Corporate Risk Management - Assignment Example

Corporate Risk Management Financial risk management is a very sensitive issue for many firms in a modern market environment. While insurance is the de facto method of hedging financial risk in business, it can be very costly and this requires the business to have alternatives to hedge its financial risk (Frank, 89). Risk management therefore involves the identification of risk, the measuring of the risk in regards to its likelihood of occurring and the impact it can have on the business if it occurs. This helps in identifying the best way to hedge a risk, how much to investment in the management of the risk and many other factors (Christoffersen 158). Derivatives Derivatives refer to a method where one party owning a risk transfers the risk to another individual (Malz 189). The party receiving the risk bears the risk but at the same time has the advantage of making a profit is the risk does not materialise. The original owner of the risk does not have to pay anything to the risk buyer but has to forego any benefits derived from the non-occurrence of the risk. The advantage of this method of risk management to the business over using insurance is that the business is not obliged to pay any insurance premiums and therefore the only cost is the opportunity cost which the business has to bear due to not being able to benefit when the risk does not occur (Deventer & Imai, 48). The market for derivatives has grown significantly for some time, perhaps because of the increasing risks in the global business environment. Globalisation and technology have brought numerous opportunities to the business environment but at the same time brought numerous risks to businesses around the worlds (Norman, 58). As several risks have increased and their intensity in terms of likelihood and impact has increased, the need to have better ways to manage the risks has also increased. In such an environment, derivatives made from financial risks have increased and there are firms which are dedicated to trading on derivatives. Derivatives come on all sorts of nature, depending on the nature of risk (Triantis, 563). Forwards Forwards are a very good tool for managing some types of financial risks. These are risks associated with unexpected unfavourable changes in the market environment in the future (Darrell, 78). For instance, a firm may be concerned that the rate of exchange will change unfavourably in the future and thus affect its revenues. This usually happens with regard to firms which operate across international borders. In this kind of scenario, the firm can choose to have a forward contract with its customers or suppliers (Verzuh, 59). Forward contracts help the business in guaranteeing that its revenues or its business will not be affected in the future by making sure that the natural laws of the market will not come into action. For instance, in the example given above, a firm may have a forward contract which binds its suppliers to deliver the goods at a predetermined dollar rate regardless of the currency exchange rates in the future. This means that such a firm will operate without worrying that unexpected foreign exchange rates will affect its revenues in a negative way. Decentralising the business functions As identified above, currency risk is one of biggest risk which international businesses have to face today. In a modern business environment, even a slight change in the currency exchange rates can lead to massive losses for firms which manufacture their products locally and sell them abroad (Gregory 57). In this regard, apart from forward contracts, there are other options which such firms can consider in order to eliminate currency risks. These include the decentralisation of business to other countries especially where the business has the biggest markets. This has been demonstrated by the recent trend of American manufacturers going to china to set their manufacturing firms there. One of the firms which have been known to have been the first one to use this strategy of decentralising the manufacturing in order to eliminate currency exchange rates risk was Caterpillar. Caterpillar, a construction equipment manufacturer realised in the 1980s that it has losing its strategic edge because the rates of exchange were making it sharper to compete with its major competitors such as Fujitsu from Japan. This was because Fujitsu could to sell its products across borders at very low costs due to the fact that the Japanese currency was low and when converted into foreign currency, the firm would be able to make huge profits. This affects caterpillar and its ability to make profits and it had to move most its manufacturing plants to other countries in order to avoid the negative effects being caused by currency issues. In a modern business environment, any business that trades across borders is affected by the risk of currency exchange rates changing from time to time (Rush, 198). In this regard, distributing the firm to foreign markets will neutralize the risk and covering this kind of risk will not be necessary in any other away. The only set back to this method of covering risk is that it is long-term-oriented and taking this option would require the business managers to be sure that they are committing for the long run. This is because the cost of setting up abroad is not an easy one and the business can’t just pull out of the foreign country as too soon as this would lead to massive losses. Internal controls Most of the financial risks which a business faces emanate from internal issues. This means that these risks can be managed by placing internal controls which will minimise the risks (Leitch 214). By placing internal controls, it is possible to reduce the risk in relation to its likelihood to happen as well its impact if it does happen at the end. These internal controls are geared towards protecting the business from poor decision which can lead to the business making losses. While the application of these internal controls comes with a cost, they are on some cases much less expensive and effective in controlling and managing risks in the firm. The other advantage is the fact that unlike insurance, these internal controls do not just guarantee a compensations of when the risk happens, but actually guarantees that the risk will not happen or reduces the chance of the risk happening. The biggest limitation of insurance policies as a way to manage risk is the fact that insurance does not minimise the risk happening but actually only guarantees that if it does happen, the business will be financially reinstated to its original state. However, there are those financial risks which would require more than just financial reinstatement and these cannot be fully covered using the instance. One such risk is product liability which occurs when the firm produces faulty products. In such ca case, even if the insurance pays the business the loss so incurred, the firm will still suffer more due to the fact that the customers will have lost faith in the products of the business. In this regard, the best alternative for controlling this risk is not to insure the risk but to invest in internal mechanisms which will help the firms to be able to prevent this kind of risk to occur. Staged financing Staged financing is a method that is used to manage the financial risk which comes with the opportunity to invest in new products or ideas. This mostly as Frenkel (48) says is best used