The Objectives of Risk Analysis and the Main Techniques Used in Risk Analysis - Assignment Example

RUNNING HEAD: THE OBJECTIVES OF RISK ANALYSIS AND THE MAIN TECHNIQUES USED IN RISK ANALYSIS The Objectives of Risk Analysis and the Main Techniques Used in Risk Analysis Name Institution Date Risk analysis is frequently employed by foreign exchange analysts to evaluate the risks underlying foreign exchange transactions. Explain the objectives of risk analysis and the main techniques used in risk analysis Introduction Foreign exchange risks form one of the most common risks that many firms encounter and, in recent times, the management of this particular risk has come to be one of the most significant (key) factors in the overall financial management of firms. As a consequence, risk analysis is often employed by foreign exchange analysts to evaluate the risks underlying foreign exchange transactions. Risk analysis can basically be defined as a technique used in identifying as well as assessing various factors that may put at risk the attainment of a firm’s goal. Risk analysis also encompasses a preventive measure that helps reduce the likelihood of these factors occurring and identifying countermeasures so as to successfully contend with these limitations when they arise, as a result preventing the likely negative outcomes on a firm’s competitiveness. This particular paper therefore intends to clarify the objectives of risk analysis and the main techniques used in risk analysis. Effective risk analysis is increasingly significant to the success of any organization. As highlighted by the Global Risk Assessments Inc. (2004), risk can be a driver of significant strategic decisions; it can be a reason for uncertainty within the organization or it can basically be embedded in the organization’s activities. As a result, effective risk analysis is increasingly significant to the success of any organization. One of the major objectives of risk analysis is that it offers a mechanism that helps identify which risks signify opportunities and which ones signify potential pitfalls. Subsequently, an organization’s wide approach towards managing the risk enables the organization to take into account the possible impacts of the risks on all activities, products, processes, and services. Therefore, according to the PricewaterhouseCoopers (2010), when done correctly, risk analysis, provides the organization with a clear understanding of the various variables that they may be exposed to, whether forward-looking, retrospective, external or internal. A good risk analysis is anchored in a firm’s well-defined risk enthusiasm and tolerance, and offers the basis for determining risk responses. A robust risk analysis process when employed continually throughout the firm empowers a firm’s management to better identify, assess, as well as take advantage of the right risks for the firm’s business, while at the same time maintaining the proper controls in order to ensure efficient operations and regulatory compliance. Another reason why risk analysis is frequently employed by foreign exchange analysts to evaluate the risks underlying foreign exchange transactions is that carrying out risk analysis enables firms to hedge (or mitigate) the enumerated downside risks and fluctuation of the organization’s foreign exchange exposure by using the derivatives market. As highlighted by Popov & Stutzmann (2003), economies are becoming more and more open with global trading continually increasing, as a result firms are getting more exposed to foreign exchange rate fluctuations. Foreign exchange risk analysis is thus crucial for firms that are frequently trading within the global market. According to Popov & Stutzmann (2003), for instance, empirical studies have revealed that profits of transnational firms are often affected by the unpredictable foreign exchange rates. Additionally, smaller firms trading mainly within their domestic markets have also been increasingly exposed to foreign currency instability. Other smaller firms are as well indirectly exposed to foreign currency fluctuations bearing the fact that their strategic positions are normally affected by the unstable foreign exchange rates. risk analysis is thus frequently employed by foreign exchange analysts to evaluate the risks underlying foreign exchange transactions is that carrying out risk analysis enables firms to hedge (or mitigate) the enumerated downside risks and fluctuation of the organization’s foreign exchange exposure by using the derivatives market. Risk analysis is also frequently employed by foreign exchange analysts to evaluate the risks underlying foreign exchange transactions in order to help quantify a firm’s currency risk exposure as well as investigate probable reasons for this. According to Kelley (2001), impending payments or distributions owed in foreign currency carry the risk of depreciating in value before the foreign currency payment is received and exchanged. Therefore, for both the domestic and international analysts, an in-depth knowledge of global risk exposure techniques can play a significant role in supplementing legal strategies for various parties involved in the global business transactions. Kelley (2001), however, argues that whereas a thorough and creative legal drafting may help in reducing some global transaction risks, a number of businesses risk can be avoided completely or partly by the financial markets. One such area associated with the foreign exchange rates is the transaction cost. Risk analysis is also carried out by foreign exchange analysts with an objective of carrying out an assessment of the probable outcomes that may arise as a result of the foreign