17. Corporate Risk Management (10%) (P8)

Front 1

Nature of risk – diff to uncertainty

Back 1

Uncertainty – insuff info to say what will prob happen

Risk – volatility in future returns, but probability of each outcome assessed w/ reasonable accuracy. Imp b/c of duration & scale of projects.

Front 2

Operating risk (‘business risk’)

Back 2

Refers to variability of operating profit (PBIT). Factors inc strikes, boom etc.

Level of risk affected by % of fixed costs in cost structure – don’t change even if trading activity declines. High fixed costs = high level of operating gearing.

Operating gearing = contribution / PBIT

Where: Contribution = sales – variable costs

Front 3

Financial risk

Back 3

The additional risk borne by s/hs when firms takes on fixed-rate debt. Large % of debt = high degree of financial gearing (measures firm’s financial risk).

Cost of capital is a function of RFR and risk premium for each risk taken on. T/f equity investor (sub to financial risk and operating risk) expects higher return than debt-holder (fixed rate).

Front 4

Key risk concepts

Back 4

Exposure – measure of the extent to which a co faces risks (op or fin).

Volatility – extent to which expected returns vary (‘dispersion’). Measured by variance and standard deviation. More variance, more volatile, more risky. RF return has no volatility so undeviating straight line.

Severity – how bad is the outcome. Risk = probability of hazard x severity of outcome when hazard occurs.

Probability – objective: based on accumulation of past info – BUT issue of changes in tech can mean info out-of-date and also capital investment projects are one-off/unique projects for which poss imp to derive historic data). OR subjective: opinion of experts/mngt judgements based on experience. BUT danger of bias as exp may be ltd + interpretation may be flawed.

Front 5

Risk responses

Back 5

Transfer – transferring risk to another party, usually by payment of a fee (insurance).

Reduction – reduce overall risk by investing in portfolio of As or carrying out market research to provide more certainty of estimates of futures sales revenue.

Avoidance – chose projects with lowest risk. Risks often taken, but only where expected return is suff high to compensate.

Retention – accept gains or losses from a risk when it occurs – viable strategy for risks w/ low severity & where cost of insuring risk over time would be greater than any loss incurred by co. (Inc’s potential risk in excess of ceiling imposed by insurance co). Some risk can’t be invested against & have to be retained (risk of war).

Front 6

Rel between risk & expected return

Back 6

Most investors are risk-averse, t/f any increased risk must be balanced by increased return.

Risk measured by SD of return, t/f higher the SD, higher the volatility & higher the risk. Shows as an upward slope on a graph. Where it cuts vertical axis rate is zero (RFR). Additional return over RFR is ‘risk premium’ (return for taking on risk) and this increases as risk increases.

Front 7

Rel between risk & expected return

Back 7

Most investors are risk-averse, t/f any increased risk must be balanced by increased return.

Risk measured by SD of return, t/f higher the SD, higher the volatility & higher the risk. Shows as an upward slope on a graph. Where it cuts vertical axis rate is zero (RFR). Additional return over RFR is ‘risk premium’ (return for taking on risk) and this increases as risk increases.

Front 8

Risk management policies (eg ERM - Enterprise RM)

Back 8

Identify risks (operational and financing decisions), assess (impact) and manage. RM allied with values of the business (eg low appetite for risk). Assessment = mechanism for identifying which risks rep opps & which rep serious threats.

ERM = framework/system for integrating & formalising RM processes w/in org. Responses to risk in ERM same as before (transfer, reduction, avoidance, accept/retain).

Portfolio approach advised - beyond just financial risks, rather all risks. Portfolio risk is not simple sum of ind risk elements & it is based on elements of portfolio and their interaction. Overall approach (total org) imp & gives co perspective on importance of diff risks.

