Financial Risk Management Tools for Maritime Firms - Assignment Example

Financial Risk Management Tools for Maritime Firms by Introduction The maritime industry is a significant industry in a number of ways. For instance, the industry is regulated by a number of unique rules that are only applicable to the industry. Unlike many industries in the world, the nature of the maritime industry or the shipping industry has unique rules that are meant to deal with the fact that the industry is a significant industry that needs to be managed in a different way. These rules and regulations include the home port rule which refers to the fact that each ship must have at least one home port. The home port rule helps in determining financial obligation such as taxes and customs. Ships fly the flags of the nations where their home ports are located and they also pay taxes to these nations. According to Cullinane (2011, p.47), this has led to ships opting to leave the flags of their nations to carry a flag of convenience in order to avoid high tax rates and other financial obligations. According to Stephenson (2006, p.75), it is difficult to predict the future markets, especially the bulk sectors and it is therefore crucial for shipping firms to take notice of any signs which indicate that the market may be turning up or down. In shipping, both the ship owner and the merchant are at constant risk and they are subject and at the mercy of elements such as adverse weather, piracy and a range of other risks (Whiteside, 1986, p.17). According to Pallis (2007, p.210), the high risk associated by the volatility of the maritime industry has led to most firms in the industry choosing to hedge their risks using various financial risk management tools and techniques. Drobetz, (p.9) points to the fact that the risk of inflation is also one that needs to be hedged to managed in order to protect the shipping firms from future financial risks. Risk of freight charges Freight charges are bound to change from time to time and this may introduce a unusually substantial financial risk to a maritime company (Cullinane, 2011, p 151). The rates of freighting and shipping are determined by an extremely large range of factors most of which are highly unpredictable and volatile. If the freight charges are lowered due to competition or any other factor, shipping companies are bound to lose a lot of money. The other reason is that shipping firms are likely to lose money if the cost of shipping rises but the firm has to continue shipping for its customers due to former contracts. This is especially cased by the fact that most shipping customers sign long term contracts with freighting companies and if the change in the cost of shipping changes the shipping company is expected to continue honoring their contract. Risk of fuel price changes Shipping firms spend millions of dollars in fuel. A single ship can consume gallons of fuel in just one voyage and these costs the shipping firm dollars in thousands. Increase in fuel cost even by a small margin can lead to a huge hike in fuel costs and this can lead to large losses. The main challenge with this is that the cost of fuel is highly volatile and there is no way to tell how the prices will behave. The main way to deal with the problem is that shipping firms want to charge the lowest possible prices in order to remain competitive especially with the increase of shipping companies and ships in the world. To make the situation even worse, the prices of fuel are highly volatile and firms are always at risk if shifting prices (Global Oil Insight, 2008). This means that shipping firms are constantly faced with the risk of hiking fuel costs and this provides them with a financial risk that is a threat to their survival. Risk of Forex changes Just like fuel costs, foreign exchange rates are always in the move and eve with the most complex system to predict the way the Forex rates will behave in the future, risk of unfavorable turn of Forex rates is always imminent and it can lead to enormous losses. It is increasingly vital that shipping firms be able to deal with this kind of financial risk. Shipping firms have to deal with this problem due to the fact that they have to deal with international customers. Failing to take care of this problem can lead to unusually enormous losses and may even lead to bankruptcy. Critical appraisal of a relevant range of financial management techniques available to mitigate risk Hedging According to Knutsen and Knutsen (2009, p. 66), hedging is one of the major ways in which most shipping firms use to manage their risk. This risk management technique is usually used to mitigate and manage uncertain costs changes such as the change of fuel in the future (Lily and Associates International, 2008). Hedging refers to a contract between two parties where one party agrees to deliver a good or a service at a predefined price regardless of any changes in the market with regard to the said product. Shipping companies can enter into such an agreement with their fuel suppliers so that they will not be affected by hikes in fuel prices in the future. This will caution them in case an unexpected hike in oil goes up. In hedging the party to a hedging contract has to calculate the cost of the hedge and the likelihood of the risk being hedged (Alizadeh, 2009, p. 161). Hedging can be either a short or a selling hedge plan. Shipping firms are at a position to offer selling hedge to their customers. Selling this kind of hedging helps the firm to be assured of smooth demand because the firms will have to buy from the eve in cases where the demand goes down and the customers could have benefited from buying from other firms. It also means that the firm will not be affected negatively by shifting demand and demand elasticity. Shipping firms can also have a short hedge plan with their suppliers and this helps to defend them from having to pay top prices to their suppliers in case there is a hike in the prices of the goods the suppliers provide them with (Zhugr and Ali, 2009, p.9). Advantages and disadvantages of hedging A hedge will cost the firm some money above the normal rate of price. The firm will have to be willing to incur this extra cost if it chooses to use hedging to manage and mitigate financial risk associated with fuel costs risks. The other disadvantage with using hedging is the fact that the firm will be unable to take advantage of the low prices if this ever comes. For example, if the shipping firm signs an edging agreement with a fuel supplier for the supplier to supply oil at ten dollars per unit, the shipping firm will not be able to take advantage even if the prices of fuel goes down because the contract is also binding to the shipping firm just as it binds the supplier. Derivatives Shipping firms are also using derivatives from the shipping industry in order to manage their financial risk (Kavussanos and Visvikis, 2006, p.58). Derivatives allow firms to be able to sell financial products to the market that are derived from the industry. While shipping derivatives are not so much as a financial risk management tool, the fact that it increases the revenue of the firm helps in securing the firm’s financial health indirectly. Selling derivatives also helps in managing financial risk by shifting the risk to another party without having to pay enormous premiums for insurance and therefore