Ch 8

Question 1

Definition of Financial Risk

Answer 1

risk of a change in financial condition such as exch rate, int rate, customer credit rating, or price of a good

political risk is not necessarily a financial risk - but often financial risk arises from business activities overseas - and political risk is to do with wider risks of foreign direct investment

Question 2

Definition of Political Risk

Answer 2

risk faced by an overseas investor that the host country take adverse action against them after the investment has been made

govts want to encourage development and growth, but also anxious to prevent exploitation of their countries by multinationals

Question 3

Example forms of political risk

Answer 3

confiscation/destruction of overseas assets

quotas, tariffs, taxes => commercial risk (local govt discrimination)

e. g. import quotas to limit quantity of goods which can be bought from holdco to resell in domestic market
e. g. import tariffs to make said holdco goods more expensive than those produced domestically

restricted access to local borrowings

govt insistence on minimum shareholding by domestic investors, or all investments to be in form of JV with local companies

restrictions on repatriation of cash (capital or dividends) - or outright ban of dividends to foreign sh/h (e.g. multinational holdcos) - example exchange control regulation

resitrctions on conversion of currency

rationed supply of foreign currencies - restricting residents from buying good abroad (example exchange control regulation)

exchange rate volatility through political actions

minimum number of local nationals req’d to be employed

price fixing by govt

min % of local components to be used

invalidation of patents

claiming compensation for past actions

Question 4

Example Discriminatory Actions by local govts creating political risk

Answer 4

SUPERTAXES

foreign firms paying more than local businesses - to give an advantage to latter and even to prevent profitability of former

RESTRICTED ACCESS TO LOCAL BORROWINGS

restrictions or even outright prohibitions - which forces org to import foreign currency into the country

EXPROPRIATING ASSETS

whereby govt seizes foreign property in “national interest”

recognized in international law as the right of sovereign states, provided that prompt consideration at fair MV in a convertible currency is given

issues arising: meaning of prompt/fair, choice of currency, and recourse for company unhappy with compensation offered

Question 5

Ways for a company to assess its political risk exposure

Answer 5

use political ranking tables e.g. Euromoney magazine tables

evaluate macro-economic situation - balance of payments, unemployment, per-capita income, inflation, exchange rate policy, rate of economic growth

evaluate govt popularity, stability, attitude to foreign investment - plus attitude of opposition parties

consider historical stability of political system

consider changing religious and cultural attitudes

take advice from company bank (if represented in destination country) and home embassy in destination country

Question 6

Ways for companies to minimize political risk

Answer 6

prior negotation - regarding concession agreements, planned divestment

struturing investment - local sourcing of labor and mat

entering into foreign JVs

obtaining agreements and contracts with overseas govt

using local financing

plans for eventual (part-) ownership by foreign country’s investors

Question 7

Minimizing Political Risk - Joint Ventures

Answer 7

if each JV partner contributes a share of funding, investment at risk for each partner is restricted to their share of the total investment (although the upside is also reduced)

if a local JV partner is selected, increased chance of winning contracts in the country - some govts require a local company in a JV to be eligible for govt contracts

the local venture partner has a better understanding of local political risks and can manage them more effectively; govt may also be less inclined to act against local partner’s interests

ALL OF THE ABOVE reduce political risk

Question 8

Minimizing Political Risk - Pre-Trading Agreements

Answer 8

prior to making inv, agreements with local govt should be struck if possible regarding

rights

remittance of funds and local equity investments

award of govt contracts (where appropriate)

Question 9

Minimizing Political Risk - Gaining Government Funding

Answer 9

govt funding for a project/contract possible in some circumstances where govt is customer, backer, or partner for a deal

if funding is secured:

• govt has an interest in success of tx
• little to no risk of exchange control regulations preventing withdrawal of profits from country

Question 10

Minimizing Political Risk - Local Finance

Answer 10

availability of local finance may depend on sate of banking and capital markets in the country concerned

major advantage of local finance is that it creates liabilities in the foreign currency, thus reducing:

(i) translation exposures - assets in foreign currency can be offset against liabilities in same currency
(ii) transaction exposures - interst costs payable in foreign currency and can be paid from income in same currency

raising finance locally may also maintain interest in success of the business of local govt - may reduce risk of asset confiscation