exchange risks. As the Global Risk Assessments Inc. (2004) highlights, these risks come up as a result of the future events and developments that are predictable, as a result, enabling an analysis to be carried out so as to assess the probable outcome. More often than not, all the foreign exchange analysts can do is to forward their findings to the decision makers on the possibilities as well as the likely impacts that may come up as a result of the risk. They also can offer solutions or recommendations on how to overcome the risks. Every so often, attention is normally given to the past trends, present situation and the future. The analysis normally demands a clear understanding of the latest economic developments in an historical context. Hence, it is significant to recollect over duration of five to ten years so as to assess the firm’s internal and external shocks that the firm has encountered and the policies that the firm has pursued in relation to these. Various techniques are employed in carrying out risk analysis by foreign exchange analysts. One of the major techniques used in carrying out risk analysis is the use of Monte Carlo Simulation. Under this technique, the various variables that affect the bottom-line net revenue variable the most, and which are also uncertain, are simulated. Their interdependencies are represented by employing the use of correlations. The uncertain variables are thereafter simulated several times in order to emulate all the possible variations and combination of outcomes. The occasioning net revenues from the simulated potential results are tabulated and analyzed. Basically, Mun (2010) highlights that the simulation technique, in its most basic form, is basically an improved version of the traditional techniques such as scenario and sensitivity analysis but repeatedly performed several times while accounting for all the dynamic interactions between the simulated variables. Another major technique employed in carrying out risk analysis is the use of the foreign exchange sensitivity analysis (Angelopoulos & Mourdoukoutas, 2001). Foreign exchange sensitivity analysis is basically a technique used to determine how sensitive a firm’s net present value analysis relates to changes in the firm’s variable assumptions. This technique determines the foreign exchange sensitivity of the on-balance sheet and that of the off-balance sheet positions. This technique focuses mainly on the impact of foreign exchange fluctuations on the net position of the bank in every currency and for every financial product denominated in the same currency. To carry out a sensitivity analysis, the base-case scenario is first determined. The base-case scenario is basically the net present value using assumptions that are believed to be most correct. From there, various assumptions that were initially made can be changed based on other probable assumptions. The net present value is thereafter recalculated and the sensitivity of the net present value determined based on the change in the assumptions. Depending on the analysts’ confidence in their assumptions, they can project how potentially risky a firm’s project can be (Investopedia, 2012). Foreign currency derivatives also forms another significant technique employed by foreign exchange analysts to carry out risk analysis. Popov & Stutzmann (2003) argue that there is sufficient evidence that a large number of exporters have a preference for this technique. Their preference is argued based on the nature of exporting which may entail customized, short-duration contracts, which are better supported by derivatives rather than by the long-term foreign debt. Popov & Stutzmann (2003) highlights that the main reason why many firms employ the use of foreign currency derivatives to manage foreign exchange risk is essentially to minimize the inconsistency in cash flows. Conclusion From the above analysis, what is evident is that foreign exchange risks can affect the competitiveness, profitability and the valuation of a firm’s global operations. Lack of a foreign risk management policy may leave a firm unprepared to control the possible adverse effects that may arise as a result of foreign currency movements. This may result in enlarged costs as well as reduced profits and market share. As a consequence, for a firm to hedge their exposures to foreign exchange risk, the firm ought to create and authenticate a policy statement that will describe the firm’s objectives, attitudes as well as appropriate reactions when handling foreign exchange risk. The main objective is to come up with a policy that will ensure the impacts of the adverse foreign exchange rate instabilities of a firm are minimized. References Angelopoulos, P and Mourdoukoutas, P. (2001).Banking Risk Management in a Globalizing Economy. Greenwood Publishing Group. Global Risk Assessments, Inc.(2004).Global Risk Assessments, Issues, Concepts & Applications in Business Environment Risk Assessment, Country, Investment & Trade Risk Analysis, Political Risk Assessment & Management. University of California. Investopedia. (2012).Corporate Finance - Risk-Analysis Techniques Mun, J. (2010).Modeling Risk, +DVD: Applying Monte Carlo Simulation, Real Options. John Wiley and Sons Publishers. Kelley, M.P. (2001).Foreign Currency Risk: Minimizing Transaction Exposure. Journal of International Law. 3(7): p133-134. PricewaterhouseCoopers.(2010). A Practical Guide to Risk Assessment: How principles-based risk assessment enables organizations to take the right risks. Retrieved on November 28, 2012 from Popov, V & Stutzmann, Y. (2003). How is Foreign Exchange Risk Managed? An Empirical Study Applied to Swiss Companies. Routledge . Read More