Risk Analysis and Techniques of Risk Management

Introduction

In any economy the market participants look for the services of the banks and other financial institution since they have the ability to provide a detailed knowledge about the market, transaction efficiency, and enforcement of different contractual arrangements. In view of the nature of products being dealt with by the banks and financial institutions as also the nature of transactions the institutions are exposed to different kinds of risks. There are activities that carry risks of complex nature like the case of illiquid and proprietary assets being held by the banks (Santomero & Trester, 1997).

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The risk management in the financial institutions center round two basic issues as to the impact of risk on the functioning of the financial institutions and the ways in which the institutions can work to mitigate the potential risks involved which form an integral part of the products of the financial institutions (Stulz, 1984). The available literature points out four distinct reasons for practicing risk management in any financial institution. They are: (a) self interest of the managerial people involved in the business processes of the financial institutions, (b) impact of taxation, (c) the cost of financial distress and the resultant economic losses and (d) capital market imperfections (Santomero, 1995). In each of the above instances there is volatility in the profits which may result in a reduction of the firm’s value to some of the stakeholders. Any one of the above reasons would have the effect of motivating the management to make a careful assessment of the risks associated with the different products and techniques for risk mitigation. This paper attempts to identify some of the various risks facing financial institutions and presents a report on the ways to manage the different types of risks.

Foreign Exchange Risk

Exchange rate risk is a natural consequence of international operations in a world where foreign currency value moves up and down. International firms usually enter into some contracts that require payment in different currencies. Exchange rate exposure and risk is the change in the domestic currency value of a firm’s assets and liabilities caused by the movements in the exchange rates. The exchange rate exposure may be positive or negative (Banking and Finance, 2000). Firms that deal in currencies of different countries face the risk of gaining or losing in the value of assets and liabilities or in respect of their revenue or outflows because of sudden unanticipated changes in currency exchange rates (Sivakumar & Sarkar, 2007). The economic globalization has made the business organizations spread their wings across the geographical locations and use the low cost locations for improving their profitability and sales growth. This has necessitated the movement of foreign exchange from one country to another in the form of capital movements and also the profits repatriated to the country of origin. But due to frequent and major changes in the domestic and international financial markets the firms have been exposed to two kinds of foreign exchange risks. These are exchange rate risks and interest rate risks. The firms adopt several measures to protect their exposure to foreign exchange risks.

Techniques used to manage Foreign Exchange Risks

One of the earliest methods adopted without involving any derivative instrument is the forward contracts in foreign currencies in which they are dealing it. However this method of mitigating the foreign exchange risks did not prove to be effective whenever there were favorable movement of the foreign currency and the firms are often exposed to loss of profits which they would have otherwise earned had they not entered in to the forward contracts. After the introduction of the various forms of financial derivatives they started covering their foreign exchange exposure by resorting to the financial derivatives.

Using Derivatives for Managing the Foreign Exchange Risks

Out of the above methods of mitigating the foreign exchange risk, the forward contract is the oldest and most popular one used by the business firms to manage the financial risks. A forward contract is “a cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date.” (Investopedia, 2009) Under forward contract the firm agrees to buy and deliver a certain amount of a specified foreign currency at a future date. The rate at which the currency is to be delivered is decided at the present point of time. If the actual exchange rate on the date of settlement is more the firm makes a profit out of the transaction and if the exchange rate is less than the agreed rate a loss results out of the transaction.

A futures contract on the other hand is more or less similar to a forward contract. It is defined as “A standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date.” (Investor Words, n.d.) Under futures contract the firm is obligated to buy certain specified currencies at specified exercise exchange rates. In this type of contract the risk to the holder of the instrument is rather high and unlimited as the there is always used to exist an asymmetry in the payment pattern. The risk of the seller is also unlimited as well.

