1-What is Financial Risk Management:Risk yield the basis of opportunity or possible losses, and arises as a result of exposure. As organizations are being exposed in the financial market, they encounter possible losses, but also opportunities for gain or profit.Events resulting in a high loss are usually highly-likely to occur, whereas those resulting in a small loss are commonly less probable to occur. However, events with a low probability of occurrence but that may result in a high loss are particularly troublesome because they are most of the time not anticipated.
As it is not always plausible to eliminate risk, identifying and understanding it are key, and form the basis for an appropriate financial risk management strategy. Addressing financial risks proactively provides competitive advantage and ensures that management, operational staff, stakeholders and the board of directors all agree on key issues of risks.Financial risks arise from three main sources. Firstly, organizations encounter changes in market prices, such as interest rates, exchange rates and commodity prices.
Secondly, risks arise from organizations’ interactions such as vendors, customers and counterparties in derivatives transactions. Lastly, they result from internal failures of the organization, particularly people, processes and systems (Horcher, 2005).DiversificationAdding an individual component to a portfolio provides opportunities for diversification. A diversified portfolio contains assets with dissimilar returns and weakly or negatively correlated with one another. Modern portfolio theory considers not only an asset’s riskiness, but also its contribution to the overall riskiness. Thus, it’s a crucial tool in managing risks. Among counterparties, it reduces the risk that unexpected events impact the organization through defaults. Among investment assets, it lowers the magnitude of loss if one issuer fails. Lastly, diversification of customers, suppliers and financing sources lowers the possibility that an organization will have its business affected by changes outside management’s control.Although the risk persists, diversification might minimize the opportunity for large adverse outcomes (Horcher, 2005).2-Factors that impact Financial Rates and Prices:Factors that Affect Interest Rates:Interest rates are the key ingredients in the cost of capital. Most companies and governments require debt financing for expansions and projects. They hold a significant impact on borrowers and affect prices in other financial markets. They are comprised of the real rate plus a component for expected inflation (since it reduces the purchasing power of a lender’s assets). The greater the term to maturity, the greater the uncertainty. Factors that shape the level of market interest rates involve: -Expected level of inflation -General economic conditions -Monetary policy and the stance of the central bank -Foreign exchange market activity -Foreign investor demand for debt securities (supply and demand) -Level of sovereign debt outstanding -Financial and political stabilityYield CurveThe yield curve is a graphical representation of yields for a range of terms to maturity and provide useful information about the market’s expectations of future interest rates. Its shape is widely analyzed and monitored by market participants and it normally slopes upward (positive slope) since lenders demand higher rates from borrowers for longer lending terms. As the chance of a borrower default increases with term to maturity, lenders seek to be compensated accordingly. Interest rates are also affected by the expected rate of inflation as mentioned above. Effectively, investors demand the least expected rate of inflation from borrowers, as well as lending and risk components (Horcher, 2005). Thus, if lenders expect future inflation to be higher in the following days, they will request greater premiums for longer terms to compensate this uncertainty. Consequently, the longer the term, the higher the interest rate (positive slope). However, occasionally, demands for short-term funds increases raising interest rates above the level of longer-term interest rates. This induce in an inversion of the yield curve which will slopes downward. This obviously detracts from gains that would otherwise be obtained by investments and make the economy vulnerable to slowdown or recession. So rising interest rates decrease demands for both short-term and long-term funds. Figure 6 Traditional Yield Curve (Investopedia, 2019). Figure 7 Types of Yield Curves (The Balance, 2019).Theories of Interest Rate Determination:Several theories have been developed to interpret the term structure of interest rates and the resulting yield curve (Pike & Neale, 1993).Expectations theory”It suggests that forward interest rates are representative of expected future interest rates. Thus, the shape of the curve and the term structure of rates reflect the market’s aggregate expectations.Liquidity theory”It suggest that investors will choose longer-term maturities when provided with additional yield that compensates their lack of liquidity.Preferred habitat hypothesis”It suggests that investors preferring one maturity over another can be convinced to change opinions and horizons given an appropriate premium Єpolicies of market participants).Market segmentation theory”It suggests that different investors have different investments horizons arising from the nature of their business or from investment restrictions. This prevent them from dramatically changing maturity dates to take advantage of temporary opportunities in interest rates (less interested).3-Factors that Affect Foreign Exchange Rates:Foreign exchange rates ae determined by supply and demand for currencies. In turn, supply and demand are influenced by factors in the economy, foreign trade and the activities of internal investors. Capital flows, given their size and mobility are of great importance in determining exchange rates. Currencies rare very sensitive to changes in interest rates and to sovereign risk factors. Some of the key drivers affecting exchange rates involve: -Interest