Risk Management - Theory and Application - Term Paper Example

RISK MANAGEMENT Theory and Application Business has become global. The world has turned into one huge marketplace for goods and services, and everywhere are potentials for creating value and realizing returns. But while the international economy moves towards integration, real differences among political, cultural, and social factors create real risks that must be evaluated before a choice is made as to the specific components that should comprise a firm’s international investment portfolio. The objective of this paper is to use the theories of risk and return analysis, applied to international business, to decide if an investment should be made by a UK-based fund on a particular stock in another country. In order to illustrate the complexities of risks involved, the subject of evaluation shall be a multinational company, principally located in an emerging Asian country, but producing an internationally marketed product. While the foreign firm boasts a fundamentally sound business, the fact that it involves investment in another country requires consideration of the various risks. The Problem A UK-based investment fund is considering investing in the Asian emerging market. It is considering SMCorp, a food and beverage company principally located in the Philippines. Its main product is the globally renowned San Miguel Beer which had won numerous prestigious international awards. SMCorp has expanded its operations abroad and established breweries located in China, Malaysia, and South America. The Philippine currency has an exchange rate of about PhP69:£1, within the past year varying between PhP73:£1 and PhP68:£1. SMCorp stock is sufficiently liquid and is a favourite among global funds that decide to invest in the Philippines, because of its excellent company fundamentals and steady rate of return. The company regularly declares a uniform stream of annual dividends and exhibits a strong cashflow pattern. Its stock price has a beta coefficient of 0.8. Its 52-week per-share figures are a high of PhP 61 and a low of PhP 38; it is currently at PhP 41. Being in the consumer food and beverage industry, demand for SMCorp’s products are consistent even during economic downturns, and sales are brisk locally and abroad. The Theory of Risk and Return Risk, as applied to investments, is the probability of earning a return less than the expected return (Brigham, 1996). Investors are usually risk-averse; that is, investors will as much as possible try to avoid chances of earning below expected income, moreso chances of loss. Investors who do not assume more than the prevailing average market risk will not incur more loss than the average market, but then again, should not expect to earn more than the average returns of the general market. Speculators, on the other hand, intentionally expect to acquire some level of risk that is higher than the prevailing market average, but in the hope and expectation of earning a higher return than the average return on the market. Since investors and speculators are both needed to create a market, there will always be parties willing to assume additional risk. The higher the risk assumed by the party, the higher the return expected to be realized; this is the basis of evaluating stand-alone investments. When investment funds are of a sizeable sum, the funds are usually placed in several kinds of instruments. The combination of the various investments is referred to as the investment portfolio, and it is in designing the portfolio that one may try to aim for higher returns while controlling or minimizing the risk associated with the placement. This is called hedging the risk of investment. If the fund were exceptionally large, overseas placements may be desirable for a small portion of the fund, in order to diversify the risk inherent in the economy of a single country. However, international investment decisions take into account various risks other than the mere market risk of a stand-alone investment. Kinds of Risk There are various types of risks associated with global investments. They are political risk, exchange risk, inflation risk, and interest rate risk. 1. Political risk – This type of risk refers to uncertainty in returns as a result of the host country’s political stability and attitude toward foreign investors. Political risks are usually classified into three general groups: firm-specific risks, country specific risks, and global-specific risks. Firm-specific risk analysis seeks to determine effects that changes in host-country policy or regulations may have on specific firms. Country-specific risks refer to macro-political analysis that seeks to establish the historical stability of the country in question, evidence of turmoil, indications of economic stability, and trends in cultural and religious activities. Finally, global-specific risks are those threats to the stability of diplomatic, economic, technological, and environmental relations among nations, and peace and order issues that affect nations collectively, such as terrorism. Below is a diagram of political risks as conceptualized by Moffett et al. (2006 p. 436). 