Under currency swap contract the buyer and seller or the other parties involved in the contract are obligated to make an exchange of predefined cash flows at the specified periodic intervals. Swap contract comprises of a series of forward contracts put together for covering the foreign exchange risks. Under the currency swap the parties exchange with each other the difference in the interest payments covering the amount contracted in one foreign currency for settlement in another currency. An option contract unlike the forward, future or swap contract creates the firm a right but not an obligation to buy (a call option) or to sell (a put option) an asset at a specified price on or before a specified date. The exercise of the right by the buyer places an obligation on the options seller to deliver the specified asset at the contracted price.

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Credit Risk

Credit risks arise due to the non-performance of a debtor and these risks usually arise either the debtor is unwilling or unable to perform according to the already committed contract terms. This has its effect on the lender who underwrote the loan, other people who advanced money to the creditor as well as the shareholders of the debtor himself (Credit & Finance Risk Analysis, 2009). In fact a major part of credit risk is the culmination of the systematic risks and the unusual losses associated with these risks pose a problem for the creditors in spite of the benefits of diversification from the whole uncertainty. This is applicable especially to the creditors who advance amounts in the local market against the security of the illiquid assets (Morsman, 1993)

Techniques of Mitigating Credit Risk

Managing credit risk form a major responsibility for the banks, as lending is the core business for the banks. Banks mainly adopt (i) portfolio diversity, (ii) conservative underwriting and account management and (iii) aggressive collection procedures as the techniques to mitigate credit risk (Dorsey, 2007). The best way banks manage their credit risk is by dividing their total amount of lending by companies, industries or geographical locations. This enables the banks to have a cushioning effect in the matter of credit risk management. If the bank experiences a higher credit risk exposure in one of the geographical locations it will be offset by the safe lending in other areas. This way the banks are able to spread their credit risk over different portfolio of lending.

Within a particular industry, the banks are able to protect themselves against credit risk by efficient underwriting and collection procedures. The focus of risk management in respect of credit risk lies in avoiding writing bad loans. If a loan appears to be doubtful, the banks take all possible efforts to realize the loan. The banks which develop the skills for better managing credit risk are able to have a higher competitive ability than the others. Establishment of sound credit approval systems and processes supplement this ability of the banks to mitigate the credit risk more efficiently.

Since lending becomes the major activity for the banks they establish detailed systems and procedures for assessing the risks and rewards of its credit risk settlement activities. An efficient credit analysis would help banks to mitigate their credit risk to a large extent. This way the banks would be able to eliminate credit risk without lowering their level of activities in credit trading by making their settlement practices more efficient. The trading patterns of the banks also have an impact on the mitigation of their credit risk to a large extent.

Interest Rate Risks

Interest rate risk can be defined as the current or prospective changes in the earnings and capital caused by periodic movements in the interest rates. “Depending on the interest rate risk profile of banks, such as the extent to which individual banks are net lenders or net borrowers in the interbank market, their profitability will be affected to different degrees.” (Yam, 2006) The major risk being faced by the banks and the financials institutions is the risk posed by the change in the interest rates. The interest rate risk for the financial institutions emanates from the financial intermediation services being undertaken by them. The risk is caused by the difference in the maturity values of the assets and liabilities of the banks. The interest rate sensitivity differences often expose the equity of the banks and other institutions to changes in the interest rates which ultimately affects the profitability of the institutions. The unexpected changes in the interest rates make the balance sheet hedging activity of the bank which is normally undertaken on the basis of the maturities of assets and liabilities at the expected maturity values shown in the balance sheets of the firms. When there are changes in the interest which affect the valuation of assets and liabilities negatively the banks and other institutions are bound to get a beating of the earnings. The other forms of interest rate risks are the refinancing risk and the reinvestment risks.

Techniques used to Protect against Interest Rate Risk

A forward contract with the interest rate changes as the base is known as ‘forward rate agreement’ (FRA). The FRA consists of an inter-bank traded contract to buy or sell interest payments on a future date and the interest is to be calculated on a notional principal. Under forward trade agreement the buyer gets a right to specify a certain rate of interest for an agreed term which is set to start on a future date. The interest amount will be calculated on a notional principal amount. Similar to the currency forward contracts, the FRAs also are entered into with maturity periods of 1,3,6,9 and 12 month periods.

