Some firms may think that playing it safe is the most appropriate way. But, there are some challenges to this as well since the missed opportunities may sometimes be as bad as failing at risk. This essay will explore different risks involving both business and finance. The paper also analyzes the measures of risk and the existence of the world initiatives in financial risk management.
Business Risk
These are the threats that if not addressed can significantly stress the operation of the firm (Wright, 2016; Thus, leading to its failure. It includes theft or misconduct among employees, the resignation of key workers, competitive threats, financing and profitability risks. Other examples of business risks are weather, foreign exchange, and economic environment. However, it often differs from one sector to the other.
Financial risks
It is one of the types of risk with high priority in every business, and it arises due to the market movements. Financial risk can be classified as the market, liquidity, legal, credit, and operational risks. Moreover, it occurs via several transactions of financial nature such as sales, purchases, loans and investments that are inclusive of other business undertakings. It can also occur as a result of legal transactions, acquisitions and mergers, debt financing, management activities, foreign states, shareholders, and competition. When the value of the finance changes dramatically, the costs will increase while revenues will decline. Otherwise, there will be an adverse influence on the profitability of an organization. The financial variation may make planning and budgeting, pricing of the goods and services, and capital allocation to be more difficult
Operational risks
This risk comes out as a result of operational failures such as mismanagement. It is classified as fraud and model risks. When there are inadequate controls, fraud risk will occur while model risk arises when there is an inappropriate application of the business models. Therefore, operational risk is what a company undertakes when attempting to operate with a given industry (Investopedia, 2007). That is it the chance of business failure due to the error of human operations. An organization with less interaction of people will experience low operational risks. Most companies will like to control this risk by setting safety checks through system set-ups and operational procedures. By having many individuals reviewing a job will ensure the quality even though they might not appreciate having to pay more time for the double check. But it is ultimately worth ensuring the sanctity of the delivery of goods and services. During the utilization of systems, rules and regulation need to be set to aid in stopping some problems that may occur such as flagging of an account when it has been applied inappropriately or setting the template to be utilized by the users.
Commodity
The commodity risk is the uncertainty of the future value of the market and the size of future income that is influenced by fluctuation in the cost of commodities such as electricity, grains, and metals (Horcher, 2005). The unexpected alteration of commodity prices can limit the profit margin of the producer, and make budgeting difficult. Luckily, manufacturers can offer protection to themselves from the fluctuating commodity values through the implementation of financial strategies that can guarantee the price to control uncertainty, and lock in a dangerous scenario of prices to minimize potential losses. The financial instrument is the option that is commonly used to hedge the price risk of commodities.
The exposures to absolute changes in price are the key risk of commodity rising and falling of costs. Enterprises that are producing or buying goods with the livelihood of price relations experience the exposure to commodity risk. For example, in the 1980s, exporters from Japan faced strategic exposure (Horcher, 2005). As the value of the Japanese Yen appreciated against key trading partners like the U.S dollar, the Japanese exporters experienced tough options between lowering profit margin to maintain the price of the foreign currency and losing the share of the market in critical areas. While responding, the Japanese decide to make an aggressive cost cutting, moved the production to low-cost places, and reduced profit margins. This allowed them to maintain the market share despite the dramatic increase in the Japanese Yen (JPY).
Credit risk
The credit risk is the probability of loss due to the failure of the borrower to make payments on debt (Sas.com, 2016). Therefore, credit risk management is the practice of moderating the losses by understanding the adequacy of the capital of the business as well as the loan reserves at any given time. This is the process that has been a challenge for the financial institutions. It is one of the most dominant perils of business and finance. That is it is a concern when a company is owed cash or when it depend on another organization while making payment on its behalf. The failure of the counterparty is not an issue especially when the company is not owed money on the net basis. However, it depends on certain limits and whether the money is owed on a net or an aggregate basis on personal contracts. The weakening of the credit quality like that of the security issues is a source of risk but through a reduced market value that a company might own.
