Corporate Risk Management - Statistics Project Example

Corporate Risk Management Total Number of Words: 2,547 Table of Contents Introduction 3 Background 3 Risk Management Decisions 4 Direct and Indirect Costs and Benefits of Hedging 5 Direct and Indirect Costs and Benefits of Insurance 10 References 13 Introduction Corporate risk management (CRM) aims to formulate major corporate strategies such as investment allocation, capital budgeting, target bearing and other aspects of financial management of a company (Froot, 2007). In real life practice, risk control process involves the use of different risk management tools and frameworks that can help corporate risk managers or bankers make important decisions making that can help companies reduce the risks of occurring losses. In general, risk management decisions can either be related to hedging or insurance (Beneplanc and Rochet, 2011, p. 164). In real life practice, it is important to discuss the benefits as well as the direct and indirect costs of hedging and insurance. After discussing the benefits, direct and indirect costs of hedging and insurance, ways on how one can possible establish the estimated direct and indirect costs will be presented in details. Background The concept of “risk appetite” is commonly used in various financial or business situations related to managing corporate risks (Gai and Vause, 2006). Basically, the term “risk appetite” is all about how people are able to create a wide-range of investment portfolios based on how corporate risk managers are able to clearly understand, develop, and implement strategic ways on how they can mitigate or control risks when managing different business situations and endless financial crisis (Gai and Vause, 2006). Often times, the companies’ “risk appetite” are dependent on the financial and economic situation in each country. As such, it is most likely for the “risk appetite” of most companies to decrease in times of serious financial crisis or economic recession. Within the corporate level, some of the direct and indirect costs of risk management decisions are strongly related to various risks. Basically, most of these risks are strongly related to the interest rate, foreign exchange rates, default risks, liquidity risks, business risks, market risks, financial risks, and marketability risks. Even though key risk management decisions can be effective in terms of reducing most business- or financial-related risks, one cannot deny the fact that some of the risk management decisions will have both direct and indirect costs (Froot, 2007). Often times, direct and indirect costs of risk management decisions could affect the companies’ cash flow and monthly expected earnings (Froot, 2007). Therefore, it is best to come up with a clear estimate on how much each of these direct or indirect costs will accumulate over time. Risk Management Decisions Decisions made by managers are important especially when they need to allocate excess funds for investment purposes or business projects. In most cases, the process of making important risk management decision requires each manager to go through a series of risk management processes which includes the following: (1) identify existing or potential future risks; (2) evaluate the identified risks; (3) assess the mechanisms and options of risk management; (3) implement risk management and risk control processes; and (5) monitor the overall risk management techniques used in the project. Earlier it was mentioned that there are some direct and indirect costs associated with key risk management decisions (Froot, 2007). Because of these unforeseen costs, risk management decisions should always be made right after considering the company’s available fund and capital structure. Often times, business organizations with huge equity and minimal debts are the ones that are far from experiencing serious financial problems. Therefore, it makes a lot of sense that companies with good credit standing and large amount of equities have more option to engage in corporate risk management strategies that requires higher direct and indirect costs. Direct and Indirect Costs and Benefits of Hedging Hedging is a good example of non-insurance type of risk management decisions (Beneplanc and Rochet, 2011, p. 164). Basically, hedging is about the process of taking certain position that could either increase or decrease in value as compared to its current position (Connolly, 2007, p. 84). One of the common reasons why financial and non-financial institutions would be hedging either stock fund or foreign exchange rates is to avoid experiencing business opportunity losses. Estimated Cost of Hedging Stock Prices Corporate stocks are commonly being traded in New York Stocks Exchange (NYSE), London Stocks Exchange (LSE), or Tokyo Stock Exchange among others. Assuming that companies or financial institutions were able to buy stocks at a much lower price, hedging on stocks can have a lot of benefits on the part of the investors. In the process of buying stocks at low prices, there is a higher chance that the company will earn more gains or profits. In case there is a positive stock price movement, companies who have invested on certain stocks would definitely benefit from capital gains. As a common knowledge, stock or equity prices are volatile by nature. It means that at any given point in time, stock or equity prices could either increase or decrease. For this reason, there is also disadvantage when it comes to investing on stocks. Assuming that there is a negative stock price movement on the purchased stocks, investors are likely to suffer the consequences of investment losses. In general, purchasing stocks can be done with or without the intervention of a