Question 11

Minimizing Political Risk - Plan for eventual part- or full-ownership of business by locals

Answer 11

setting target dates in advance for this

transfer of ownership should take place over a long term, partly to ensure that a satisfactory ROI can be obtained but also so local govt can understand l/t benefits of foreign investment

Question 12

Definition of Interest Rate Risk

Answer 12

risk of gains/losses on assets and liabilities due to changes in interest rates

will occur for any org which has assets/liabilities on which interest is payable or receivable

Question 13

Interest Rates and LIBOR

Answer 13

non-fin orgs typically have many more interest-bearing liabs than assets, incl bank loans, overdrafts, bonds/debentures

bank loan/overdraft interest typically payable at VARIABLE or FLOATING RATE - e.g. LIBOR benchmark plus margin

bond, debenture, loan stock interest at FIXED RATE

Question 14

Definition of LIBOR

Answer 14

London Interbank Offered Rate

money market rate at which top-rated banks are able to borrow s/t in London sterling or eurocurrency mkts

LIBOR rates exist for major traded currencies - USD, JPY, EUR, GBP

Question 15

Types of Interest Rate Risk Exposure

Answer 15

FLOATING RATE LOANS

changes in interest rates alter interest A/P or A/R - direct impact on CF and profits => obvious risk impact

FIXED RATE LOANS

although interest charges themselves unchanged, fixed rates make company uncompetitive if costs are higher than those with a floating rate and interest rates fall

e.g. an asset that pays a fixed rate of interest will be worth less if interest rates rise

companies which pay a fixed interest rate on liabilities are at risk that:

• if interest rates fall, unable to benefit from lower rates in the market
• competitors may have floating liabilities, thus able to improve their profitability and competitive strength

Question 16

Measuring exposure to Interest Rate Risk

Answer 16

FLOATING RATE LOANS

Interest risk exposure = total amount of floating rate assets and liabilities

Higher value of loans => greater exposure to changes in interest rates

FIXED RATE LOANS

Total amount of fixed rate assets/liabilities together with average time to maturity and average interest rate

longer period of tie-in at fixed rates could be beneficial or costly to business depending on market rates and expectations for future changes - these expectations determine risks

Question 17

Example - calculating interest rate exposure

Answer 17

Company has these liabilities:

• Bank loans $400 million, interest at LIBOR + 50 basis points
• $50 million floating rate bonds, interest at LIBOR + 25 basis points
• $200 million 6.5% bonds, redeemable 30 June Year 3
• $350 million 6% bonds, redeemable 30 September Year 4

INTEREST RATE EXPOSURE (floating and fixed rate)

Floating = 400+50 = $450m

Fixed = 200+350 = $550m

AVE INTEREST RATE (fixed rate only)

(200m * 6.5%) + (350m * 6%) = 34m of interest per year

divide by 550m of loans = 6.18% average

compare this to other companies in industry and bear in mind expectations regarding base rate

e.g. if higher than competitors and base rate expected to fall => higher risk as we will pay more in the future than our competitors

AVE TIME TO MATURITY (fixed rate only)

(200m * 2.5 years) + (350m * 3.75 years) = 1,812.5

div by 550m of assets = 3.3 years average remaining life

compare to competitors

if time to maturity is longer and rates expected to fall => risk increased as org is tied into paying too much interest, may face a redemption penalty if they try to restructure debt

Question 18

Refinancing Risk

Answer 18

associated with interest rate risk

considers risk that loans will not be refinanced, or not at the same rates

this may be because:

• lenders unwilling to lend, only prepared to lend at higher rates
• credit rating of org has reduced, making them more unattractive lending option
• company may need to refinance quickly, thus have difficulty obtaining best rates

Question 19

Currency Risk

Answer 19

arises from possible future exchange rate movements

two-way risk - as mvmts may be adverse or favorable

risk affects any org with:

• assets/liabilities in foreign currency
• regular income/expenditures in foreign currency
• no assets, liabilities, or txs in a foreign currency - economic risk b/c competitors may be faring better due to favorable exchange rates on THEIR transactions

