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Managing Financial Risks: Concept, Techniques and Processes

Risk Concept

An adverse impact on an organization and its systems if it is created by a possibility or occurrence of an event or activity is called a Risk. If a given threat exploits sensitivities of an asset or cluster of assets that may cause damages or loss to the assets, then it may be called a potential risk. It is normally calculated either by the probability of happening of an event or by a composite of effect. Inherent risks are those which are correlated with an event in the absence of precise controls. Residual risks are those which are correlated with an event when the controls in place to minimize the probability or the effects of that event are taken into consideration.

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Risk assessment or evaluation is a process employed to recognize and evaluate risks and their probable effect on a business. (Barton, Shenkir and Walker, 2002, p.24).

Thus, risk management is the process whereby businesses methodologically address the risks attached to their business activities with the prime aim of attaining sustained advantages within each business activity and across the assortment of each business activity.

A risk evaluation process is one where the comprehensive process of risk evaluation and risk examination is carried out. It includes risk recognition, risk delineation, and risk estimation.

Risk evaluation in a business will include the following:

  • Does the business have a vibrant liquidity status as corroborated by a high quick ratio or CR?
  • Does the business have forex risk vulnerability?
  • Does the business have a low gearing or leverage ratio?
  • Is the business is susceptible to interest rate risks?
  • What is the status of the market for the products of the business?
  • What is the economic coverage of the firm? (Kit, 2005, p.281).

Risk Management Techniques

A business may encounter the following wide range of risks, which are classified into the following varieties;

  1. Financial risks
  2. Economic risks
  3. Performance risks
  4. Technological risks and
  5. Legal risks (Kit, 2005, p.18).

The types of risks that a business may encounter:

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Credit Risk

This risk arises if a debtor fails to pay his loan back or other lines of credit. The risk may be extended to both the principal or interest or both. (Lam, 2000, p.149).

Interest Rate Risk

This may arise if there is an increase in interest rates for the debentures or loans taken by the company or business. (Lam, 2000, p.183).

Volatility Risk

If a business is having forex exposures, this risk will arise due to volatility in the exchange rates. Thus, it is a probable yardstick of the risk that an exchange rate movement creates to an investor’s portfolio in a foreign currency. A data set of exchange rate movements is measured as a standard deviation to reflect the volatility of the exchange rate. (Lam ,2000,p.24).

Liquidity Risk

This risk is arising from the circumstances in which a party is enthusiastic about selling an asset who cannot encash it as there are no buyers in the market. It is especially significant to parties who are about to hold or currently are holding an asset since it impacts their capacity to trade. ( Lam ,2000,p.182).

Operational Risk

If any risk is created due to insufficient or failed internal systems, people, and processes, or from external incidents.

Some Illustrations of Operational Risk

  • Technology failures
  • Non-availability of business premises
  • Insufficient record-keeping or document retention
  • Lack of accountability, supervision, control, and poor management
  • Errors in financial reports and models
  • Fraud committed by the third party
  • Efforts to conceal losses or make personal profits.( Lam ,2000,p.26).

Market Risk

If the value of an investment is affected due to volatility in market factors, then such risk is known as market risk. ( Lam ,2000,p.115).

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Business Risks

The risk associated with a business can be classified into the following groups;

Compliance Risk

This risk is related to legal requirements to comply with regulations and laws.

Strategic Risks

These risks are specific to a particular industry and include the following:

  • Changes in demand or customer’s preferences
  • Impact due to merger and acquisition strategies
  • Changes in industry
  • Transformations due to research and developments. (Lam, 2000, p.23).

Financial Risks

It relates to the financial structure that the business is operating and the financial system that the business is already having and includes the following:

  • By recognizing the financial risks involved by analyzing daily financial operations,
  • Monitoring cash flow daily

It is to be noted that many businesses have ‘operating’ or ‘economic’ vulnerability that is not mirrored on their balance sheets. Even business that has no foreign exchange payments or receipts can still be vulnerable to forex risk. (Smith & Wilford, p.284).

Operational Risk

It is correlated with one’s business administrative and operational procedures;

  • Supply Chain
  • Recruitment
  • IT systems
  • Accounting checks & controls
  • Composition of Board
  • Internal policies, rules, and procedures (Lam, 2000, p.26).

Other Risks in Business

Other risks include environmental risk including natural calamity, employee risk management like maintaining adequate employees, and risk associated with employee safety, economic, safety, and health risks and political instability in the foreign market where a business export its products. (Lam, 2000, p.25).