Front 9

RM processes of ERM & potential severity score

Back 9

Environment of RM established
Identify & analyse risks (probabilities)
Prioritise risks
Portfolio approach to risks
Strategies dev'd for controlling risks &/or exploiting opps available
Monitoring/reviewing process in place (review RM perf)

potential severity score = potential impact x likelihood of adverse outcome (p279)

Distinguishes between inherent risk and residual (mitigated) risk (ie after action taken)

Front 10

Credit risk & market risk

Back 10

Credit risk - risk of loss arising from a borrower or trade receivable who fails to make necy payments ('default').

Market risk - risk that value of a portfolio will decrease due to change in equity values or change in value of market risk factors. Include:

Equity risk
Interest rate risk
Currency risk
Commodity risk

Front 11

5 methods for hedging financial risk

(offsetting or reducing potential losses from financial risks)

Back 11

Derivatives (security whose existence is dependent, or contingent, upon the existence of another security):
- futures (hedge against risk arising from future contracts)
- options (hedge against risk arising from future contracts)
- forward rate agreements
- swaps

Not derivatives:
- money market hedges

Front 12

Futures v Options

Back 12

Future contract - standardises price / quality / time
Option contract - specifies price / quality / time

Future contract - both parties obligated to complete futures contract
Option contract - purchases has no obligation to complete but writer (originator) does if holder of option wants to.

Front 13

Futures

Back 13

A/g between 2 counterparties that fixes terms if exchange that will take place at some future time. Both obligated to complete trans. Poss re currency or interest rate on a loan.

Key features:
Interest rate futures traded on an exchange - greater the rate, lower the value of future.
Categories of trans are in set amounts - standard unit of trading £500k, 3-month contracts.
To hedge against increase in rate (want to borrow), sell futures.
To hedge against fall (want to lend), buy futures.
Price of future = 100 - annual interest rate.
No risk running exchange - every day, profits/losses paid in to exchange by one of the counterparties.
UK exchange is LIFFE (London International Financial Futures Exchange).

See p282

Front 14

Options

Back 14

Option contract confers the right to buy or sell a given underlying asset at a specified price sometime before (or on) a specified date. Owner of contract has right but not obligation. Eg convertible bonds, 'traded options' on LIFFE.

Purchaser of contract pays seller ('writer') of option a premium that gives purchaser (holder) the right (not obligation) to purchase from (call contract) OR to sell to (put contract) the writer (original seller) a specified volume of a specified security (fixed no of shares/units) at the specified price ('striking price' or 'exercise price') and by a specific date.

Risk implications:
Buying risk - exposure ltd to option premium paid, but in traded option market the option can be sold readily
Writing risk - sells contract and receives fee ('option premium') - open ended exposure to risk, unltd potential loss.
Contract risk - on LIFFE option contract is for 9 months, at end of which contract becomes void. Each option contract is for 1,000 shares or can be generated relating to FTSE100 index.

(see p 284)

Front 15

Forward rate agreement (FRA)

Back 15

Issued by a bank and tailored to specific needs of purchaser (not traded on an exchange).

Bank agrees to enter into a notional loan or accepts a deposit from customer for specified period & settle w/ customer the diff between IR agreed w/ customer and the actual rate when notional loan/deposit is deemed to start. The FRA is separate from the actual contract to borrow money (could be from another source). If IR is greater than specified in FRA, bank pays diff, if vice versa, customer compensates bank.

Can be used by cos whose bus is severely hit by increases in IRs - protect themselves when IRs rise & demand falls off.

(see p287)

Front 16

Swaps

Back 16

IR swaps involve 2 cos who agree to swap their liabilities for IR payments on a given capital sum. Usually between a fixed IR liability & a variable IR liability. Ends result is similar to FRA - both parties securing reduction in exposure to IR changes. May be agreed w/ aid of intermediaries.

(p288)

Front 17

Money market hedge

(not a derivative)

Back 17

If need to finance for a short period, can secure loan against future income.

Often used if co involved in buying/selling in foreign markets - use money market (where price is IR) instead of forward exchange market for currency. The firm taking the loan borrows in one currency and exchanges the resulting proceeds for another currency. Cost of money market hedge determined by differential interest rates.

(p289)