Credit risk arises when there is a failure to meet an obligation towards the counterparties. Therefore, it can be classified as sovereign and settlement risks. Where autonomy occurs due to technical policies of the foreign exchange, the settlement risk will arise when one makes payment as the other party fails to fulfil the obligations. The global financial crisis and the credit crunch made the regulation of the credit risk management to be in the spotlight. Consequently, the regulators started to demand transparency. That is they wanted to determine whether organizations are knowledgeable regarding their customers and the associated credit risks. To observe the stringent regulatory requirements and absorb higher costs for credit risk, several firms including financial institutions are servicing their approaches to credit risk. However, banks that viewed this have complied with the exercise, and this has given them an opportunity to improve greatly on their overall performance and secure a competitive advantage.
Foreign exchange risks
It is also known as the currency risk that exists when a financial transaction is denominated in the form of a currency other than that of the base exchange of the company (Horcher, 2005). Moreover, it exists when the foreign affiliates of the parent organization maintain financial records in a currency instead of making reports on the consolidated entity. The risk is that there is an opposing movement in the exchange rate of the denomination currency concerning the base before the date of completing the transaction. The people who are at this risk are the investors and businesses that are exporting products or making foreign investments. This is because they usually face severe financial consequences. The risk can be reduced by managing the foreign exchange transactions through offsetting such contacts to limit the currency exposures. This will involve different locations for manufacturing. For instance, a firm with foreign currency sales may use a supplier with products that are priced with similar bills.
The bids on oversea projects always require a component of foreign exchange to be fixed in the value of the product (Horcher, 2005). There may be a risk that rates will change once the submission of the bids has been made but before the notification of the winning bidder occurs. However, certain organizations control this by inserting an adjustment clause into the contract so that when exchange rates rise than the predetermined figure, the contract value should be adjusted to reflect the change in exchange rate. Hence, this will shift the risk to the purchasers.
Interest rate risks
This occurs when the value of investment changes due to the change in the absolute level of interest rates (Investopedia, 2004). That is in the spread that exists between the two rates, the shape of the yield curve, and in any other relation between the interest rates. The alterations may inversely influence the securities but can be controlled through diversification. That is investing in fixed income securities that have different maturity periods or hedging through swaps. The interest rate risks influence the value of the bonds directly as compared to the stocks. Therefore, it is the main risk for the bondholders. Consequently, the interest rates increase, the price of the bonds will decrease. The logic is that when there is a growth in interest rates, the opportunity cost for the bondholders will fall because the investors will be able to realize greater yields by shifting to other investments with more interest rates. For example, a bond with 5% is worthy especially if the rate of interests falls because the holders of the bond will get a rate of return that is relative to the market value that is providing a lower rate of return due to the decrease in rates.
The risk of interest rate is more appropriate to fixed income securities since the potential rise in the market interest is hazardous to the price of the income securities. As the market rate increases, the value of the past issued securities that were trading in the market will decline. Therefore, a potential investor will be more inclined to purchase new shares with higher interest rates. The previous securities can only have lower rates by having possessing lower selling price. Hence, they may become competitive after issuing securities once the market interest rates have proved to be high.
The cost of the existing income securities that are fixed with different maturities decreases by various levels as the interest rate rises. This is the price sensitivity that implies that the value of securities on some maturity lengths are said to be more sensitive to increase in the market interest rates. Thereby, leading to a sharp fall in the security costs. Suppose two income securities where one matures in one year while the other in ten years, when the rate of market interest increase, the holders of one-year securities will make quick reinvestment at a higher rate after experiencing low return for only a year. In contrary, the owners of the ten-year bonds will be stuck with a lower rate for the next nine years. This justifies a lower security cost as compared to a short run that attracts the willing buyers. That is the longer maturity rate, the more the price will reduce to a definite increase in interest rates.
The superior price sensibility of long run securities leads to higher risks of the interest rate. In order to compensate the investors for considering risky investments, the expected rate of return on such long-term collaterals will be higher as compared to the short-term securities. Alongside other risk premiums such as liquidity and default risks, the possibility maturity premiums assist in determining the provided rates of different maturities above the diverse credit and liquidity conditions.