Management of the Business Risks

Companies witnessing large vulnerabilities to exchange rates, interest rates, or prices of a commodity can augment their market importance by employing derivatives to minimize their vulnerabilities. Derivatives include futures, forwards, options, and swaps. Derivatives can help minimize the vulnerability of corporate cash flows and reduce various costs linked with financial distress. Derivatives are extensively employed by large companies, mainly to buy protection against financial trouble. The majority of companies go for ‘selective ‘as opposed to ‘full-cover’ hedging. (Lam, 2000, p.84).

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Successful Risk Management Strategies by Business

There is no business without any risk. Risk is inherent in every business. A business must first know what risk it has to manage or control. In DuPont’s initial days, all understood and admired the risk of making dynamite. For United Grain Growers (UGG) weather was a significant risk factor that could impact the performance of the company. In Chase, in its initial years, the loan portfolio’s risk could dramatically modify the company’s earnings. For Unocal, the risk is to discover more gas and oil or else face losses. (Barton, Shenkir and Walker, 2002, p.12-13).

For Microsoft, it has to innovate continuously before someone edges it and occupies its market share. The risk management group in Microsoft repeatedly encourages the segmentation of risk management to the business units. Its business managers believe that they ‘evangelize’ the business units about the significance of recognizing risk and its probable impact on business decisions. Further, risk managers emphasize face-to-face time with business units so that they could comprehend about 90% of risks facing the Microsoft. It also employs scenario analysis to recognize its material business risks. (Barton, Shenkir and Walker, 2002, p.12-13).

At Chase, all managers in various categories have to undertake self-assessment scorecards to recognize their unit’s risks. Likewise, Unocal demands risk assessment on an annual basis in each of its business units. It stresses the dramatic change in its new risk-oriented approach by recognizing the provinces of the greatest risk and chalking out steps to administer all those risks. (Barton, Shenkir and Walker, 2002, p.12-13).

Some Failures due to Non-Management of Business Risks

The following failures in business have happened mainly due to the non-adoption of risk management techniques.

Due to fraudulent trading and internal fraud, Allied Irish bank had lost $691 billion, Barings lost $1 billion and Daiwa Bank limited lost $1.4 billion. Due to external fraud, Republic New York Corp had lost $611 million due to fraud committed by the custodial client. On the grounds of gender discrimination, Merrill Lynch paid $250 million through legal settlement under employment practices and workplace safety. (Mema & Al-Thani, 2008, p.269).

Household International lost $484 million due to improper lending practices and Providian Financial Corp lost $405 million due to improper billing and sales practices.

On the technology side, Bank of America lost $225 million, and Wells Fargo Bank lost $150 million due to system integration failures and due to failed transaction processing. Bank of New York lost $140 million due to damage to its physical assets on the September 11, 2001 incident. Further, Solomon Brothers lost $303 million due to changes in computer technology, which resulted in ‘un-reconciled balances.’ (Mema & Al-Thani, 2008, p.269).

Likewise, Lego, a well-known toymaker had to recall one of its products worth £ 3.5 million even though the company had extensive risk avoidance procedures. NEC, a mobile phone manufacturer had to recall about 97,000 units of mobiles due to a faulty circuit in its mobile chargers, and it had incurred heavy losses including an advertisement, manning a call center, and cost of the defective products. Smith Kline Beach was compelled to recall 12 million glass bottles after it discovered a defect that made the neck of the bottle crack when opened. A manufacturer of baby car seats anticipated that a recall due to a defective seat-belt clasp made them forego a whole year’s profit. (Sadgrove, 2005, p.61).

The Steps the President and His Czars Have Taken to Address the Global Financial Crises

The first reaction from the US government came on September 7, 2008, to address the global financial crisis. It ordered the Federal Housing Finance Agency to absorb Freddie Mac and Fannie Mac thereby putting a full stop to their existence as government patronized corporations. By initiating this action, the U.S. Government openly guaranteed the debt of the two companies and barred them from declaring bankruptcy. (Nanto, 2009, p.9).

Obama’s administration initiated its strategy for regulatory reforms in the U.S financial system on June 17, 2009. Various bills have been introduced in the Congress to sort out the financial crisis which includes measures like creating a select committee/commission to probe into reasons for a financial crisis, to offer greater oversight and accountability of Treasure and Federal Reserve’s lending policies, to sort out the issues in mortgage and housing markets, offer to fund for the IMF, to address the issues with consumer credit cards, to offer for enhanced supervision for commodities and financial markets, to deal with the national debt of U.S and to set up a methodical risk monitor. (Nanto, 2009, p.9).

For addressing the global financial crisis, G-20 under the leadership of the U.S.A along with IMF and the Swiss-based new Financial Stability Board is making its best efforts.

The G-20 summit held in April 2009 in London called for an enhanced role for the new Financial Stability Board and IMF to offer an early warning of financial and macroeconomic risks and actions required to address them. (Nanto, 2009, p.9).