Question 20

Definition - Economic Risk

Answer 20

any change in the economy, home or abroad, which can affect value of tx before a commitment is made (payment or receipt)

a company may not have an tx in a foreign currency but can still be affected by economic risk

it is the variation in the value of a business (PV of future CF) due to unexpected changes in the economy

Question 21

Reasons economic risk applies even to orgs without foreign txs

Answer 21

COMPETITIVE POSITION

other orgs can lose us money through reduced sales

e.g. competitor buys/sells abroad and this allows cheaper supplies or higher sale price, competitor more profitable

ELASTICITY OF DEMAND

exchange rates make our products more or less expensive

more expensive => less demand

however, if a competitor has a product available more cheaply because they trade in a different currency enabling cheaper production, demand doesn’t fall but merely transfers to that competitor => lost sales, less profitability, and reduced sh/h return

PRICING

currency mvmts affect pricing decisions - even for those without foreign operations

e.g. a Scottish sheep farmer selling lamb to local supermarkets only

farmer must be aware that a strengthening of GBP versus NZD makes it cheaper for farmers to import NZ lamb, thus farmer may have to reduce his prices

Question 22

Management of Economic Risk

Answer 22

DIVERSIFICATION

• of production and sales
• of suppliers and customers
• of financing

MARKETING - to convince customers of superior worth hence higher price

NOTE - diversifiation will not necessarily help in extreme circumstances such as a global recession

Question 23

Diversification of prod’n and sales to manage economic risk

Answer 23

if org makes all products in one country, that country’s exchange rate strengths, firm finds it harder to export

future CF and thus PV drop

if org had established prod’n plants and purchased components worldwide, unlikely that all currencies of all operations would revalue at same time

thus - although losing on exports for some manufacturing locations, not for all

also - if raw mat was purchased worldwide, strengthening home currency would reduce input costs - which would compensate for lost sales

Question 24

Diversification of suppliers and customers to manage economic risk

Answer 24

diversification of supplier and customer base such that if currency of a supplier strengths vs ours, purchasing can readily be shifted to a cheaper supplier

Question 25

Diversification of financing to manage economic risk

Answer 25

when a firm borrows in Swiss Francs it must repay in the same

if Swiss Francs then strengthen vs our currency, interest and principal repayments become more expensive

if borrowing is spread across multiple currencies it is unlikely all will strengthen simultaneously - thus risk is reduced

borrowing in foreign currency is only truly justified if returns will be earned in that currency to finance repayment and interest

int’n borrowing can also be used to hedge adverse economic effects of local currency devaluations - if a firm expects to lose from devals of currencies where subs operate, it can arrange to borrow in this currency and any operational losses will then be offset by cheaper financing costs

Question 26

Examples of Economic Risk in Practice

Answer 26

EXAMPLE 1

UK company has an investment in recession-hit SE Asia in late 1990s

economic downturn reduces trade and impacts exchange rates, so UK investment worth less at first glance

however, downturn may have reduced costs and firm may have a competitive advantage vs those producing in the “booming” west with higher prices

EXAMPLE 2

UK company invests in African sub whose currency depreciates year on year for several years

CF remitted to UK worth increasingly less, driving a red’n in investment value

EXAMPLE 3

French company bests raw mat priced in USD, converts into a finished product which exports to Japan

EUR progressively strengthens vs dollar, weakens vs JPY

thus EUR value of income incrases while USD cost of materials drops, causing increase in value of company CF

EXAMPLE 4

insisting on dealing only in domestic curreny may affect foreign demand for products if GBP appreciates, may impact supplier relationships if GBP weakens

EXAMPLE 5

UK company exporting to Spain in competition with US firms

USD weakens vs Euro (GBP unchanged), Spaniards find it cheaper to import from US if order is denominated in foreign currency

even if order denominated in EUR, euro price from US supplier might not convert into enough GBP to make it worthwhile for UK provider

EXAMPLE 6

deciding to acquire rscs in Italy to supply into UK market

costs in EUR with expected revenues in GBP

if GBP were to weaken vs EUR, costs up while revs down => unecominic

Question 27

Example of Economic Risk and Inflation

Answer 27

if exchange rate of Brazil deprciates rapidly - likely due to high inflation

if Brazilian sub of UK company increases prices in line with inflation, CF in local currency increase but conversion back to GBP gives constant CF in GBP (theoretically)

alternatively, the sub maintains prices and sells at a lower price - sales volume increases and sub/group has not “lost out”