Measure of risks by organizations
Maximum Probable Loss and value at risk
When moderating the inherent danger of running a business, organizations need to identify the hazard and control the extent of the peril. The measurement of risks by companies follow different methods during their determination and assessment. An organization can use a probable maximum loss to measure the level of risk (Wright, 2016). This method will make a consideration to the maximum amount that a firm may lose for a particular period if some conditions happen and the probability of their occurrence. On the other hand, the value at risk will consider the amount of asset that is at risk in certain cases. The above measurements look at the statistical probability that certain circumstances may occur and multiply the resulting figure against the maximum possible loss.
Frequency of Loss
It measures the number of times there is an occurrence of losses during a particular duration. When companies have measured this loss previously, they can apply the historical records to make predictions. The accounts receivable, and reserve account are examples of frequency losses. In case an enterprise has about 3% in losses of an uncollectible receivable in the past two years, this estimate is appropriate for the present year.
Scenario Analysis
The application of scenario analysis assesses the risk of a downturn especially in real estate companies and other prices of assets or down shift in rate of interests as well as other marketing factors. Concerning the scenario analysis, organizations can determine what affects various situations in their business. That is if a company has a line of credit with variable interest rates, the managers could determine the default risk of the enterprise when the interest rate jumps three times during the year using the situation analysis (Wright, 2016). Other measures are highly technical and quantitative while some are subjective and qualitative. It is essential for a company to identify risks then measure them through a technique that is sufficiently modest for the staff to apply consistently.
Global initiatives that exists in financial risk management
The basis swaps allow the counterparties to alternate the exposures from one benchmark of floating rate to the other (Horcher, 2005). Therefore, this will provide for a better match between the asset and liability cash flows of the organization when anticipating the movement of interest rates while maintaining the exposure of floating rate of benefits.
The zero coupon bonds that comprise of a single payment at maturity inclusive of all interests (Horcher, 2005). That is minus payment of coupons; the zero-coupon will eliminate the reinvestment risk particularly for the coupon income. However, the financing of zero-coupon may be difficult to obtain from the lender though most desirable, a cost effective alternative should be borrowed by applying a zero-coupon swap to create the debt. This will leave the original coupon debt unchanged but overlays the structure of the coupon
The use of forward interest rate swaps will enable the hedgers to arrange an advance swap of its requirement as well as its beginning. The forward swaps allow the borrowers and shareholders to change the flow of the cash in anticipation of future alteration in interest rates and the yield curve. Additionally, it is applied to convert the fixed rate of interest to a floating or protect it against the anticipation of the changes in rates until a constant liability or asset rate is arranged. At this point, the interest rate swap will be offset with another or even terminated.
Conclusion
The main market risks arise out due to changes in prices in financial markets such as interest rates, commodity prices, and exchange rates. The above key market risks are always the most understandable type of financial risks within the organizations. Therefore, the interaction with many risks can change or extend the potential impact to the company. For instance, a corporation may possess both commodity and foreign exchange risks, if both make an adverse movement, such corporations may face significant losses.
References
Horcher, K. (2005). Essentials of Financial Risk Management. Hoboken, New Jersey: John Wiley & Sons, Inc.
Interest Rate Risk Definition | Investopedia. (2004). Investopedia. Retrieved 20 August 2016, from http://www.investopedia.com/terms/i/interestraterisk.asp
Operational Risk Definition | Investopedia. (2007). Investopedia. Retrieved 20 August 2016, from http://www.investopedia.com/terms/o/operational_risk.asp
Sas.com. (2016). Credit risk management: What it is and why it matters. Retrieved 20 August 2016, from http://www.sas.com/en_us/insights/risk-fraud/credit-risk-management.html
Wright, T. (2016). Smallbusiness.chron.com. Retrieved 20 August 2016, from http://smallbusiness.chron.com/business-risk-measurement-methods-68122.html
