8. An introduction to risk management tools
External risk management techniques and their importance.
Risk is a term that is becoming increasingly common over the past few years as we try and deal with the worst financial crisis since WWII. With companies hiring top financial advisors to try and deal with the increasing levels of risk and lower their risk exposure, questions must be asked. Are these efforts necessary and effective and do risk management techniques deserve the importance that is placed upon them?
Financial institutions encounter fiver general types of risk
Interest rate risk
2) Price risk
3) Prepayment risk
4) Credit risk
5) Exchange-rate risk
These risks are unavoidable and cannot be completely eliminated, however with the help of risk management techniques, they can be significantly lowered in an attempt to reduce any considerable loss. There are a number of ways to manage risk; both internally and externally, however I feel that the scope for reducing a company’s exposure to risk internally is small and firm specific, therefore I will focus more on external tools. External risk management techniques are all market based tools in which expectations of future prices, interest rates or foreign exchange rates are used in an attempt to profit off favourable movements. For example an option could be used for a future transaction at a price agreed today. The buyer of the option gains the right-but not the obligation, to buy the good for an agreed price at some point in the future. Consider the price of the asset in question doubled 2 months after the option was bought; the buyer could exercise the right to buy that asset at the pre-arranged price, which would only be half of what the asset is worth if it is bought. If a company expects the price of a asset to rise in the future, they can purchase an option which reduces the risk that they will have to pay the higher future price. This is an example of hedging, which involves taking an offsetting position in a related security. However there is no guarantee that price will rise, so it is possible that the company could lose money on the purchase of the option by not actually exercising it if the prices in fact fall below current prices.
There are a number of different techniques similar to buying options that can be used to manage risk; with 2 of the most common and effective given the current volatile markets being forwards contracts and interest rate swaps. Like options, they are external risk management techniques known as derivatives, however interest rate swaps - as the name would suggest hedges the buyer against changes in the interest rate. Forward contracts are very similar to options except unlike an option which gives the buyer the right, not the obligation to buy; these derivatives assert that the asset WILL be bought for a price agreed today. Along with explaining both types of derivatives I will comment on their relevance to today’s markets and use an up-to-date example to help demonstrate how they can be used to manage and reduce risk.
Forward contracts essentially protect against unfavourable changes in the interest rate. With the extremely volatile and uncertain foreign exchange market seen today, forward contracts are very handy in limiting the risk of sudden jumps in a currency. As we can see from the graph, the exchange rate between euro and dollars has been up-and-down. In fact yesterdays close saw a 1.4% fall in the euro with the exchange rate now at 1=1.2993- the euro’s lowest rate since the 11th of January this year.(1)
The growing uncertainty in the foreign exchange market means that companies such as Microsoft have engaged in forward contracts as a form of hedging. With over 9.3$ billion worth of foreign exchange contracts sold in 2011, Microsoft is actively involved in using derivatives to reduce their risk. (2) Their hedged currencies include the euro, Japanese yen, British pound and Canadian dollar. With a large amount of business activities, suppliers and customers internationally, Microsoft must manage their exposure to foreign exchange risk accordingly. For instance, if their New Zealand suppliers Black Diamond Technologies (3) limited charged them 1 million New Zealand dollars for an order at a rate of 1:.7523, this would translate to 752,300 US dollars. If however Microsoft expected the New Zealand dollar to appreciate against the US dollar, they could enter into a forward agreement to lock in the price of 752,300 for that order. Not only does this allow Microsoft to eliminate any risk of a loss due to an appreciation of the NZ dollar, it also provides certainty on the price they will pay. This allows Microsoft to set final prices and continue with production without having to worry about their supply price.
Microsoft are not unique in using forward contracts to hedge. Many other S&P 500 companies such as AIG, Intel, McDonalds, Coca-Cola, Hewlett-Packard and Procter & Gamble also engage in forward contracts which, given the risky nature or current foreign exchange markets are very attractive and widely used.
Similarly the use of interest rate swaps can be employed as a risk management technique and can considerably reduce a company’s exposure to changes in the interest rate. Interest rate swaps are cash-settled over-the-counter derivatives under which two counter parties exchange two steams of cash flows.(4) The most popular interest rate swaps are fixed-floating swaps, whereby cash flows of a fixed-rate loan are exchanged for those of a floating rate. They are useful when one company wants to receive a payment with a variable interest rate, while the other wants to limit future risk by receiving a fixed-rate payment instead. As we saw earlier, there are advantages to knowing the exact value of future cash flows, as is the case if you receive a fixed interest rate. With a greater certainty of income, companies can engage in more accurate budgeting and cost management techniques. This has become an increasingly necessary attribute for companies over the past few years due to the collapse of global banking systems and the financial crisis.
An example of a firm that engages in interest rate swaps is Unilever. Unilever is a British-Dutch multinational company specialising in fast-moving consumer goods. According to their report of directors 2011, Unilever uses interest rate swaps to ‘minimise interest costs and reduce volatility’. (5) Their interest rate management approach aims to achieve an appropriate balance between fixed and floating interest rate exposures, offering them the ability to both reduce uncertainty, and take advantage of current interest rates which are at a historic low in both the US and Europe.
Consider a situation whereby Unilever is borrowing at a variable rate – the LIBOR rate which stands at 2.1%. They want to engage in a swap to allow them to have a fixed rate of borrowing rather than the LIBOR rate which is unknown after the first period. A second counterparty with a fixed interest rate payment of 2.3% will enter into a swap with Unilever. Therefore Unilever will pay interest of 2.3% for all periods i.e. a fixed rate to the counterparty, and the counterparty will pay the LIBOR rate plus 1% to Unilever. The incentive for Unilever is that the interest they pay on their borrowing is fixed, allowing them to budget more accurately. The counterparty will engage in the swap as they have the chance of receiving a higher interest rate than they are paying to Unilever, therefore making a gain. If the LIBOR rate is above 1.3%, they will receive more than 2.3% from Unilever (1.3% + 1%) although they are only paying 2.3% back.
The use of financial derivatives is a great way to reduce exposure to risk and is commonly used risk management techniques. Given the nature of these external market-based methods, companies have realised the scope these techniques possess in reducing the chance of a loss. The unforgiving current market conditions necessitate that risk managers are extremely careful in the decisions they make and from previous experience derivatives can prove to be very dangerous if not handled properly. However the high level of volatility that causes this risk can provide greater scope to hedge successfully.
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