it does not quite cushion the firm completely. (Slatyer, 2008, p. 98) Advantages and disadvantages The main advantage of derivatives as a way to manage financial risk is that the firm does not have to pay premiums to insurance firms but instead receives the money and this is used to boot the firm’s revenue. On the other hand, although this tool for managing financial risk is used to transfer the risk, it is not useful where there is a need to minimise reduce the possibility of the risk happening. Shipping insurance According to Christopher (2011, p. 789), insurance is also used in managing financial risk for shipping firms. There is a range of financial risks that a shipping firm encounters in its daily operations and these risks require vigilance. To mitigate these risks, the shipping firm may need to use insurance policies. Some of the most common maritime risks that can be managed using insurance policies include the risk of damaged goods on transit, damaged vessels, loss due to sea piracy etc. However, as Francis, Doherty and Herring (2010, p. 217), say insurance may not always the best way to insure because the cost may be extremely high because the insurance companies sets their premiums in accordance to the risk probability in to guarantee their profits. Merging Like any other industry, the maritime industry is realizing the power of mergers. Mergers can happen horizontally and vertically and in any case, they can be used to manage financial risk. For shipping firms, vertical mergers can help in eliminating any risk whose origin is competition. For instance, a maritime firm can merge with a fuel supplier to make sure that it will not be affected by fluctuating fuel costs. This can be used to manage the risk of fluctuations of fuel cost without necessarily having to incur immense costs as would be if the firm decided to get a hedging arrangement or an insurance policy. Horizontal mergers are also used to mitigate risk and cushion the firm against financial risks. Horizontal mergers however don’t manage risk by mitigating it but by spreading the risk and also spreading the losses in case the risk eventually occurs. Horizontal mergers can be seen as in-house insurance schemes because it makes sure that the risk is distributed to all the members of a merger and therefore it means that if the risk does materialize, the members of the merger will be able to handle the damage because it will be spread evenly thus reducing the impact. For instance, two maritime firms merge and one of them is finally faced with a risk of 1 million dollars materializing, the cost to the firm will be only half a million because it will be shared by both the firm. If more firms are added to the merger, the impact of the risk will be even lower. Point to point shipping Most shipping firms have found that there is a significant risk associated to shipping from port to port and outsource the inland transport to external parties. This however depends on the type shipping arrangement that he shipping firm signs between itself and the customer. In cases where the shipping firm commits to be responsible frit the goods until they reach their destinations, there is always a risk that the goods may be lost and the firm would have to pay for the lost goods. Current corporate examples to support discussion Managing the inland transport instead of outsourcing the process gives the shipping firm more control and this makes sure that the firm is able to mitigate this risk. As a result, most shipping firms such as Maersk Sea land are taking the business to a new level where the firm provides transport of goods from doorstep to doorstep. This also increases the revenue of the shipping firm while at the same time helping in dealing with the financial risk associated with letting another firm handle the inland transport. Sea Containers Ltd risk management uses a combination of financial risk management tools to manage their risks. This includes diversification, freight insurance, and hedging for risk if fuel price hikes. The use of combined risk management tools is becoming popular as the risk of operation increases becomes even more unpredictable. Increasing competition among shipping firms has also brought another form of risk that is associated with demand elasticity. The massive increase of Asian shipping firms most of whom are from china has brought this competition and as more and more firms realize that the demand for shipping services is flexible, they are being forced to lower their prices thus affecting their revenues and putting their financial stability in jeopardy. This has called for better ways to manage the financial risk that most of these firms are faced with every day. Hedging is becoming exceedingly common as to eliminates the risk of uncertainty whether it the uncertainly of fuel cost or demand for freighting services. As such, most firms such as Maersk and Sea Containers are looking towards this direction of risk management to make sure that their future is more predictable and stable. Justification and articulation of a recommended approach Hedging is one of the most economical ways of risk management in the maritime industry. Shipping firms can use this as a way to manage their financial risks. Using hedging as a way to mange financial risk will be better because of the following issues; Nature of risk The nature of most of the risk that a maritime firm faces demands hedging as a way to manage risk. Most of the financial risks that a maritime firm faces are usually based in the volatility of some financial elements. For instance, the uncertainty of future fuel prices is one of the most eminent risks for shipping firms. When the risk being managed is the risk of fluctuations such as fluctuations of oil prices, insurance may not be the best way to secure the risk. Fluctuations can occur at almost any rate and frequency and the best way is to secure the firm against the financial risk that emanates from the fluctuations is a hedging agreement to make sure that the firm can enjoy stabilized costs. The use of hedging is crucial because it is minima as compared to the other ways of hedging. Although there are a number of hedging methods, hedging involves paying a little more than the current prices. However, because the firm would still need the product even if it did not use the hedge, the cost is minimal. For instance, if a shipping firm uses one million dollar worth of fuel per month, it may pay only ten percent of its cost in order to make sure that it will enjoy stabilized prices all year round or for a specified length of time. In other words, the cost of risk management in this case will be only ten percent of the original costs. Other reforms of risk management can be more expensive. For instance, insurance, although it efforts the fir the luxury of securing its total risk, can be hugely expensive. Once these firms are able to eliminate the risk uncertainly, they are able to operate better and even reach out for opportunities that would be otherwise too risky to attempt. Hedging is crucial because it leads to win and win situation where both parties at both sides of the hedge plan stand to gain more than they stand to lose. Reference List: Alizadeh, A. &. (2009). Shipping Derivatives and Risk Management. Basingstoke: Palgrave Macmillan,. Christopher, L. (2011). 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