Integrated Financial Risk Management

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Terms of Reference

This paper presents an Integrated Financial Risk Management System for a multinational company which is exporting to the United Kingdom, certain South American and Asian countries. The enterprise sources inputs from the USA and Nigeria. It is also invested in Japan, Zimbabwe, and Botswana.

The paper focuses on the foreign exchange rate risks with special attention on the economical and political situation in the involved countries and the likely exchange rate movements, the channels of risk to which the business is faced, aspects of the regulatory environment, and on methods how to manage the inherent risk factors.

The developed strategy is of a generic manner because figures about volumes of trade and the size of investments are not given. The suggested methods therefore have to be ‘filled’ with numbers to derive a risk management for the company.

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Executive Summary

The objective of an Integrated Risk Management System is to maximise shareholder value. Shareholder Value is mainly determined by t he Market Value (MV) which is the most aggregated measure for the value of a company. MV is influenced by future cash flows which are exposed by the risk of Exchange Rate changes. This risk can be hedged by using financial instruments such as derivatives or it can be minimized by applying operational hedging which involves strategic considerations like plant locations and sources of input.

The business of the company assumed in this case consists of Export & Import trades to a variety of countries as well as of Equity Investments in Africa and Asia. An assessment of the countries and areas shows actual economical and political developments to evaluate the most efficient Risk Management decisions.

By looking at the Direct Economical Exposure the extent by which the company is threatened by Exchange Rate changes is examined. Furthermore the Value at Risk approach and the Scenario method is explained and applied to draw a picture of the size and likelihood by what extent the enterprise is exposed to Financial Risks.

It is suggested to use the Dynamic Hedging technique to overcome fluctuating cash flows. Another proposal is to apply Multi-Currency Accounting which supports the company to comply with regulatory standards and provide management information to efficiently control foreign business.

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Table of Contents

  DECLARATION OF ORIGINAL WORK  I

  TERMS OF REFERENCE  II

  EXECUTIVE SUMMARY  III

TABLE OF  CONTENTS  IV

1  COMPANY RISK ASSESSMENT  1

1.1  RISK MANAGEMENT OBJECTIVES  1

1.2  IMPORT EXPORT BUSINESS  2

1.3  EQUITY INVESTMENTS  3

1.4  CHANNELS OF RISK  4

1.5  REGULA TIONS  5

1.6  PLAN OF DEVELOPMENT FOR A RISK MANAGEMENT STRATEGY  6

2  MANAGING STRATEGIC EXCHANGE RATE EXPOSURE  6

2.1  VALUE AT RISK (VAR)  6

2.2  SCENARIO ANALYSIS  7

3  RISK MANAGEMENT STRATEGY  7

3.1  DYNAMIC HEDGING  8

3.2  MULTI-CURRENCY ACCOUNTING  8

4  REFERENCES  9

APPENDIX A   11

APPENDIX B   12

1

1 Company Risk Assessment

1.1 Risk Management Objectives

A recognised objective of financial and corporate management is to maximise shareholder value (Rappaport, 1996). The Market Value (MV) states the overall value in a monetary unit of a specific company or a financial portfolio. The MV is threatened by forces like future cash flows, estimated dividends or returns on investment and the inherited market risk in which areas the enterprise operates. In particular the MV of either a company or a financial portfolio is exposed to the risk of foreign exchange. Therefore corporate treasurers are interested in a sensitivity measure of the MV to the exchange rate. In seeking to manage this economic exposure firms can either adopt operational or financial hedging strategies, or more typically a combination of both. Financial hedging can not prevent a company’s competitive position being eroded by a strengthening domestic currency because of the uncertainty of the underlying cash flows (Bradley and Moles, 2002: 29). Operational hedging involves firms in decisions as the location of their production, sourcing of inputs, the nature and the scope of the products, the firm’s choice of markets and market segments, and strategic financial decision, such as the currency denomination of the firm’s debt. The objective is to match the input and output sensitivities as to reduce the degree of exposure (Rawls and Smithson, 1990).

The main focus in this paper lies on the financial methods of hedging which mainly involves financial market transactions rather than operational decisions such as plant locations and sourcing of inputs. An international firm operating in an open economy faces the risk of real exchange rate changes which influences the firm’s cash flows, and hence its MV.

Changes in currency value influence both the value of firms and riskiness of their cash flows. Unexpected fluctuations in the exchange rate are more pronounced in developing economies, especially those experiencing chronic inflation. Moreover, firms with a high degree of export and import involvement bear higher exchange rate exposure (Kiymaz, 2002). This risk which is in all cases to be minimized can be differentiated in translation and transaction exposure. Translation exposure is a static measure and focuses on the Book Value (BV) of assets and liabilities as stated in the firm’s balance sheet. The transaction exposure on the other hand is influenced by the economic value of foreign currency denominated transactions that are forecasted to occur in the next reporting period and therefore will be realized in the firm’s next income statement.