Risk Management and Its Effectiveness

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Introduction

Risk is a four-letter word used in businesses, governments and investments; political leaders and entrepreneurs comprehend that if no action is taken, there will be no gain, and thus risk cannot be eliminated. Nevertheless, many companies are putting more effort to reduce and manage risk, thus it has become a norm for many listed firms to disclose the risks they are facing in their annual reports (Nicholson, 2010).

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Any efficient risk management arrangement normally starts with possible risks identification, which may affect the firm’s operations of both tangible and intangible assets. After the identification of risks the firm must evaluate the possibility and the degree of the damage likely; one general formula for evaluating risks is the probability of occurrence multiplied by the cost of occurrence (Theirm.org, 2002). Risk management is normally performed after the identification and assessment of processes. Therefore, these first steps are critical, but they are not risk management themselves; risks must be given priority so that each can be allocated the required resources and time necessary to address it. The effectiveness of the risk management arrangement is normally determined by effective initial stages. All together, evaluation should be thorough and correct for any advanced stages to be significant and efficient (Mindtools.com, 2010).

Risk management function includes procedures and policies or controls that assist managers or owners to manage risks. Managers normally use risk management techniques to offer more information for this function (Vitez, 2011). Therefore, this paper will deal with the techniques used by Walmart, De La Rue, Marks and Spencer Group Plc (M&S), Tesco Plc and BT Group Plc on risk management and the information disclosed by these firms relating to risk management.

Financial risk management techniques

A firm’s top leadership institutes internal processes in risk management in the financial systems to avoid losses emanating from fraud, operations and business deals with partners. Risks inherent in the transactions such as financial risks are linked with bonds, interest rates, stocks, exchange rates and commodities (Codjida, 2010). These risks are also linked to loan provision agreements with the business partners or counterparties (Codjida, 2010). There are various risk management types as well as procedures and characteristics that are different from each other. Risk management procedures play an important role in the firm growth in the long-range. These types of a risk management deal with clients defaulting from payments and the interest charged by lenders (Codjida, 2010), they include;

Risk management from the market

This type of management deals with risks emanating from the market like the equity risk, rate of interest risk, currency risk and commodity risks (Codjida, 2010). The credit and market risks may make the shareholder lose the wealth or fortune while with the liquidity risk the owners may lose the company. Market risks are possible losses resulting from decreasing prices in the financial market which are driven by the market volatility measured by the standard deviation and the investment position. The firms use some instruments to manage these risks and they include; factors identification, Value at Risk (VaR), sensitivity analysis, capital adequacy, scenario analysis, and stress testing (Codjida, 2010). All the firms use the process of risk management to identify risks that will impact the business operations and hence the profits of the firm (Hou, 2005).

The risk management process of the firm starts with the identification of the source and problem analysis. The method chosen to identify the risks depends on the industry practice, culture and compliance; these methods are created by templates for source, event or problem identification. The most common methods of risk identification are; first, objectives-based that is any event that endangers the firm from attaining its goals is regarded as a risk. Second, in scenario-based, the firm creates different scenarios. These scenarios are optional ways of attaining a goal and any occasion that generates an unwanted scenario option is regarded as a risk. Finally, company like De La Rue uses a method like the taxonomy-based through the use of a questionnaire to reveal risks that the firm is faced with. Fourth, risk charting is used by all the firms under study where they list the resources of the firms that are exposed to risks and try to identify the effect of each one of them (Hou, 2005).

All the firms are exposed to market risks and use VaR to manage interest rate risk, the VaR is used by the firms to predict the worst-case loss situation at a particular confidence level and at a particular time period (Imf.org, 2007). They determine the market value of the firm at risk across various products, markets, and periods (Imf.org, 2007). Walmart and De La Rue also use sensitivity analysis to determine the interest rate risk in that the firms use cash flows as well as weighted-average rates of interest by anticipated maturity dates to determine how the firms’ financial instruments like Interest Rate Swaps are sensitive to the changes in the rate of interest (Walmart, 2011).

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Risk management from debtors

This type of risk management is linked to the possibility of default from the account receivables (Imf.org, 2007). An efficient management of debtors is important for the stability of a firm and for the continuation of the firm’s profitability whilst a weakening quality of credit is the main reason for poor financial condition and performance. Sensible management of the credit risk may reduce the operational risk at the same time improve the firm’s returns (Dico.com, 2005).

The main principles in the management of the credit risk used by firms are; first, institutional of comprehensible structure, distribution of accountability and responsibility, procedures should be prioritized as well as disciplined, clear communication of responsibility and accountability should as well be done. The five firms under analysis in this paper are faced with credit risks and their main goals are to decrease any risk that leads to loss emanating from the non-payments by the other parties to the financial deals crossways an accepted counterparties list of a good quality credit. The debtors’ positions are normally monitored by the firm as well as through their credit ratings that are monitored by rating agencies like the S&P, Moody’s, and Fitch. The firms use the policy framework for credit risk to manage the default risk (Tesco, 2011).

