Financial risk

Chapter 8
Types of financial risk:
Credit Risk:
Management of credit risk:
The most common methods used to manage and control credit risk
are:
a) Strong credit control procedures, including:

• policies regarding credit checks

• credit limits and terms
• debt collection activities such as aged debtor analysis,
• statements and reminders.

b) Insuring against the risk:

It is possible to take out credit risk guarantees to act as

insurance against debtor default.

c) Debt factoring without recourse:

The debts can be sold to a factoring business but without the

obligation to buy back those debts in the event of default.
Political risk:

Political risk is the risk faced by an overseas investor, that the host
country government take adverse action against, after the company
has invested.

It can take different forms and the threats (financial and non-
financial) can include:

a) Risk of confiscation or destruction of overseas assets

b) Commercial risks because foreign governments discriminate
against overseas firms e.g. quotas, tariffs, other taxes
c) Restricted access to local borrowings
d) Insisting on resident investors or a joint venture with a local
company
e) Restrictions on repatriating cash (capital or dividends)
f) Restrictions on conversion of the currency
g) Rationing the supply of foreign currency

More sources of political risk:

1. Exchange control procedures
2. Import quotas
3. Import tariffs
4. Insist on a minimum shareholding
5. Company structure.
Discriminatory actions:

Supertaxes:

Imposed on foreign firms, set higher than those imposed on local

businesses with the aim of giving local firms an advantage. They may
even be deliberately set at such a high level as to prevent the
business from being profitable.

Restricted access to local borrowings:

By restricting or even barring foreign owned enterprises from the

cheapest forms of finance from local banks and development funds.
Some countries ration all access for foreign investments to local
sources of funds, to force the company to import foreign currency
into the country.

Expropriating assets:

Whereby the host country government seizes foreign property in the

national interest.

Management of Political Risk:

1. Using ranking tables before investing.
2. Evaluating country’s macro-economic situation
3. Evaluating current governments popularity and stability
4. Looking at historical stability of the political system.
5. Looking at changing religious attitudes
6. Taking advice from the company’s bank.
Some methods that can be used to manage political risks:
Joint ventures:
A company might go into a joint venture with one or more partners.
A joint venture can reduce risk because:

If each joint venture partner contributes a share of the funding for

the venture, the investment at risk for each partner is restricted to
their share of the total investment (although, the upside is reduced
because each party has less invested in this potentially lucrative
venture)

If a local company is selected as a joint venture partner, the

likelihood of winning major contracts in the country might be much
greater. Some governments have made the involvement of a local
company in a joint venture a condition of awarding contracts to
consortia involving a foreign company

The local venture partner has a better understanding of the local

political risks and can manage them more effectively than a foreigner
would be able to. Also, the government might be less inclined to act
against the interests of the local venture partner.

Pre-trading agreements:

Prior to making the investment, agreements should be secured if

possible, with the local government regarding rights, remittance of
funds and local equity investments and (where appropriate) the
award of government contracts to businesses.
Gaining government funding:

In some situations, it might be possible to gain government funding

for a project or contract, with the government being either a
customer, a backer or a partner for the deal. If government funding
can be obtained the government will have an interest in the
transaction reaching a successful conclusion

There should be little or no risk of exchange control regulations

preventing the withdrawal of profits from the country.

Local finance:

A company might try to obtain local finance for an investment in a

particular country. The availability of local finance might depend on
the state of the banking and capital markets in the country
concerned. The major advantage of local finance is that it creates
liabilities in the foreign currency, and so reduces translation
exposures: assets in the foreign currency can be offset against
liabilities in the same currency transaction exposures, in the sense
that interest costs will be payable in the foreign currency and can be
paid from income in the same currency.

Interest rate risk:

Risk of gains or losses on assets and liabilities due to change in
interest rates. It will occur for any organization that has assets or
liabilities on which interest is payable or receivable.
Generally:
a) Interest rate on Bank loans/overdraft = Variable/floating
rate/LIBOR
b) Interest rate on most bonds, loan stock, debentures= Fixed
rate.

Floating rate loans:

Changes in interest rate can affect the amount to be paid as interest.
Interest risk exposure is the total amount of floating rate assets and
liabilities. The higher the value of the loans, the greater the exposure
to the changes in interest rates.
Fixed rate loans:
Even though interest rates don’t change and affect the company it
can indirectly render the company uncompetitive because you will
not be able to take advantage of cheaper/lower interest rates when
the rates fall. Total exposure is measured by the total amount of
fixed assets or liabilities together with average time to maturity and
average interest rates.
Refinancing:

Refinancing risk is associated with interest risk because it looks at the

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

The reasons for this could include:

a) Lenders are unwilling to lend or only prepared to lend at higher

rates.
b) The credit rating of the company has reduced making them a
more unattractive lending option.
c) The company may need to refinance quickly and therefore have
difficulty in obtaining the best rate.
Currency risk: Risk that arises from possible future movements in
an exchange rate. It is a 2-way risk.