middleman. When it comes to hedging on stocks using a middleman, the direct costs normally include amount of money invested on stocks whereas the indirect costs may include the salary or a commission paid to an external financial consultant or a middleman. For instance, assuming that Company A invested $1000 using a middleman who will receive 8% commission, direct cost and indirect cost would be $920 and $80 respectively. In this case, the estimated cost of hedging stock prices is $1000 for both direct and indirect costs. USD ($) Direct Cost (Shares of Stocks) 920 Indirect Cost (Commission of a middleman) 80 Total 1000 As a common rule, investors can acquire more shares of stocks in case the actual price of shares is low. On the contrary, investors are less likely to be able to acquire more shares of stocks in case the actual price of shares is high. For example, last February 2014, Company A managed to purchase $920 worth of stocks from Coca-Cola Co. at the price of $36.70 (Market Watch, 2014). It means that Company A has acquired 25.06 shares of stocks from this particular Food and Beverage Company [$920 / $36.70 = 25.06 shares of stocks]. In November 2014, the stock price of Coca-Cola Co. increased up to $44.59 (Market Watch, 2014). In case Company A is going to sell their acquired shares of stocks, this particular company will receive $1,117.78 [25.06 shares of stocks x $44.59 = $1,117.78]. Based on these data, it simply means that Company A’s investment has earned $197.78 in a short span of 10 months [$1,117.78 – $920 = $197.78]. Considering the case of Company A, it is clear that the benefits of hedging on stocks actually outweighs the actual costs of investment. (See Figure I – Stock Prices of Coca-Cola Company below) Figure I – Stock Prices of Coca-Cola Company Source: Market Watch, 2014 Corporate risk managers will always have the power to control investment losses. To avoid the risks of serious financial losses, the finance manager of Company A should closely monitor the stock performance of Coca-Cola Company. Eventually, the finance manager of Company A should immediately make important investment decisions before responding to some serious negative news or external factors that could negatively affect the stock prices of Coca-Cola. Estimated Costs of Hedging Foreign Exchange Trading Foreign exchange (forex) trading is all about selling of a currency in exchange of buying another currency; or vice versa (Mendelsohn, 2006, p. 8). In practice, forex traders are expected to place a market order which clearly states his or her intention to buy or sell certain currencies (i.e. USD/JPY, EUR/USD, GBP/USD, USD/AUD, USD/CHF, and USD/CAD) (Mendelsohn, 2006, pp. 8–9). As part of the limit order, forex traders have the option to specify specific price he or she intends to buy or sell certain currency. For example, forex trader can in advance place a buy order of GBP/USD at 1.9725 and sell at 1.990. Since the forex market is volatile, forex traders are given the option to place a stop loss order as a way to cut down their potential losses. In exchange of a specific currency, people who are hedging foreign currencies are expected to buy a currency they expect to increase in terms of “price interest points” or “pips” (Mendelsohn, 2006, p. 10). In the process of selling a currency with decreasing “pips”, forex traders can cut down their future losses. In case forex traders would buy a specific currency with continuously increasing “pips”, the forex trader is most likely to benefit from future expected gains. There are quite a lot of online companies that offer foreign exchange trading. Similar to purchasing stocks through a middleman, buying or selling of currencies through an online foreign exchange trading company also have some cut on the initial investment of each official forex trader. Basically, the estimated cost of hedging foreign exchange currencies may vary from one forex trader to another as long as they have invested a minimum deposit required by the online forex trading company. For example, one of the UK-based online foreign exchange trading companies requires a minimum deposit of 250 EUR, 250 USD, or 250 GBP (http://www.forex.com/uk/index.html). The “spread” is also known as the difference between the bid/offer prices. Instead of initially deducting a specific amount from the forex trader’s account, FOREX.com’s cut on forex traders’ initial investment is actually being compensated or taken out from the. Let us assume that Company B invested $250 in www.forex.com on November 30, 2014. A day after, Company B placed a market order buying USD against JPY at around 18:00 pm eastern time with a stop loss order dated December 2, 2014 at around 15:00 pm eastern time (Forex.com, 2014). At the time when Company B was able to officially buy USD against JPY, the USD/JPY currency was at 117.906 points (Forex.com, 2014). On December 2, 2014 at around 15:00 pm eastern time, the USD/JPY currency increased up to 118.886 points (Forex.com, 2014). It means that Company B has earned 0.98 pips in this particular currency trading [118.886 points – 117.906 points = 0.98 pips]. Assuming that www.forex.com will be compensated by 0.40 pips, it means that Company B’s total gain would only come from the spread of 0.58 pips [0.98 pips – 0.40 pips = 0.58 pips]. Considering this case, the estimated direct costs of hedging foreign exchange trading was $250 whereas the indirect costs is 0.40 pips which will be taken out from Company B’s spread as soon as a market order has been officially placed. (See Figure II – Forex Trade on USD/JPY on page 10) Direct Cost (minimum investment) $ 250 Indirect Cost (Commission of www.forex.com) 0.40 pips from the spread Figure II – Forex Trade on USD/JPY Source: Forex.com, 2014 Direct and Indirect Costs and Benefits of Insurance Insurance is another good example of risk management decision that most managers should consider when managing finances (Beneplanc and Rochet, 2011, p. 164). Insurance in general can be classified as either life (i.e. whole life insurance) or non-life (i.e. auto insurance, health insurance, fire insurance, etc.) (Outreville, 1998, p. 34). Often times, insurance are considered as a heterogeneous product. It means that business organizations now-a-days can choose from a wide-range of insurance coverage (Outreville, 1998, p. 34). To protect the businesses from long-term financial losses, a lot of financial and non-financial institutions have been relying much on the financial protection that most non-life insurance can offer. For example, fire insurance policy is a good non-life insurance. Normally, fire insurance policy clearly states that in exchange of paying a fixed amount of premium, the insurance company promises to compensate the insured amount of money in case the insured property is damaged by accidental fire. Considering the main purpose of fire insurance, some people may consider it as one of the best ways to protect their properties from being destroyed by fire. With this in mind, it is clear that companies can have the benefits of claiming insurance in case of accidental fire has occurred. As a common knowledge, companies can lose the businesses’ equity value through fire. Therefore, the fire insurance policy can serve as leverage for the business organization to cut down their losses (Frenkel, Hommel and Rudolf, 2005, p. 440). As agreed upon between Company C and the insurance company, the estimated direct cost of fire insurance is highly dependent on the annual premium fee of fire insurance policy. In real life practice, insurance agents will receive a commission from the insurance policy they sell. Upon selling a fire insurance policy, let us assume that the insurance agent will receive 5% of the premium price. It is also assumed that the annual premium price of $1,000,000 worth of fire insurance protection is $25,000. Therefore, to be covered by the fire insurance policy, Company C should pay the insurance company the price of $25,000 each year. In this example, direct cost of the fire insurance policy is $25,000. On the other hand, indirect cost of paying the insurance agent’s commission is $1,250 [$25,000 X 0.05 = $1,250]. Likewise, indirect costs of fire insurance may also include the need to increase external financing or the loss of opportunity because of the inability of the company to pay the premium of higher fire coverage policy (Frenkel, Hommel and Rudolf, 2005, p. 443). Conclusion There seems to be quite a lot of different ways in which managers can maximize the earnings and profitability of business organizations without the need to experience huge losses from their short-term and long-term decisions. In case the top management officials would want to make use of their excess money on investments, choosing between the hedging on stock prices or foreign currencies can be a good choice. Similar to stock prices, foreign currencies are also volatile by nature (Mendelsohn, 2006, p. 8). Therefore, the act of hedging foreign exchange currencies through forex trading is similar to hedging corporate stocks in the sense that forex traders can benefit from gains or losses out of fluctuations in foreign currencies. In case the top management would like to have more protection in their physical assets, the company may choose to invest more on insurances. One of the main differences between hedging stock prices and foreign currencies is that the practice of hedging on stock prices involves more risks as compared to forex trading. Similar to what happened to the Worldcom and Enron among others, this statement is true due to the fact that corporate investments can bring about the risks wherein some of the company employees may end up manipulating the real performance of the company (Mendelsohn, 2006, p. 8). Property damages can be happen because of fire, flood, and possible losses in the shipment of goods among others. In line with this, most of the non-life insurance packages can be used to reduce the company’s risks of experiencing huge losses due to serious damages to properties. Insurance policies will not give the businesses the opportunity to earn more from the volatility in the stock and foreign currency market. One thing for sure is that investment made in insurance policies can serve as a protection for unforeseen future destruction on business properties. References 1. Beneplanc, G. and Rochet, J.-C. (2011). Risk Management in Turbulent Times. New York: Oxford University Press Inc. 2. Connolly, M. (2007). Fundamentals of International Finance. 1st Edition. New York: Routledge. 3. Forex.com. (2014). FOREXTrader & MetaTrader Spreads. [Online] Available at: http://www.forex.com/uk/pricing-comparison.html [Accessed 2 December 2014]. 4. Frenkel, M., Hommel, U. and Rudolf, M. (2005). Risk Management: Challenge and Opportunity. NY: Springer Science. 5. Froot, K. (2007). Risk management, capital budgeting, and capital structure policy for insurers and reinsurers. The Journal of Risk and Insurance, 74(2), pp. 273-299. 6. Gai, P. and Vause, N. (2006). Measuring Investors’ Risk Appetite. International Journal of Central Banking, 2(1), pp. 167-188. 7. Market Watch. (2014, December 1). Coca-Cola Co. [Online] Available at: http://www.marketwatch.com/investing/stock/ko [Accessed 2 December 2014]. 8. Mendelsohn, L. (2006). Forex Trading Using Intermarket Analysis. Market Technologies LLC. 9. Outreville, J. (1998). Theory and Practice of Insurance. 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