Integrated Financial Risk Management

Table of Contents

DECLARATION OF ORIGINAL WORK

TERMS OF REFERENCE

EXECUTIVE SUMMARY

1 COMPANY RISK ASSESSMENT
1.1 RISK MANAGEMENT OBJECTIVES
1.2 IMPORT & EXPORT BUSINESS
1.3 EQUITY INVESTMENTS
1.4 CHANNELS OF RISK
1.5 REGULA TIONS
1.6 PLAN OF DEVELOPMENT FOR A RISK MANAGEMENT STRATEGY

2 MANAGING STRATEGIC EXCHANGE RATE EXPOSURE
2.1 VALUE AT RISK (VAR)
2.2 SCENARIO ANALYSIS

3 RISK MANAGEMENT STRATEGY
3.1 DYNAMIC HEDGING
3.2 MULTI-CURRENCY ACCOUNTING

4 REFERENCES

APPENDIX A

APPENDIX B

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.

Executive Summary

The objective of an Integrated Risk Management System is to maximise shareholder value. Shareholder Value is mainly determined by the 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.

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.

The case involves both risks as the company exports and imports goods and is invested in foreign equity. Hence to address these matters a brief evaluation of the likely financial development of the involved countries is given. Afterwards the strategic positioning of the company in terms of exposure to financial risks is discussed before the next sections deal with the objectives, regulations and approaches to hedge the risk.

1.2 Import & Export Business

This section will examine the most important political and financial factors of the firm’s involved countries in the import and export business. The export business includes the following areas:

- Asia: Most recent developments show a high impact of the last G7 meeting. on Japan’s Yen, the Thailand Baht, the Taiwan Dollar and the Korean Won rose to highest levels in the last two years. The reason seems to be the acknowledgements of the G7 countries that there is macroeconomic unbalance and the see the solution in more flexible exchange rates. This will definitely have impact towards appreciating Asian currencies compared to the US-Dollar (FAZ.NET, 2003a).

The political and economical situation is faced by ongoing developments concerning the AFTA (Asean Free Trade Zone) and movements to the independency from the USA. The focus lies on inter-Asian relations especially to China and India so that there is a high operational risk in terms of trade barriers.

- South America: The currencies in this area are dominated by the two largest economies which are Argentina and Brazil. The last years showed the high impact of one of the currencies on the other. As Argentina dropped the US$-fixing after the Brazilian Real was depreciated dependability of these currencies were clearly seen. As the rates of these currencies are interrelated there is the idea to switch to a common currency which would force the government to do their homework instead of to escape through the “currency - back door (FAZ.NET, 2003b).

The South American Continent is still affected by political turbulences which are even more difficult to predict than financial forecasts. The high return opportunities in several countries are therefore burdened by a high risk.

- UK: The UK economy performed very stable in 2002. All of the Maastricht criteria were accomplished and the fiscal policy was still on consolidating course even there were high government expenditures for public services (Auswärtiges Amt, 2003a).

The import business is exposed to the following countries:

- USA: The company imports machinery and equipment from the USA. The country was recently faced by a recession and a negative trade balance. The inflation rate is actually at about 1,6%. The exchange rate of the US$ turned in 2003 in favour for exports. The dollar has continued to slide against both the euro and the yen, despite intervention from the Bank of Japan. Though America’s trade gap has narrowed slightly, its current account deficit of roughly 5% of GDP still represents a macroeconomic instability that makes a further devaluation of the dollar extremely likely (The Economist, 2003a). - Nigeria: The operations of the company import package material from Nigeria. The Nigerian economy is dominated by government regulations and is highly dependent on oil exports. The start of privatization leads to inefficient performances only. The exchange rate is still regulated and works on the “Dutch auction system” since 2002 which could not prevent the depreciation of the currency. An inflation rate of over 12% is still evident (Auswärtiges Amt, 2003c).

The Economist (2003b) predicts growing GDP of annual nearly 4% - mainly driven by the oil industry - and inflation rates in the double digits.

1.3 Equity Investments

The company is exposed with equity investments in Zimbabwe and Botswana in agricultural businesses which export to Europe & SA:

- The political situation in Zimbabwe has had a catastrophic effect on the economy. Foreign investors have left the country in droves and this has been devastating in economic terms. The political situation and lack of foreign investment have led to a major shortage in foreign currency which means that it is extremely difficult and expensive to import goods (MBendi, 2003a) The inflation rate rose to 220% in March 2003 and the unemployment rate varies between 70 and 80 %. The political force in person of President Mugabe is still not willing to accept the structural adjustments suggested by the IMF and the World Bank and the entire economy will stay dependent on the export of tobacco minerals and be therefore exposed to environmental risks like aridity (Auswärtiges Amt, 2003c).
- Botswana’s economy is one of the healthiest in Africa and the country can boast one of the world’s highest growth rates. Many have attributed this to the fact that despite continued regional tension and the conflict experienced by neighbouring countries, Botswana remains relatively peaceful. The country has also practiced fiscal discipline and sound management. The country’s economy depends on the important revenues earned from diamond and beef exports as well as tourism and the foreign currency injected through donor aid. Economic problems in the country are similar to those experienced by other African states. The government is faced with the problem of high rates of unemployment and poverty. The government has taken a proactive approach and has invested heavily in infrastructure as well as education (MBendi, 2003b). The inflation rate is stable at around 8%.
- The investment’s export market (Europe and SA) shows consistency and the value of the Pula appreciated against the Euro. South Africa is still under the influence of a strong Rand which hampers the export to SA. The government recently lowered the prime rate so that an adjustment to a fair va lue is likely. But technical analysis shows that the Rand is valued in the fair range. Furthermore trade agreements are under high pressure especially after the Cancun Round and are enforced by the Developing Countries to be more fairly. - Other equity investments are held in Japan which is pushed by the Prime Minister to build a more central role in international affairs. It is planned to increase the rate of growth in the money supply, from the current 2% to between 3% and 4%. Increasing the money supply will provide a needed boost to the nascent recovery in Japan’s economy, which has been severely hurt by deflation. The chief economist for Japan at Deutsche Securities has said that he expects deflation to end in 2005, but warned that this might not be possible unless the United States helps Japan keep the yen from rising too high against the dollar. A higher yen would harm exports, striking a blow to Japan’s recovering economy (The Economist, 2003d)