Interest rate futures on the other hand are largely used by the finance and treasury managers of non-financial companies in contrast to the currency futures (Bodnar & Gebhardt, 1999; Eiteman et al., 2000). The enhanced usage may be due to the fact that interest rate futures are having relatively high liquidity, are simple to use and the interest rate exposures of the firms are standardized in nature. However Phillips, (1995) and Mallin et al., (2001) are of the view that the interest rate futures are not popular among firms to manage their interest rate risks.

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The interest rate swap is an agreement entered into by two parties wherein a series of payments is being made by one party to the other on predetermined dates, but at different rates of interest. ‘Plain Vanilla’ is the popular type of interest swap agreements where one part of the payments is fixed and the other part of payment is maintained at floating rates. This type of interest rate swaps has become the largest derivative contract in the world.

Interest rate options are just like forward rate agreements. In the interest rate options, instead of being bound by a firm commitment to receive interest at one rate and make payment of the interest on another, a right is given to the holder to receive interest at one rate and make payment of the interest on another.

Conclusion

The objective of risk analysis is to ensure that the organization places efficient risk management techniques in place so that it can sustain the overall profitability. In the present day competitive business environment, it has become vitally important that organizations adopt effective risk management techniques to remain competitive. Implementation of a firm-wide risk management practice needs a focus on the central business activities, a complete review of lending patterns, trading or market making and intermediating operations of the firm from the angle of risk management. This process of risk management requires a number of guiding principles that facilitate the smooth implementation of the firm level risk management techniques. This also requires the risk management to be an integral part of the overall business plan of the company. Any decision of the firm to take up or leave or to focus on any business activity or process needs a careful assessment of the risks to which the firm is exposed as well as the potential returns that the firm can expect by undertaking or discarding the business process or activity.

References

BankingandFinance, 2000. Hedging Foreign Exchange Risk – Isn’t is also a Risk. 2009. Web.

Bodnar, G.M. & Gebhardt, G., 1999. Derivatives used in Risk Managment by US and German Non-Financial Firms. Journal ofInternational Financial Accounting, 10(3), pp.103-33.

Credit & Finance Risk Analysis, 2009. Credit Analysis Basics and Risk Definitions. Web.

Dorsey, P., 2007. The Five Rules For Successful Stock Investing. Morningstars Guide To Building Wealth And Winning in the Stock Market. UK: Wiley & Sons.

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Eiteman, D.K., Stonehill, A.I. & Moffett, M.H., 2000. Multinational Business Finance. USA: Addison – Wesley.

Investopedia, 2009. Forward Contract. Web.

Mallin, C., Ow-Yong, K. & Reynolds, M., 2001. Derivatives Usage in UK Non-financial Listed Companies. European Journal of Finance, 7, pp.63-71.

Morsman, E., 1993. Commercial Loan Portfolio Management. Philadelphia: Robert Morris Associates.

Phillips, A., 1995. Derivatives Practice and Instrument Survey. Financial Management, 24(2), pp.115-25.

Santomero, A.M., 1995. Financial Risk Management: The Whys and Hows. Financial Markets, Institutions and Insturments, 4(4), pp.1-14.

Santomero, A.M. & Trester, J., 1997. Financial Innovation and Bank Risk Taking. Journal of Economic Behaviour and Organization.

Sivakumar, A. & Sarkar, R., 2007. Corporate Hedging for Foreign Exchange Risk in India. Web.

Stulz, R., 1984. Optimal Hedging Policies. Journal of Financial and Quantitative Analysis, 19(2), pp.127-40.

Investor Words, I., n.d. Futures Contract. [Online] 2009. Web.

Yam, J., 2006. Managing Interest Rate Volatility. [Online] 2009. Web.

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