Question 28

Measurement of Economic Exposure

Answer 28

very difficult to measure but of vital importance to firms as it concerns their l/t viability

cannot be ignored as could lead to red’ns in future CF or increase in systematic risk of firm, resulting in fall of sh/h wealth

limited number of factors that can be observed to attempt to quantify economic exposure - one of them is PRICE ELASTICITY OF DEMAND for products

e.g. prices rising => demand falling - but rate of fall and resulting CF will impact value of company – price rise could be due to change in exch rate

Question 29

Application of Economic Risk to Airlines

Answer 29

PASSENGER MIX IS 20% DOMESTIC AND 80% INTERNATIONAL

the 80% will be exposed to foreign currency movements making trips +/– expensive

e.g. UK traveler to US may decide against trip if GBP drops vs USD

“natural hedge” - in this scenario more US travelers would come to UK, but a UK-based airline would have to increase prices to offset dwindling GBP - they may offset

10% BUSINESS VS 90% PLEASURE TRAVEL

90% of travelers could change plans and reduce demand for routes, presumably business travelers are going to a particular place for a particular reason

INTEREST RATES

GBP movements may affect interest rates => people’s mortgages increase => holiday makers decide against it

FUEL PRICES

if fuel is bought from US supplier and paid in USD, more expensive if GBP weakens vs USD => airlines forced to raise prices, may reduce passenger numbers or number of flights

Question 30

Definition of Transaction Risk

Answer 30

Risk related to buying/selling on credit in foreign currencies

danger that - between tx time and date of CF - exch rates will have moved adversely

unlike translation risk - this actually affects org cash flows

Question 31

Definition of Translation Risk

Answer 31

arises when company has assets or liabs denominated in foreign currencies - volatility in exch rate will cause value of assets to fall/liabilities to increase => losses to company

this is entirely a paper-based excercise of translation - not the actual conversion of money

Question 32

Translation Risk - Settled vs Unsettled Transactions

Answer 32

SETTLED TXS

any tx denominated in a currency other than functional must be translated into fnl before being recorded

tx will initially be recorded by applying spot rate

however, cash settlement will be translated using spot rate on settlement date

exchange difference taken to SOPL

UNSETTLED TXS

monetary “foreign” items on SOFP are re-translated at y/e spot rate

non-monetary items including investments are not - left at historic cost

Question 33

Translation Risk - l/t loan for NCA

Answer 33

NCA are non-monetary thus would remain at historical cost

Loan is monetary thus would be translated to y/e spot

Currency risk arises b/c assets and liabilities no longer offset each other

Question 34

Recording of Foreign Exchange gains/losses

Answer 34

In equity on SOFP

unrealized - only realized when subsidiary is sold

Question 35

Hedging of Translation Risk

Answer 35

changes in parity due to translation will affect profits (thus EPS), total assets, borrowings, net worth (thus gearing) - but not CF

translation has no effect on CF and is a theoretical exercise

company share prices in efficient markets should only react to exposure likely to impact CF

thus translation should not normally be hedged - however, some managers do spend money hedging it

Question 36

Two strong arguments in favor of relevance of translation risk

Answer 36

ONE

although not affecting value of entity, can affect attribution of value between st/h

higher gearing => higher interest on bank loans - either directly b/c of loan agreements or indirectly as a result of org credit rating being reduced

banks here benefit at expense of equity investors

thus treasurer would want to manage risk if his objective is maximizing sh/h wealth

TWO

if accounts are being used “beyond their design specification” - e.g. as basis for calculating bonuses for directors - temptation is to protect current year accounts - despite l/t costs

comparable with pulling profit into current year, knowing it will reduce next year’s profit and result in tax being paid earlier than necessary

often the real reason for managing translation risk

Question 37

Two extremes of financing options

Answer 37

EQUITY (ORDINARY SHARE CAPITAL)

usually carries highest risk but also highest return

(risk b/c unsecured, uncertain dividend, share price not guaranteed, last in line during liquidation)