2. Exchange rate risk – This risk is incurred due to the unpredictability of shifts in the exchange rate between two currencies. Funds originating from one country begin as value denominated in that currency of that country. When these funds are invested in another country, they are converted into value in the currency of the destination country. At some future time these funds and their gains will have to be reconverted to the currency of the country of origin when they get repatriated. While the original rate at which they were exchanged remains stable, then the value will remain constant from the vantage point of currency. However, if the exchange rate fluctuates, then the converted funds either gain a premium or suffer a loss when they get re-converted to the original currency. Such a possibility of a change in value is the exchange rate risk. 3. Inflation risk – This refers to the risk of depreciation in the purchasing power of the currency in which the returns or income payments are denominated (Bodie 1996 p. 892). Inflation risks are particularly pronounced for investments in bonds, since they are by nature long-term (lasting many years and even decades) and the regular income payments are fixed and periodic throughout the life of the bond. Were inflation to rise during this time, as in all likelihood it will, then this will result in certain erosion of the real return of the investment, as the purchasing power of the returns is reduced. 4. Interest rate risk – Again this type of risk is particularly true of investments in bonds and fixed income instruments. An inverse relationship exists between bond prices and yields on bonds, and it is commonly known that interest rates fluctuate substantially depending on the country’s monetary policies. (Interest rates are commonly used to effect monetary stability and control liquidity.) As interest rates rise, bond value erodes, while when interest rates fall, bondholders experience capital gains. The fluctuation in value makes fixed-income investments risky, even if the coupon and principal payments are guaranteed. Risks may further be classified as to whether they are systematic or non-systematic. Non-systematic risk is the risk that may be eliminated by diversification. It is also known as unique risk, firm-specific risk, or diversifiable risk. Systematic risk is the risk that remains after extensive diversification. It is attributable to market-wide risk sources. It is also known as non-diversifiable risk. Problem application: SMCorp is principally located in the Philippines. A cursory look at the profit opportunity recommendation rankings in the Appendix shows the Philippines listed as a high-risk country, ranked together with Greece, Russia and Iran. It is, however, outranks Indonesia – which is often an alternative Asian location – as well as Venezuela, Argentina and Ecuador, which are listed as prohibitive. This signifies that the political risks posed by investing in the Philippines and, thus, in SMCorp poses a high possibility that the environment is not conducive to investment. As far as exchange rate risk is concerned, the Philippines has enjoyed a relatively stable currency situation, with regular and strong dollar remittance into the country. Inflation likewise is stable at 4-5% annually. Interest rate risk is minimal, since the investment being considered is in equity which is hedged against both interest and inflation risks. Measures of Risk Among the most popular and commonly used methods of measuring risk for investment analysis are variance, standard deviation, and the beta coefficient in the case of stock investments. Variance and Standard Deviation. Risk is defined as the variability of actual returns from the expected return. Thus, a risky investment will realize returns that are distributed over a wider range or spread of outcomes. Statistical measures of dispersion about the expected value, namely the standard deviation and variance, provide a convenient and commonly familiar method of measuring risk. The greater the risk, the higher these measures of dispersion. n σ2 = Σ ( ki - k)2 Pi t=1 where: σ = the standard deviation of the returns on the investment σ2 = the variance of the returns on the investment kj = the realized rate of return of an investment k = the expected rate of return of an investment Pi = the probability that the expected return will be realized Problem application: Without undertaking the exact mathematical computation, it may be conjectured that SMCorp, since it enjoys a steady stream of business and declares regular dividends, yields a constant rate of return to its investors. The standard deviation and variance are thus expectedly low. The value of the stock, however, is a different matter. If the investor aims for a steady capital appreciation, the Philippine Stock Market, like most emerging, markets, experiences wide swings; in