G-20 London Summit resolved to fund $1.1 trillion in funds to the global financial institutions which include $250 billion to augment global trade, to grant $750 billion for the IMF, and $100 billion was earmarked for multilateral development banks. P.L 111-32 was signed as law by President Obama on June 24, 2009. This Act authorized to increase the U.S. share in the IMF by 4.5 billion SDRs and offered additional loans to the IMF of up to an extra 75 billion SDR and authorized the IMF to sell some stock of gold from its stock.

Obama’s government introduced a proposal for financial regulatory reform on June 17, 2009. Obama’s financial reforms spotlight five broad areas as detailed below:

  • Financial firms should be under robust supervision and regulation.
  • To frame overall oversight of financial markets.
  • To safeguard investors and consumers from financial exploitation.
  • To offer the U.S government the mechanism it requires to oversight future financial crises.
  • To augment international regulatory norms and to enhance international cooperation. (Nanto, 2009, p.9).

The Major Historical Trends to Date Regarding the Use of Financial Derivatives as Hedging Tools

In 1600, Tulip dealing in Holland was a great business, and dealers and farmers engaged in trading in options to guarantee prices. Thereafter, many speculators joined and created a thriving option market. However, the market crashed soon as many speculators failed to honor their commitments.

Around 1650, Japan can be considered as the first future’s contract which offered standardized contracts, which is analogous to present-day futures through the Yodoya rice market in Osaka,

In 1700, Options transactions were declared unlawful in London.

In 1848, CBOT (Chicago Board of Trade) was established, which offered forward contracts on different commodities.

In 1934, the USA legalized the Options through Investment Act. In 1968, the annual volume grew by 300,000 contracts.

In 1973, CBOT in Chicago commenced to trade listed call options on 16 stocks. The first-day volume of 911 contracts was reported.

In 1974, the daily volume in CBOT increased from 20,000 to over 200,000 contracts.

In 1980, the futures trade witnessed around-the-clock trading.

1n 1985, the top ten busiest traded futures exchanges in the world were situated in the U.S.A.

In 1990, 8 of the top 10 futures contracts which were traded on US exchanges, are started to be traded outside the US foreign exchanges. (Gupta, 2005, p.23).

Major Advantages of Derivatives

For companies that selectively employ risk management tools, VAR is useful for administering risk only in the provinces where the company distinguishes no proportional information benefit. For instance, an airline may find VAR more beneficial in evaluating its exposure to jet fuel prices. (Culp, Miller & Neves, p.467).

One study points out those users of financial risk management tools surpassed industry control clusters over 24 months by about one percent each year while nonusers underperformed their industry peers by about the same quantity. (Dolde, p.337).

Due to failure to hedge its anticipated dollar receivable, Daimler-Benz reported also DM 1.56 billion in 1995, which is the highest in its 109-year history. (Stulz, p.414).

Major Failures of Derivatives

‘Value at risk ‘(VAR) is a technique evaluating the financial risk of an asset, exposure, or portfolio over some specific period. One research study examined the four “great derivative disasters ‘of 1993 -1995 – Barings, Mettallgesllschaft, Procter & Gamble, and Orange County, mainly to know how ex-ante VAR evaluations likely would have impacted those scenarios. The research concluded that VAR had been only of little value in preventing those adversities. It concluded that in some cases, it had misled the results. (Culp, Miller & Neves, p.462).

In the case of MGRM, the U.S. oil marketing subsidiary of Metallgessellschaft, the use of futures and cash position ended in real losses and thereby leaving MGRM vulnerable to increasing prices on its remaining fixed-price contracts. (Stulz, p.414).

Integrated risk management

An ‘Integrated Risk Management ‘or Enterprise Risk Management (ERM) demands an integrated risk organization. Under IRM, the centralized risk management unit will report to the Managing Director or CEO and the board, with accountability for extensive policy setting across risk-taking activities in the business. Now, the majority of companies have employed a chief risk officer (CRO) who is accountable for supervising all features of risk within the business. (Lam, 2000, p.45).

Integrated risk management demands the amalgamation of risk transfer practices. Under this silo method, risk transfer policies were carried out either at an individual or at a transaction risk level. For instance, financial derivatives were employed to hedge market risk and insurance to transfer out operational risk. However, this strategy would not introduce diversification within or across the risk types in a portfolio and thus tends to end in over hedging and excessive insurance coverage. An IRM, by contrast, makes a portfolio approach for all kinds of risk within a business and trims down the employment of insurance, derivatives, and alternative risk transfer products to hedge only the residual risk deemed detrimental by management. (Lam, 2000, p.45).