rate differentials net of expected inflation -Trading activities in other currencies -International capital and trade flow -International institutional investor sentiment -Financial and political stability -Monetary policy and the central bank -Domestic debt levels -Economic fundamentalsKey Drivers of Exchanges Rates: When trade in goods and services between countries was the prime determinant of exchange rate fluctuations, market participants monitored trade flow statistics accurately for information about the currency’s direction. Nowadays, capital flows are major factors and monitored closely. Risk issues taken equally, currencies with higher short-term real interest rates are more attractive to foreign investors and are the beneficiaries of capital mobility. Some currencies are specially attractive during financial turmoil. Safe-haven currencies include the Swiss franc, the Canadian dollar, and the U.S dollar. In freely traded currencies, traders arbitrate between the forward currency markets and the interest rate markets (which are tightly linked), ensuring interest rate parity.Theories of Exchange Rate Determination:Diverse theories have been advanced to explain how exchange rates are determined.Purchasing power parity”It suggests that exchange rates are in equilibrium when the prices of goods and services in different countries are the same. If local prices increase in a country compared to others, the local currency would be expected to decline in value compared to its foreign counterpart.The balance of payment approach”It suggests that exchange rates result from trade and capital transactions, which in turn affect the balance of payment. The equilibrium exchange rate is reached when both internal and external pressures are in equilibrium.The monetary approach”It suggests that exchange rates are determined by a balance between the supply of and demand for money. When the monetary supply increases in a country, prices rise and currency depreciate.The asset approach”It suggests that currency holdings by foreign investors are chosen based on factors such as real interest rates.5-Factors that Affect Commodity prices:Commodity prices are influenced by many factors including: -Expected levels of inflation, particularly for precious metals -Interest rates -Exchange rates -General economic conditions -Cost of production and ability to deliver buyers -Availability of substitutes and shifts in tastes and consumption -Weather, particularly for agricultural commodities and energy -Political stability, particularly for energy and precious metals.4-Identifying Major Financial Risk:Major market risks arise out of change to financial market prices such as exchange rate interest, interest rates and commodity prices. They include foreign exchange risks, interest rate risk, commodity price risk, equity price risk. Moreover, others involve credit risk, operational risk, liquidity risk and systemic risk (Horcher, 2005).1-Interest Rate Risk:Interest rate risk is the probability of an adverse influence on profitability as a result of interest rate changes. It affects many organizations, borrowers and investors, and particularly capital-intensive sectors. Those risks arise from various sources and involves absolute interest rate risk (changes in the level of interest rates), yield curve risk (changes in the shape of the yield curve) or basis risk (mismatches between exposure and the risk management strategies undertaken). Absolute Interest Rate Risk:Absolute interest rate risk originates from the possibility of a directional, or up or down, change in interest rate. It should be monitored by organizations due to both its visibility and its potential for affecting profitability.Rising interest rates may lead to higher project costs and changes in strategic plans forma borrower’s perspective. However, a decline in interest rates generate lower or inadequate incomes on investments, from a lender’ perspective.Thus, the typical method of hedging those risks is to match the duration of assets, or replace floating interest rates with fixed ones. Forward rate agreements, swaps, and interest rate caps, floors, and collars are great alternative tools to hedge risks.Yield Curve Risk:Yield curve risk arises from changes in the relationship between short and long-term interest rates. Usually, the yield curve has an upward-sloping shape to it. Thus, longer-term interest rates are higher than shorter-term because of higher risk to the lender. Its steepening or flattening influence borrowing and investment decisions, and therefore profitability. However, in an inverted yield curve environment as mentioned earlier, demand for short-term funds pushes its rates above those of long-term. When there is a mismatch between an organization’s assets and liabilities, yield curve risk should be assessed as a component of the organization’s interest rate risk.When the curve steepens, interest rates for longer maturities increases more than for shorter terms since demand for longer-term financing rise. Alternatively, short-term rates may drop whilst long-term rates remain relatively unchanged. A steeper curve induces to a greater interest rate differential between short and long-term rates, making rolling debt forward more expensive. A flatter curve shows a smaller gap between long and short-term interest rates, making rolling debt forward cheaper.Yield curve swaps and strategies using futures and forward agreements might provide many advantages. The yield curve is a consideration whenever there’s a mismatch between assets and liabilities.Basis Risk:Basis risk is the risk that a hedge, such as derivatives contract, does not move with the direction to offset the underlying exposure, and it is a concern when there’s a mismatch. It occurs when one hedging product is used as a proxy (substitute) hedge for the underlying exposure, possibly because an appropriate hedge is expensive or impossible to find. The basis might narrow or widen, with potential for gains or losses.It applies to future prices, where basis is the difference between the cash and the futures prices. The relationship between those