Risk management by use of quantitative methods

Quantitative methods in modern world of business are very important processes and they mainly deal with ideas of hazard and risk and attempt to decrease the possibility of any event of financial loss. Firms use a statistical or mathematical model that is quantitative techniques to offer more information concerning the function of risk management. Inputs to these quantitative risk methods of assessment include risk register, project and risk management preparation, and the project range statement. All the five firms use risk register or risk profile as an input to the analysis process. Risk Register executes the same function as the plans for risk management. It prioritizes and categorizes several features of the procedure of the quantitative risk assessment.

On the other hand, project management preparations comprise of preparations for cost and schedule management. The former indicates the ways in which a project can be run while the latter shows the financial features of a project. Project range management emphasizes the positive features of a specific business project. The preparation contains information like the budget, the impact of the risk on the business, risk types, impact matrix, probability, schedule and timing of the risks (Finance.mapsofworld.com, 2010).

In this type of technique, most of the firms use analytical techniques (NPV, CVP, ROI, and IRR), modeling (Game theory, Demand-supply, Decision trees) that evaluates external and internal information, and financial ratios (investment ratios, profitability ratios, efficiency ratios and gearing ratios) (Vitez, 2011). The end result of this type of analysis is the risk register which contains quantified risks, and trends (Vitez, 2011).

Enterprise management of risks

Firms have practiced for long the company risk management. Recognizing and prioritizing the firm’s risks, with prudence or subsequent to a tragedy, has for long been the standard management action. Transferring risks through the use of insurance or financial products like derivatives (Interest Rate Swaps, Forward Rate Agreement, Options and Futures) has been a general practice just like crisis management and contingency planning (Casact.org, 2003).

There are so many risks facing the firms today such as hazard risks like the fire on a production facility or to goods or services obtained on the account. Financial risks materialize with business environment changes for instance currency risks emanating from globalization. Recently, the knowledge of strategic and operational risks has risen as a result of a series of superior-profile circumstances of the firm destroyed or crippled by malfunction of the control systems or by inadequate comprehending of business dynamics.

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The technological advancement, picking up pace of the businesses, rising financial complexity, globalization, and uncertainty emanating from the unreasonable activity of terrorists all add to the increasing number as well as the sophistication of the risks. It’s rational to anticipate that the trend will persist. Firms now make out that managing all identified risks is important from the familiar ones to the easily quantifiable ones. Even the irrelevant risks may interact with varying conditions and events to lead to great damage (Casact.org, 2003).

As a result of well-publicized failures of the risk management stated above rating agencies, institutional investors, regulators as well as corporate governance supervisory bodies have insisted that firm’s top executives take superior accountability in risk management on a firm-wide scale. That is the reason why the five firms use the organizational chart in risk management where every individual in the firm is engaged in risk identification and implementation of the strategy. These firms have also assigned risk committees to assemble all the information from various departments, identify, assess and recommend the necessary action that needs to be taken in order to reduce the exposure (Casact.org, 2003).

For instance, BT Group has a Board Review and Oversight Committee to which the risks identified, assessed, monitored and mitigated are reported. That is, the business activities or operations are fed into the process of risk management and they go through the four processes, identification, assessment, mitigation and monitoring. The identification is connected to goals and strategy, assessment of the net, gross and target risk, mitigation through the use of avoidance, transfer, acceptance, and treatment, and monitoring is done through the use of Risk Registers, and forewarning signals.

After this process, there is risk reporting activity by the executives to the Board Review and Oversight, which is made up by various committees like the review (Operating Committee and Group Risk Panel) committee and Assurance (Board Audit Risk Committee and Lob Audit and Risk Committees) committee (BT Group Plc, 2011). These committees make sure that all the risks facing the firm are identified and assessed jointly in order to come up with the comprehensive conclusion that will enable the firm to mitigate the risks or manage them to avoid financial damages which will affect the stakeholders involved (BT Group Plc, 2011).

Information disclosed

The firms have disclosed various types of risk management information connected to finance. The information relates to market risks such as interest rate risks and currency risks, credit risks, liquidity risks, insurance and capital management. The firm’s exposure to the above risks and how they are managed are discussed below. The risk management responsibilities in these firms lie with the Board who are responsible for institution and supervision of the firms’ framework for risk management. The risk committees are instituted by the Board of each firm and the committee is in charge of the development as well as monitoring the policies used in risk management. The committees report back to the Board on their actions. The policies established are used in identifying and assessing risks faced by the firms as well as in setting suitable risk restrictions and controls, together with risk monitoring and adherence to the restrictions.