Enterprise risk management demands the amalgamation of risk administration into the business processes of a business. Instead of the control-oriented or defensive approaches employed to administer downside risk and earnings volatility, IRM optimizes the performance of the business by influencing and supporting resource allocation, pricing, and other business decisions.

For multinational companies, their investment in risk management is more than counterbalanced by reduced losses and enhanced business efficiency. The major benefits of ERM are better risk reporting, increased organizational effectiveness, and enhanced business performance. (Lam, 2000, p.45).

COSO was established in 1985 as an independent body, initiated by private-sector, mainly to research the casual elements that can drive deceptive financial coverage and to support the “National Commission on Fraudulent Financial Reporting.” COSO also framed suggestions for SEC, for public corporations and their external auditors, educational institutions, and other regulators.

Its governing body not only consisted of representatives from the above-sponsored institutions but also representatives from public accounting, industry, the New York Stock Exchange, and investment firms.

ERM –Integrated Framework (2004)

COSO issued ERM –Integrated Framework (2004) guidelines to assist the business to devise and carry out efficient enterprise-wide approaches to manage risk. The aforesaid framework delineates critical enterprise risk management elements, defines vital ERM doctrines and concepts, recommends a common ERM language, and offers clear direction and assistance for an effective ERM. The above framework not only initiates an enterprise-wide overture to risk management but also introduces new concepts like risk tolerance, risk appetite, and portfolio approach. The above-said framework is widely used by companies around the globe to structure and introduce an efficient ERM process. (www.coso.org)

COSO’s guidelines are mainly intended to assist businesses and other stakeholders to evaluate and improve their internal control system. COSO’s framework has integrated into a rule, policy, and regulation and is widely utilized by companies to manage their business activities in shifting toward the achievement of their recognized goals. (www.coso.org)

Conclusion

Companies should use ERM to evaluate risk across the organization. Viewing risk, specifically on a project-wise basis can restrict a business capacity to evaluate the effect of risk connected with that project can have on the whole of the organization.

ERM plays a key role in mitigating the risk. Many case studies corroborated that ERM is an inevitable process for increasing shareholders’ value in any company, and it has to be efficiently introduced and managed to reap higher benefits from ERM.

The senior management should be committed to risk management, and they have to foster a risk culture in their company. The risk management team should be dedicated to playing a vital role in risk evolution, dissemination of information, and monitoring of risk in the organization.

Companies that are exposed to forex risks, interest rate risks, volatility in energy prices, and other market volatilities have to manage these volatilities by applying ERM, mainly to minimize the sensitivity of a company’s future earnings and market value to external volatilities. Managing earnings volatility is more significant today than ever given that the stock market will harshly castigate stocks that do not meet earning expectations. (Lam, 2000, p.8).

Under ERM, financial price risk can be well managed. The risk that appeared in bearing any market position relies on the volatility of the fundamental market. The most significant volatility yardstick is the price volatility element, which is the “paramount approximation’ of the future volatility of market prices daily. Under ERM, a company may study its historical volatility, the future volatility can only be guessed employing historical data, approximation about the future status of the markets, or the oblique volatility of traded options. Thus, ERM offers a very viable solution to the management of future financial price risks that a company may pose.

It has been now established that ERM does play a significant role in risk identification, elucidation and mitigation, avoidance, dissemination of information, and monitoring the risk control process and to improve the overall performance of the company resulting in enhanced value to shareholders.

References

Barton, Thomas L, Shenkir, William G & Walker, Paul L. (2002). Making Enterprise Risk Management Pay Off. New York: FT Press.

Culp, Christopher L, Miller, Merton H & Neves, Andrea M.P. Value at Riks; Uses and Abuses. The New Corporate Finance.

Dolde, Walter. The Trajectory of Corporate Financial Risk Management.

Gupta, S.L. (2005). Financial Derivatives Theory Concepts and Problems. New York: PHI Learning Pvt Ltd.

Lam, James. (2000) Enterprise Risk Management: From Incentives to Controls. New York: John Wiley and Sons.

Merna Tony & Al-Thani, Faisal F. (2008). Corporation Risk Management. New York: John Wiley and Sons.

Nanto, Dick K. (2009). The Global Financial Crisis: Analysis and Policy Implications. Congressional Research Service. Web.

Sadgrove Kit. (2005). The Complete Guide to Business Risk Management. London: Gower Publishing Ltd.

Smith, Clifford & Wilford Sykes. Managing Financial Risk. –The Evolution of Corporate Finance.

Stulz, Rene M. Rethinking Risk Management. The New Corporate Finance.

coso. (2009). COSO’s Enterprise Risk Management. Web.

Zandi, Mark M. (2009). Financial Shock: a 360o Look at the Subprime Mortgage Implosion and How to Avoid Future Crisis? New York: FT Press.

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