two prices may change over time, impacting the hedge. If the price of a bond futures contract does not change in value in the same magnitude as the underlying interest rate exposure, the hedger may suffer a loss as a result.Moreover, basis risks arise when prices are prevented from fully reflecting underlying market changes. It usually occurs with some futures contracts, where daily maximum price fluctuations are permitted.2-Foreign Exchange Risk:Foreign exchange risk emerges from transaction, translation, and economic exposures. It might also arise from commodity-based transactions where prices are determined and traded in different currencies (Horcher, 2005).Transaction Exposure:Transaction risk influences an organization’s profitability via the income statement. It springs up from the transactions of an organization typically exposed to foreign currencies, including purchases from suppliers and vendors, contractual payments, royalties or license fees, and sales to customers. Its monitoring is key and provide a competitive advantage in a global economy. Translation Exposure:Translation risk commonly referred to fluctuations owing to the accounting translation of financial statement, notably assets and liabilities on the balance sheet. Effectively, it arises wherever assets, liabilities or profits are translated from the operating currency into a reporting currency. Put it differently, it impacts the value of foreign currency balance sheet items such as accounts payable and receivable, foreign currency cash and deposits, as well as foreign currency debt (increases in the value of the foreign currency mean an increase in the translated market value of the foreign currency liability). Note that longer-term assets and liabilities are more likely to be affected.Foreign Exchange Exposure from Commodity Prices:As many commodities are priced and traded globally in U.S. dollars, exposure to commodity prices may indirectly lead to foreign exchange exposure for non-U.S. organizations. Even though purchases are made in the domestic currency, exchanges rates might be embedded in the commodity price. In most cases, suppliers are forced to pass along changes to their customers, or suffer losses themselves.Thus, by splitting and assessing the risk into currency and commodity components independently, organizations can determine efficient approaches for dealing with prices and rate uncertainties.Protections through fixed rate contracts are advantageous if exchange rates move adversely. However, if exchanges rates move favorably, buyers might be better off without them. Apart from the benefit of hindsight, hedgers should understand both the exposure and the market when the market exposure involves combined commodity and currency rates (Van Horne & Wachowicz, 2008).Strategic Exposure:The location and activities of major competitors are of utmost importance when they are exposed to foreign exchanges. Strategic or economic exposure strike an organization’s competitive position as a result of exchange rate changes. While economic exposures, such as declining sales, do not show up on the balance sheet, their impact appears in income statements. For instance, a firm whose domestic currency has appreciated dramatically may find its products too expensive in international markets (although its efforts to decrease costs of production) whereas a firm located in a weak-currency environment becomes cheaper by comparison without any action on their part.3-Commodity Risk:Exposure to absolute price fluctuations is the risk of commodity prices rising or falling. It specially affects organizations dealing with commodities. Some commodities cannot be hedged considering there is no effective forward market for the product. Usually, if a forward market would be available, options market might arise, either on an exchange or among institutions in the over-the-counter market (Horcher, 2005).Instead of commodities markets, many commodity suppliers offer forward or fixed-price contracts to their clients. Financial institutions might provide similar products, hedging their own exposure with the market. In some markets, they are limited by regulations to the type of transactions they undertake.Commodity Price Risk:Commodity price risk takes place when there is potential for changes in the price of a commodity that must be purchased or sold. It can also arise from non-commodity business if inputs or products and services have a commodity component.Commodity price risk impact customers and end-users suchlike manufacturers, governments, processors and wholesalers. When prices rise, cots of commodity purchases increase, minimizing profits from transactions (Van Horne & Wachowicz, 2008).Furthermore, price risk also influences commodity producers and is generally considered the greatest risk affecting their livelihood, thus should be managed accordingly. If commodity prices decline, revenues, the revenues from production fall too, reducing business income.Commodity prices might be set by local buyers and sellers in the domestic currency; however, the exchange rate will be a component of the total price for commodities normally traded in another currency. In this case, currency exposure remains a consideration.Effectively, suppliers assume currency risks by either offering domestic commodity prices to clients or passing along commodity price changes while enabling customers to use a fixed exchange rate for domestic prices.Commodity quantity Risk:Organizations are exposed to quantity risk through the demand for commodity assets. Even though quantity and price are closely tied, quantity risk remains a threat with commodities, since supply and demand are critical. For instance, if a famer anticipate demand for product to be high and plan the season accordingly, there’s a risk that market demands will be less than what has been produced for many reasons. In such a case, the farmer might suffer a loss by being unable to sell all the products, even if prices do not change dramatically. However, this might be monitored using a fixed price contract overlaying a minimum quantity of commodity as a hedge.