LOAN CAPITAL

usually lower risk (secured, specified interest) but lower typical return

Question 38

Use of convertible loan stock by venture capitalists

Answer 38

Purpose = skewing their risk exposure

if org performs moderately => risk exposure amounts to getting interest paid and loan being redeemed at some future point (usually <5 years)

if investment performs poorly, downside exposure is limited to getting some interest paid and perhaps investment returned in winding up scenario

if investment performs well, company usually prepared for flotation, VC will convert debt into equity and sell large # of shares at high profit

Question 39

Definition - Value at Risk

Answer 39

Allows investors to assess scale of likely loss in portfolio at a defined probability level

Becoming the most widely used measure of fin risk

Based on assumption that investors car emainly about probability of a large loss

VaR of a portoflio is the maximum loss on portfolio occurring within given period of time with a given probaility (usually small)

Question 40

More details - VaR

Answer 40

three components to calculation: time period, confidence level, loss amount/%

stat methods used to calculate st’d dev for possible variations in value of portfolio over specific period of time

assuming normal dist of MV variations, it is possible to predict at given probability level the maximum loss bank might suffer on portfolio

bank can control this risk by setting target maximum limits for VaR over different time periods (one day/week/month, etc.)

VaR = st’d dev x Z-score (from normal dist tables)

Question 41

Characteristics of a normal distribution

Answer 41

curve is symmetrical about the mean

mean, median, and mode all the same

how far the values spread out from the mean = standard deviation

68% of values within one deviation (between -1 and 1), 95% within 2, and 99.7% within 3.

total area under curve equal to 1

STANDARD normal distribution has mean of 0, st dev of 1

Question 42

Formula for standard normal distribution

Answer 42

Z = score

x = value being considered

u = mean

σ = st dev

Question 43

Two types of VaR calculation

Answer 43

Confidence level that the result will be above a particular figure = “one-tail test”

Confidence level that a figure will be within a particular range = “two-tail test”

Question 44

Example - one tail test

Answer 44

value of bank asset portfolio = $1,500m, st dev’n $300m

calculate VaR at 97.5% confidence

Z-value for 97.5% = 1.96 (normal dist’n tables)

VaR = st dev’n x Z-val = 300m * 1.96 = 588m

thus, 2.5% chance that value of portfolio will be 1,500 - 588 = 912m or below

Question 45

Example - two tail test

Answer 45

UK company expecting to received USD 10m

mean exchange rate is USD 1.25/GBP 1 and daily volatility is 0.25%

what range of values can we be 95% confident of receiving in 1 day?

mean value of USD 10m = GBP 8m, daily st dev’n = 8m * 0.25% = GBP 20k

range = two tailed test = 47.5% on each side = Z-score of 1.96

VaR = Z * std dev’n = 1.96 * 20,000 = 39,200

thus 95% confidence that value is within 39,200 of mean

thus amount will be 7,960,800 < x < 8,039,200

Question 46

Calculating Value at Risk for longer holding periods

Answer 46

n-day VaR = 1-day VaR * √n

VaR increases with holding period => longer holding period means greater VaR

Question 47

Example of multi-day VaR

Answer 47

UK company expecting USD 14m

today’s exchange rate is USD 1.75 / GBP 1, volatility is 0.5%

1-day and 30-day 99% VaR?

USD 14m = GBP 8m today, std dev = 40,000 (0.5% * 8m)

one-tail 99% confidence level = 2.33

1-day VaR = 2.33 * 40,000 = 93,200

thus 1% chance that loss would exceed this

30-day VaR = 1-day 99% VaR * √30 = GBP 93,200 × 5.477 = GBP 510,477

showing that VaR increases as holding period gets longer

Question 48

Value at Risk and the global financial crisis

Answer 48

Basel II = rigorous risk/capital mgmt reqs to ensure banks hold reserves sufficient to guard against risk exposure given its lending and investment practices

regulators require banks to measure mkt risk using risk measurement model which is used to calculate the VaR

global financial crisis identified substantial problems with governance re. understanding risk and applying models like VaR - evidenced by failing banks in UK and US

VaR is based on historical observations, thus cannot allow for an extreme event not predicted by past trends

2008 credit crunch: banks evluated value of mortgage portfolios knowing house prices had risen consistently for years - banks assumed this would continue, but it didn’t

Question 49

Diagram - Types of Financial Risk

Answer 49