Currency risk affects any organisation with:

a) assets and/or liabilities in a foreign currency

b) regular income and/or expenditures in a foreign currency
c) no assets, liabilities or transactions that are denominated in a
foreign currency. Even if a company does not deal in any
currencies, it will still face economic risk since its competitors
may be faring better due to favorable exchange rates on its
transaction.

Currency risk is of 3 types:

Economic risk:
Any change in the economy home or abroad, which can affect the
value of a transaction before the payment is made or before the
money is received. A company which does not deal in any foreign
exchange will also be affected by economic risk.
This can be due to several factors:
Competitive position:

Even if a company trades wholly in its own currency, other

companies can cause it to lose money in the form of reduced sales.
For example, if a competitor company trades (either buys or sells)
abroad where the currency is more favourable –cheaper for supplies,
or allows a higher price for sales, then the competitor will be more
profitable. Conversely, if the exchange rates are adverse for the
competitor, they would be less profitable.
Elasticity of demand:

Exchange rates can make a company's products more or less

expensive. When an exchange rate makes the product more
expensive, say, the demand for that product will probably fall.
However, if the product is available at a lower price from another
company, who perhaps trades in a different currency which enables
the product to be made and sold more cheaply, then demand does
not fall but transfers to that other company. Therefore the home
company has lost sales, is less profitable and shareholder returns will
fall.

Pricing:

Competitor's product prices will affect a company's ability to raise

their prices and affect their competitive position. For example,
Scottish sheep farmers are exposed to economic risk when New
Zealand lamb comes onto the market more cheaply in
October/November. (Lambing in the UK occurs around March). The
Scottish sheep farmers have to reduce their prices through
October/November to maintain their volume of sale.

Management of economic risk: Remember “portfolio theory”

a) Diversification of production and sales
b) Diversification of suppliers and customers
c) Diversification of financing
d) Marketing
Transaction Risk:
Risk that is related to buying or selling on credit in foreign currencies.
This is the risk related to buying or selling on credit in foreign
currencies.

There is a danger that, between the time of the transaction and the
date of the cash flow, exchange rates will have moved adverse

Translation Risk:
Risk that the exchange rate volatility will cause the value of assets to
fall or liabilities to increase resulting in losses to the company.
This arises when a company has assets or liabilities denominated in
foreign currencies. The risk is that exchange rate volatility will cause
the value of assets to fall or liabilities to increase resulting in losses
to the company.

Remember: The financial statements of an overseas subsidiary are

usually translated in the home currency for consolidation. This is only
a paper-based exercise and not the conversion of real money from
one currency to another.
There are 2 types:

a) Settled: Whenever a company enters into a transaction

denominated in a currency other than its function currency
it will be converted on using the spot rate. When the cash
settlement occurs, the settled amount will be translated
using the spot rate at the settlement date. If there is a
difference it will be taken to P and L.
 b) Unsettled: If any foreign items remain on the statement of
financial position at the year-end then treatment would
depend on whether they are classified as monetary or non-
monetary.

Monetary include: cash receivables, payables, loans and they are

re-translated at closing rate.
Non-monetary include: non-current assets, inventory and
investments and are not re-translated but left at historic cost.

Management of translation risk:

Any change in parity will affect reported profits (and hence earnings
per share), total assets, borrowings, net worth (and hence gearing)
but –to repeat –it will not have affected the measured cash flow in
the period being reported on.

Academic theory argues that translation risk, of itself, need not

concern financial managers, but in practice, there are two strong
arguments in favour of the relevance of translation risk.
2 Strong arguments in favor of translation risk:

a) Higher gearing= higher interest risks. So, if maximizing

shareholder wealth/value is the objective then this risk
has to be managed.

b) If the accounts are being used to calculate bonus

payments for directors and senior managers then they
will want to protect/inflate current year’s figure even
though it may affect the company in the long term.

Using financing packages to split risks:

As you will be aware, different finance options carry differing levels

of risk and return for the investors concerned. The two extremes are

Equity (ordinary share capital) usually carries the highest risk

(unsecured, uncertain dividend, share price may fall, last in line in
the event of a liquidation) but potentially the highest return.

Loan capital is usually lower risk (secured, specified interest) but has
a lower typical return.
For example, venture capitalists often like to invest in unquoted
companies via convertible loan stock to skew their risk exposure.

a) If the company concerned performs moderately then the risk

exposure effectively amounts to getting interest paid and the
loan redeemed at some future point (usually within 5 years).

b) If the investment performs badly then the downside exposure

is limited to getting some interest paid and perhaps their
investment back in the event of a winding up.

c) If the investment performs well, then the company is usually

prepared for flotation when the VC will convert the debt into
equity to sell a large number of shares at a high profit.