Ch 8 Flashcards
Definition of Financial Risk
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
Definition of Political Risk
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
Example forms of political risk
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
Example Discriminatory Actions by local govts creating political risk
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
Ways for a company to assess its political risk exposure
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
Ways for companies to minimize political risk
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
Minimizing Political Risk - Joint Ventures
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
Minimizing Political Risk - Pre-Trading Agreements
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)
Minimizing Political Risk - Gaining Government Funding
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
Minimizing Political Risk - Local Finance
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
Minimizing Political Risk - Plan for eventual part- or full-ownership of business by locals
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
Definition of Interest Rate Risk
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
Interest Rates and LIBOR
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
Definition of LIBOR
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
Types of Interest Rate Risk Exposure
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
Measuring exposure to Interest Rate Risk
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
Example - calculating interest rate exposure
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
Refinancing Risk
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
Currency Risk
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
Definition - Economic Risk
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
Reasons economic risk applies even to orgs without foreign txs
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
Management of Economic Risk
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
Diversification of prod’n and sales to manage economic risk
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
Diversification of suppliers and customers to manage economic risk
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
Diversification of financing to manage economic risk
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
Examples of Economic Risk in Practice
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
Example of Economic Risk and Inflation
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”
Measurement of Economic Exposure
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
Application of Economic Risk to Airlines
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
Definition of Transaction Risk
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
Definition of Translation Risk
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
Translation Risk - Settled vs Unsettled Transactions
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
Translation Risk - l/t loan for NCA
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
Recording of Foreign Exchange gains/losses
In equity on SOFP
unrealized - only realized when subsidiary is sold
Hedging of Translation Risk
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
Two strong arguments in favor of relevance of translation risk
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
Two extremes of financing options
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
Use of convertible loan stock by venture capitalists
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
Definition - Value at Risk
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)
More details - VaR
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)
Characteristics of a normal distribution
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

Formula for standard normal distribution
Z = score
x = value being considered
u = mean
σ = st dev

Two types of VaR calculation
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”
Example - one tail test
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
Example - two tail test
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
Calculating Value at Risk for longer holding periods
n-day VaR = 1-day VaR * √n
VaR increases with holding period => longer holding period means greater VaR
Example of multi-day VaR
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
Value at Risk and the global financial crisis
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
Diagram - Types of Financial Risk
