Chapter 7 - Financial Risk

Question 1

Process of managing risks:

Answer 1

• Risks will be identified, quantified & assessed
• Risks that are acceptable = risks of lower frequency and severity; may be mitigated or controlled by diversification or hedging (derivatives)
• Risks that are unacceptable = risks of high frequency and severity and will be abandoned

Question 2

Political Risk:

Answer 2

1. Caused by government action
2. Could include:
   * Expropriation of investment by government of host country (ultimate risk)
   * Import quotas used to limit quantities subsidiary could buy from parent and import for resale in domestic markets
   * Exchange control regulations which may affect the ability of the subsidiary to remit profits to the parent
   * Government actions could restrict ability of foreign companies to buy domestic companies (especially those in politically sensitive industries)
   * Government legislation may specify minimum shareholding by residents – force multinationals to offer some of the equity in a sub to investors in the sub’s country

Question 3

Economic Risk:

Answer 3

• Risk that the present value of a company’s future cash flows might be reduced by adverse exchange rate movements in the medium & long-term
• Can be managed by carefully assessing the risk of the foreign currency changing in value
• One of the causes of a long-term decline in a currency is if the rate of inflation in the foreign country is higher than in the domestic country
• Purchase power parity (PPP) theory = the impact of higher inflation is to decrease the purchasing power of the foreign currency which over time will reduce its value on foreign currency markets

Question 4

Currency Risk:

Answer 4

1. Risk arising from unexpected movement in exchange rates
2. Currency risk can affect companies in the following ways:
   * As an exporter/ importer of goods
   * Through having an overseas subsidiary
   * Through being the subsidiary of an overseas company
   * Through transactions in overseas capital markets

Question 5

Transaction Risk:

Answer 5

• Risk that a transaction in a foreign currency is recorded at one rate and then settled at a different rate
• This is due to timing between entering into the transaction and the time that the actual cash flow will materialise

Question 6

Translation Risk:

Answer 6

• Risk that a company’s assets and liabilities will change in value due to exchange rate movements
• It has an impact on retained profits & company’s overall valuation
• Can be managed by matching foreign currency assets with foreign currency liabilities (natural hedge)

Question 7

Interest Rate Risk:

Answer 7

• Faced by both borrower and lender

* Risk that the interest rate will move in such a way so as to cost a company money

Question 8

Quantification of Financial Risk - Value at Risk (VaR):

Answer 8

• Value at risk measures the maximum loss possible due to normal market movements in a given period of time for a given level of profitability
• OR VaR is the maximum likely loss over a set period with only an x% chance of being exceeded

Question 9

VaR is used to measure:

Answer 9

• Risks attached to the values of portfolios of shares if market prices fluctuate
• Value of a sum of foreign currency subject to exchange rate fluctuations

Question 10

VaR Formula:

Answer 10

VaR = confidence interval value x standard deviation

* The confidence interval value comes from the normal distribution table

Question 11

Value at risk & time:

Answer 11

• May need to convert the standard deviation (sigma or σ )for a longer period of time into the daily figure
• Formula = Daily σ =
  Given σ ÷ √Number of days covered

Question 12

Drawbacks of value at risk:

Answer 12

• VaR is based on a normal distribution which assumes that virtually all possible outcomes will be within three standard deviations of the mean & success and failure are equally likely (neither is likely to be true for a one-off project)
• VaR is also based around the calculation of a std deviation & this is hard to estimate in reality since it is based on forecasting the possible spread of the results of a project around an average