The policies, as well as the systems, are re-examined frequently to mirror changes in the market situations and activities. The program for the risk management centers on irregularity of the financial markets as well as on the minimization of possible unfavorable results on the firm’s financial performance. Derivative instruments are used to hedge particular risk exposures and it is mainly implemented by the Treasury or the Group Treasury under the finance department through the use of the policies set by the Board. The Treasury identifies, assesses and hedges the financial risks in conjunction with the operating department. The financial risks identified by the firms are as follows;

Credit risks

This is risk of the financial loss faced by the firm if the account receivables or the customers fail to pay or meet parts of their contract (Walmart, 2011); it occurs mainly from the firm’s receivables, investment securities, and clients. The firm’s exposure to the credit risk is affected principally by the customers’ characteristics. The firms usually limit cash transactions and derivative counterparties of superior quality of the credit and the firms restrict the financial institution’s credit exposure amount (Walmart, 2011).

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Liquidity risks

This type of risk establishes whether the firms are able to meet their short-term obligations. The firms manage liquidity risk to make sure that they have adequate cash or money to meet short-term obligations when time is due. Efficient liquidity management of risk means maintaining adequate marketable securities and cash, the accessibility of finances through a sufficient amount of dedicated credit facilities as well as capability of closing out the positions of the market (Marks and Spencer Group Plc, 2011).

Market risks

Risks change the market prices like the interest rates and currency risks that normally affect the income and value of the firm. The goal of the risk management of these market risks is to administer and control the exposure to market risks in the suitable parameters and at the same time maximize the returns. Most of these firms operate globally and they are exposed to currency risk emanating from several currency exposures, mainly with regard to the Euro and US dollar. Currency risks emanate from future business transactions, recognized liabilities and assets, unrecognized company commitments as well as net investments in the foreign operations (De La Rue Plc, 2011).

Hedging activities

Most of the investors deem that the hedge accounting must be strongly associated with the firm’s risk management actions to enhance the helpfulness of the information from the financial reporting. The disclosures offered on the hedge accounting today mainly focus on instruments used in hedging by the firm instead of the firm’s activities of the risk management (Ifrs.org, 2010). Thus the information disclosed by the firm on hedge accounting is found by investors to be of no help and many think that the disclosure in the IFRS 7 Financial Instruments does not assist them to comprehend the firm’s activities on the risk management. Recently the firms are providing information on how they are using strategy to manage risks as well as how the firms’ activities on hedge accounting have affected the timing, uncertainty and amount of their predicted cash flows, and finally, the impact the hedge accounting has on the firm’s financial reports (Ifrs.org, 2010).

Risks that are under management are those risks that the firms are exposed to and that the firms make decisions to hedge as well as for which application of hedge accounting is possible. Therefore, the disclosures must enable the investors to comprehend the firm’s performance on the activities relating to risk management as well as the impact of such management on the firms’ future earnings. But the firms do not identify all the risks they are exposed to, though they try to disclose those that they have identified, those that will have an impact on their operations and earnings.

The hedge accounting does not disclose the important features of the financial markets trading (Ifrs.org, 2010). Therefore, as an investor, I should not only make investment decisions based on the company’s disclosure on hedge accounting rather I should fully comprehend the technical and fundamentals of any contract or transaction as well as the contractual relationships into which I will be entering into and the degree of the risk I will be facing. Trading is inappropriate for most community members if they have no experience. Thus they must carefully think about whether participating in financial markets trading is suitable for him/her based on their experience, financial resources, objectives, and relevant situations.

Conclusion

Risk evaluation allows the firms to study risks the company is facing. It is normally founded on a structured process from the risk identification, followed by an assessment of the possible occurrence as well as the cost of such an occurrence. Risk assessment forms the foundation of risk management in addition to crisis prevention. The main goal of risk management is cost minimization and value maximization, therefore, it involves making good use of the existing resources and planning for the future.

References

BT Group Plc 2011. BT Group plc: Annual report & form 20-F 2011. London, Pindar Plc.

Casact.org. 2003. Overview of enterprise risk management. Web.

Codjia, M. 2010. Types of Financial risk management. Web.

De La Rue Plc. 2011. De La Rue Plc Annual Report 2011. Hampshire, Fulmar Colour Printing Company.

Dico.com, 2005. Credit risk management. Web.

Finance.mapsofworld.com. 2010. Quantitative risk management. Web.

Hou, A. 2005. Market risk management. Web.

Ifrs.org., 2010. Disclosures. Web.

Imf.org. 2007. Do market risk management techniques amplify systematic risks? Web.

Marks and Spencer Group Plc. 2011. M&S Annual report and financial statements 2011. London, Royle Print.

Mindtools.com. 2010. Risk analysis: Evaluating and managing the risks that you face. Web.

Nicholson, J. 2010. What are risk management techniques? Web.

Tesco. Teco Plc Annual Reports and Financial statements 2011. Web.

Theirm.org. 2002. A risk management standard. Web.

Vitez. O. 2011. Quantitative risk management techniques. Web.

Walmart, 2011. 2011 Annual Report: Building the next generation Walmart. Bentonville, Arkansas, Wal-mart Stores, Inc.

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