1.4 Channels of Risk

John Pringle and Robert Connolly (1993) argued that the overall impact on a firm from exchange rate changes depends not only on how the firm reacts, but also on how the firm’s competitors, customers, and suppliers react. This leads to assessment of the channels of risk which can be inferred from the firm’s operations. Direct FX Risk includes Sales abroad - Export, Source abroad - Import and Profits abroad - Equity Investments. The assessment in the appendix (see Appendix A) considers the likely exchange rate movements as pointed out in the brief country descriptions and gives indications for strategic actions.

Indirect FX Risk is an important part of an integrated risk management system as it examines the price changes caused by foreign competitors, suppliers and customers. The limitation of this case only allows making the assumption that customers abroad - export business - are affected by exchange rate movements in either improving or decreasing margins. This effect is in fact the opposite of the direct FX risks described above.

If a company hedges risks - the recommendation is that the total amount invested in hedging instruments should be not more than 5% of firm’s profit - new risks occur. This risk is called basis risk whereby the basis is the spot price of the asset which is to be hedged minus the futures price of the contract used. Risk exposure of a derivative contract is therefore given by the difference of the asset whose price is to be hedged and the underlying asset of the futures contract. Furthermore the timing decision of buying and selling may be uncertain as well as the risk of the requirement that the hedge has to closed out before the expiration date. To overcome these issues Dynamic Hedging is suggested for an efficient use of derivatives in the final section (Hull, 2002).

1.5 Regulations

The Statements SFAS 52, Foreign Currency Translation, and SFAS 80, Accounting for Futures Contracts, address hedging activities relating to changes in foreign exchange rates and other futures contracts, respectively. In addition SFAS 133 Accounting for Derivative Instruments and Hedging Activities broadly defines derivative instruments by their characteristics of determining their intrinsic values. This broad definition may be applied to other instruments that will be developed in the future. The fair value of a derivative shall be presented in the balance sheet and gains or losses for a period shall be recognized in the income statement. A gain or loss on non-hedging derivative instrument is recognized in current year's earnings (Kim).

Foreign Currency Hedges are defined as a derivative that hedges the change in foreign exchange rates. It is divided into foreign currency fair value hedge and foreign currency cash flow hedge, such as a foreign currency fair value hedge of available-for-sale security, a cash flow hedge of a forecasted foreign currency-denominated transaction, or a hedge of a net investment in a foreign operation. Foreign Currency Hedges includes derivatives instruments used for hedging foreign currency exposure from changes in foreign currency exchange rates with either a forecasted foreign-currency-denominated transaction or a forecasted inter- company foreign-currency-denominated transaction. In addition to the requirements under the cash flow hedges, this hedging transaction shall be performed by the operating unit that has the foreign currency exposure and it is denominated in a currency other than that unit's functional currency. Net gain or loss shall be accounted for as that of cash flow hedges.

Another form of Foreign Currency Hedge s is a derivative instrument or a non-derivative financial instrument that hedges foreign currency exposure of a net investment in a foreign operation. Gain or loss shall be, to the extent it is effective as a hedge, treated in the same manner as a foreign currency translation gain or loss under SFAS 52.

1.6 Plan of development for a Risk Management Strategy

The following will concentrate on assessing the risk of foreign currency exchange rate changes by using different approaches to deal with this issue.

An explanation of the Value at Risk (VaR) method is given which could be used to calculate the size of loss if an unlikely adverse price movement occurs. Unfortunately this can be done on a theoretical basis only because the given data is not sufficient in terms of sizes for investments and volume of import/export.

The scenario approach is more likely to be applied in this case. An assessment of the predicted economical developments and the riskiness of the firm’s involvement will be combined to a Risk Matrix. This graphical solution will identify the parts of the business which are most useful and recommended to hedge.

After examining the company’s risk exposure recommendations for a Risk Management System are given. This includes the use of Dynamic Hedging methods and Multi-Currency Accounting which are highly recommendable in this particular case.

2 Managing Strategic Exchange Rate Exposure

2.1 Value at Risk (VaR)

A Value at Risk (VaR) calculation is aimed at making a statement of the form “We are X percent certain that we will not lose more than V monetary units in the next N days.” The variable V is the VaR, X is the confidence level, and N is the time horizon (Hull, 2002: 347). The calculation of VaR can be done either on a historical basis which involves engineering a database consisting of the daily movements of all market variables. An alternative is the model-building approach which uses daily updated volatilities and correlations. The results of this approach can be produced quickly by using updating schemes such as exponentially weighted moving average (EWMA) (Hull, 2002: 346-347).

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