Financial Risk Management Issues - Assignment Example

Implied Volatility delta EAP gamma August 87.14* 0.5289 4.2441 September 18 0.5979 168.1736 October 0.13 0.9873 125.7652 November 0.12 0.9923 85.8558 *assuming dividend yield of 0 and Risk Free rate of 1% b) Market risk is one of the most important aspects of derivative trading and involves tailoring of very accurate policies to mitigate this risk. Market risk mostly tend to arise out of external events on which firm has very little or no control therefore market risk is often classified as systematic risk or undiversifiable risk. It is however critical due to the fact that it can create greater volatility in asset prices and hence there is greater probability that the underlying asset values may change. As the China Aviation was trading in a commodity i.e. oil therefore commodity risk was one of the main sources of market risk for the firm. Commodity risk arises from the potential movement in the underlying commodity and as such includes energy products as commodity. (Jorion, 2007). The speculative trading in options by CAO indicate that the company was betting too much on speculations about the movement in the prices of the oil in international market which however, did not happened positively all the time and company plunged into troubles. Historically, it has been observed that the energy products are relatively more volatile as compared to other commodities and as such unorganized speculative activity in such products definitely result into losses for the firms. c) Credit Risk is another important aspect of overall risk management and firms have to relatively take care of the fact that credit worthiness of the parties with whom they are trading is good. Credit rating therefore plays a critical role in defining the future relationship of the counter parties to any transaction. The major role of credit ratings and credit rating agencies is therefore of providing an independent opinion based on certain specific criteria.(Servigny & Renault, 2004). The analysis of the given facts will indicate that the firm attempted to involve itself in trade with companies whose credit worthiness was not good in the market. By trading on their behalf, CAO actually attempted to acquire the credit of risk of those companies whose overall credit risk was relatively higher as compared to other companies. CAO entered on behalf of the airlines by offering identical contract terms to counter parties and in return of premium waiver of those air lines, CAO basically assumed the credit risk of all such airlines. The involvement of back to back transactions itself indicated that the CAO was more than willing to assume the credit risk of these airlines however, with more volatile increase in the oil prices, the overall net exposure of CAO increased mainly due to assuming such credit risk. Further, CAO also violated the normal prudence to be exercised in properly evaluating the credit worthiness of the airlines and even not bothered to obtain the credit ratings of its counter parties thus effectively exposing itself to much larger credit risk. d) Agency risk usually arises when managers of the firm usually do not act in the larger interest of the shareholders and often takes actions which are largely in their own favour. Numerous studies indicate that the shareholders often attempt to include risk discounts in their return calculations for incorporating the agency risk. (Wendels, Keinberg & Sievers, 2008). Similarly, behavioural biases especially overconfidence of managers, more emphasis on speculation etc also lead to a systemic decline in the overall value generating capability of the firm. First of all speculative trading was restricted to just two individuals thus the overall probability of collusion inherently increases due to lack of effective checks and balances. Further, the overall attitude of the managers in properly recording the options at their true mark to market (MTM) value does indicate about a potential bias of the managers in deliberately selecting accounting methods which helped them to collude and hide some important information about the true accounting of options in the company’s books. Frequent restructuring at the top as well as at the lower level of the organization also indicated a more collusive approach of the management of the firm to conceal some of the most important facts about the company’s involvement into rouge trading and fictitiously increasing the profits of the firm by employing those methods which assisted the firm in manipulating the accounting records. Overall we can safely assume that the firm’s managers did not acted in a manner to increase the value for their shareholders and rather acted to increase their own well being. e) An operational risk often arises out of the company’s overall functioning of its systems and procedures. This type of risk mainly arises due to errors committed by the people, procedures as well as the overall system of the firm and as such this type of risk is also often hard to quantify and assess. Operational risk is relatively obscure too because most of the losses emanating from risk often tend to be of small value thus management do not pay much attention to such losses until they snowball into something bigger.(Chernobi, Rachev & Fabozzi, 2007). First of all it’s really clear that the firm has adapted accounting methods which were faulty and did not resulted into providing true and fair view of the affairs of the firm. Thus the overall accounting and control environment was relatively weaker and more prone to risks which could further result into other types of risks such as reputation risk. The purchasing of the system for calculating the option prices as well as its non-use also indicates the lapses in the operational environment of the company and as such most of the problems that were faced by CAO were directly or indirectly a result of lapses in its internal control environment and thus due to high operational risk. f) From the given facts it can be easily assumed that the firm’s counter parties are also running relatively higher risk arising due to operations. There are multiple indications of this that can be easily assessed from the given facts in the case study. First the presence of higher premiums itself indicate that the counterparties were willing to pay relatively higher premiums to CAO despite the fact that market was relatively more volatile. Further the downgradation of credit ratings of the counterparties also indicated the impaired ability of these firms and their operational viability to generate consistent streams of cash flows. It may also be concluded that such decrease in the credit worthiness of these counter parties itself reflects the confidence and trust of market in the abilities of these firms to provide required return to their shareholders. The exercising of extendibles also indicate as how to the counterparties were executing their trades and indicated the lack of quality control environment that can put an effective checks and balance over their trading affairs. Further, counterparties also seem to ignore the fact that CAO was recording negative MTM in its books and as such reconciliation of trades and setting off mechanism was not properly implemented at CAO as well as its counterparties. Absence of an effective setting off mechanism indicate that the parties to the transactions were largely transacting more in a collusive manner rather than from the perspective of generating real value for their shareholders. Overall, it is safe to assume that both CAO and its counterparties were running relatively higher operational risks and were working under relatively weaker control environments. g) From the risk management perspective, higher management of the firm including its board of directors must perform a more robust role in setting up effective and efficient risk control environment. Board of Directors, Audit Committee are two of the most critical power centres within an organization to ensure that managers of the firm take actions which are in-line with company’s overall strategic objectives and does not deter the interests of shareholders. The role of Chinese holding company may not be entirely considered as effective because it failed to bring in changes that were required to effectively enforce the derivative trading within the firm. CAOCH mostly continued the same policies and procedures as adapted by CAO and even took steps which were relatively more risky than the steps taken by CAO. It continued to practice and adapt more risky policies and as such augmented the impact of already undertaken ill practices. Further, despite the fact that the more serious matters were brought to the notice of new managers however, they continued with the existing practices and completely ignored to inform their shareholders regarding practices which were not directly involved in generating value for the shareholders. Subsequent restructurings also indicate that the CAOCH was in fact searching for best combination of managers to properly address this issue however; it failed to achieve the desired results due to risks which were typically more inherent into the systems and procedures of the organization. As for as lack of action is concerned, it must be noted that CAOCH remained silent on many critical issues and failed to raise timely objections to correct some of the situations which were clearly not in favour of the shareholders of the company. References 1. Hartmann-Wendels, Thomas, Keienburg, Georg and Sievers, Soenke, Agency Risk and Firm Valuation: An Empirical Analysis of Venture Capitalists Private Expectations (October 11, 2008). Available at SSRN: http://ssrn.com/abstract=1282674 2. Chernobai, A Rachev, S & Fabozzi, F (2007) Operational risk: a guide to Basel II capital requirements, models, and analysis. New York: John Wiley and Sons 3. Jorion, (2007). Financial Risk Manager Handbook. 4th ed. New York: John Wiley and Sons,. 4. Servigny, A & Renault, O (2004) Measuring and managing credit risk. New York: McGraw-Hill Professional,. Read More