this case, despite being a blue chip and index heavyweight, SMCorp prices varied from PhP 38 on the low and PhP 61 on the high. Currently, though, at PhP 41 it is at the lower end of the swing, and thus prospects for better than higher returns on the value of the capital are good if entry is made at this point. Coefficient of Variation. Standard deviation and variance are useful in comparing investments with the same expected rate of return. There is difficulty, however, in assessing risk through measures of dispersion where the expected rates of return are different. This difficulty may be eliminated by using the coefficient of variation V. This term calls for nothing more difficult than getting the result of dividing the standard deviation of an investment by the expected value (Block and Hirt, 2006 p. 389). The coefficient of variation may be mathematically arrive at by the formula: V = σ / k where: V = the coefficient of variation σ = the standard deviation of the returns on the investment k = the expected rate of return of an investment The CAPM and the beta coefficient The capital asset pricing model (known by the abbreviation CAPM) first appeared in an article “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” The CAPM theory was developed by William F. Sharpe, and it earned him the Nobel Prize for economics. The article was published in the September 1964 issue of the Journal of Finance (Brigham and Gapenski 1996, p. 67). Mathematically, it is summed up in the equation: kj = kRF + βj (km – kRF) where: kj = the expected rate of return of an investment kRF = risk-free rate of return βj = the beta of the investment km = the expected rate of return of the market The beta coefficient is “an index of the degree of movement of an asset’s return in response to a change in the market return,” and the market return is “the return on the market portfolio of all traded securities” (Gitman 1995, p. 346). Beta is the measure of the non-diversifiable risk of the investment, particularly for stocks. The CAPM establishes the relationship among expected investment return, the risk free rate and the expected market return, and associates this relationship with the systematic risk of the investment. Problem application. SMCorp’s beta coefficient was computed at 0.8, indicating that it has a lower non-diversifiable risk than the market average. While the lower beta means that returns on the stock price will on the average be lower than the prevailing market return, during downswings affecting majority of the other stocks, this firm’s shares will not suffer so large a drop. Issues to consider in investing. In conclusion, the foregoing risks are all important to assess for any potential investment abroad. The final decision to invest, or not, ultimately depends, however, on the risk tolerance of the investing entity. The plus and minus factors considered, even an investment with a high level of risk could prove particularly attractive to a speculator. On the other hand, safety of capital and regularity of yield provided by low risk would be sufficient to others, instead of higher returns. References Block, S.B. and Hirt, G.A. (2006) Foundations of Financial Management, Eleventh Edition, Mc-Graw Hill, N.Y. Bodie A., Kane A. and Marcus A.J. (1996), Investments, Third Edition, Richard D. Irwin Inc., Chicago Brigham, E.F. and Gapenski, L.C. (1996) International Financial Management, Fifth Edition, Dryden Press, Fort Worth, TX Chance, D.M. (2001). An Introduction to Derivatives and Risk Management, Fifth Edition, Harcourt College Publishers, Orlando, FL Eiteman D.K., Stonehill A.I. and Moffett, M.H. (2004), International Business Finance, Tenth Edition, Pearson Education, New York Gitman, L.J. (1997) Basic Mangerial Finance. Harper and Row, New York. Hirt, Geoffrey A., Block, Stanley B., and Basu, Somnath (2006) Investment Planning for Financial Professionals. McGraw-Hill, New York. Moffett, M., Stonehill, A., and Eiteman, D. (2006) Fundamentals of Multinational Finance, Second Edition. Pearson Addison-Wesley, Boston. Reilly, F.K. and Brown, K.C. (2006) Investment Analysis and Portfolio Management, Eighth Edition, Thomson Higher Education, Mason, OH. Appendix A Profit Opportunity Recommendation Rankings, 1997 Low Risk (70-100) POR Combined Score High Risk (40-54) POR Combined Score Switzerland 82 Saudi Arabia 54 Singapore 77 Chile 52 Netherlands 73 South Africa 51 Taiwan (R.O.C) 72 Czech Republic 50 Japan 72 Italy 50 Norway 71 Thailand 48 Germany 70 Hungary 46 Kazakstan 46 Moderate Risk (55-69) Poland 45 Austria 69 India 45 Belgium 67 Egypt 44 United States 66 Greece 43 Sweden 65 Russia 43 Finland 64 Iran 43 France 64 Philippines 43 Ireland 64 Vietnam 42 Canada 63 Colombia 41 Spain 62 Mexico 41 United Kingdom 62 Ukraine 41 Denmark 61 Peru 40 Korea (South) 58 Turkey 40 Malaysia 58 Brazil 40 China (P.R.C.) 58 Pakistan 40 Australia 57 Protugal 57 Prohibitive Risk (0-39) Indonesia 39 Venezuela 36 Ecuador 35 Argentina 34 Source: Business Environment Risk Intelligence, by permission Read More