in managing the Research and Development costs. Every firm engages in Research and Development as a way to develop new products which will make the firm to remain in the market. Research and Development is one of the most costly investments that an organisation can have and this exposes the firm to huge financial risk if the results of the Research and Development don’t end up giving the firm a product that is accepted by the market. These costs associated with Research and Development need to be hedged in at least one method of hedging. To be able to minimise the risk, the firm can have two options. The first option is to secure the risk by either buying insurance policies from insurers or by using other insurance methods such as forward contracts or options. However, these options don’t usually lead to minimised risk and also lead to costs associated with managing the risk. Staged financing as a risk management tool is better in such a situation because there are no costs involved and if the risk does occur, the loss is minimized and the firm can easily absorb it (Sihler 189). This is because staged financing actually refers to investing smaller bits of financial resources sequentially. For instance, if a firm intends to invest ten million dollars on a Research and Development project, instead of injecting the whole amount all at once, it can invest in stages such as half a million per stage. Once the first phase is successful, the second phase is them activated and this is done until the whole project is done. This guarantees that if the project is not successful, the failure will be detected at the very early states which will mean that only the money invested at the early stages will be lost. This makes it more useful than insurance because of two main issues. To begin with, buying insurance means that that there will be a definite cost whether or not the risk actually happens. Secondly, even in the event that the loss occurs, the loss will be approximately the equal amount as would have been used to insure the project. Part B: factors to consider when choosing a tool As already indicated, the choice for right tool of risk management is a trade between many factors affecting the risk. The process of choosing the tool to manage the risk is guided by the hedging irrelevance proposition theory which postulates that a firm creates no value whatsoever in hedging a risk if the cost of the risk if it occurs is the same or less than the cost of hedging (Westen 55). In this regard, there is no need to hedge a risk if the cost of hedging such a risk is more than the rate of the risk itself. If buying insurance to cover the risk is more than the risk itself, there is no need to buy the risk. In choosing the type of tools to be used, the following factors will be articulated to ensure that the tools are best suited in managing the particular risk. Probability of the risk The probability of the risk is a major factor to consider as it points to the likelihood of the risk happening (Hicks 89). In this regard, the higher the probability of the risk, the more a firm should invest in the management of the risk. A firm should therefore be more willing to pay more for protecting itself against those risks which have higher likelihood of happening. Low probability risks can be handled internally because if they do occur, the firm can easily be able to absorb the risk. Impact Impact refers to the amount of damage, financial or otherwise, that the firm would have to bear if the firm eventually occurs. Of course, the bigger the impact, the more the firm should invest in the management of the risk. Securing a low impact risk using an outsider such as by buying insurance is very unnecessary considering that the cost of handling the loss if the risk occurs may be much higher than the loss itself (Okpara 259). Types of the costs Different risks bring different types of costs to the firm. Some risks only cost the firm in terms of money but there are those risks which cost the firm more than just financially. In such a case, these risks will need to manage with tools which will take care of not only the financial loss but the other kinds of loss. A good example of this is the product risk which is caused by producing defect products. When a firm produces defect products, the firm will incur financial loss if the firm has to recall the products and if the firm has to pay anything in legal suits (Dash 347). More than that, the firm would have to incur more non financial losses as it would lose the goodwill of its customers. In such a case, in choosing the tool to manage the loss, it will be necessary to make sure that this non financial risk is also taken care of and this will determine which tool will be used. Conclusion Managing financial risk is a delicate issue and also a costly one. However, there are numerous tools for managing risk within the business environment. While the number of financial risk has increased with time, the tools for managing these risks have also increased. However, businesses have to be able to know the best tools for them to employ in managing specific risks. In this regard, there is always a need to make sure that the tools used are going to be effective and useful to the firm. This means that the firm must be able to understand its position and what it intends to achieve in order to make sure that that it will choose the best tools to manage its risks. Works Cited Christoffersen, Peter. Elements of Financial Risk Management. New York, NY: Academic Press, 2012. Print Darrell, Douglas. Globalization and Systemic Risk. New York City, NY: World Scientific, 2009. Print Dash, Desheng. Quantitative Financial Risk Management. New York, NY: Springer, 2011. Print Deventer, Donald & Imai, Kenji. Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. Hoboken, NJ: John Wiley & Sons, 2013. Print Frank, F. Financial Risk Management. Hoboken, NJ: John Wiley and Sons, 1989. Print Frenkel, Michael. Risk Management: Challenge and Opportunity. New York City, NY: Springer, 2005. Print Gregory, Duckert. Practical Enterprise Risk Management: A Business Process Approach. Hoboken, NJ: John Wiley & Sons, 2011. Print Hicks, Alan. Managing Currency Risk Using Foreign Exchange Options. New York, NY: Woodhead Publishing, 2000. Print Leitch, Matthew. Intelligent Internal Control and Risk Management: Designing High-performance Risk Control Systems. Farnham, UK: Gower Publishing, Ltd., 2008. Print Malz, Allan. Financial Risk Management: Models, History, and Institutions. Hoboken, NJ: John Wiley & Sons, 2011. Print. Norman, Peter. The Risk Controllers: Central Counterparty Clearing in Globalised Financial Markets. Hoboken, NJ: John Wiley & Sons, 2011. Print Okpara, John. Globalisation of Business: Theories and Strategies for Tomorrow's Managers. New York, NY: Adonis & Abbey, 2008. Print Rush, John. Foreign Exchange Risk Management. Hoboken, NJ: John Wiley & Sons, 2013. Print. Sihler, William , et al. Smart Financial Management: The Essential Reference for the Successful Small Business. New York, NY: AMACOM Div American Management Association, 2004. Print Triantis, Alexander. "Corporate Risk Management: Real Options and Financial Hedging." Journal of Applied Corporate Finance, 2000. Print. Verzuh, Eric. The Fast Forward MBA in Project Management. Hoboken, NJ: John Wiley & Sons, 2011. Print Westen, Peter. Advanced Corporate Finance. New York City, NY: PHI Learning Pvt. Ltd, 2008. 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