Objectives and Main Techniques of Risk Analysis - Coursework Example

Objectives and main techniques of risk analysis Name: Institution: Date: Objectives and main techniques of risk analysis Foreign exchange risk is the additional variability which is experienced by a multinational corporation in its global consolidated earnings that are occasioned by unexpected fluctuations in currency. Foreign exchange rates fluctuations affect the cost of profitability, competitiveness, and valuation of the international operations of a given company. Without a policy of foreign exchange management, the company is left ill-prepared from currency movements’ adverse effects. A company has to develop a policy statement which describes the company’s objectives, attitudes, and appropriate responses when it comes to the management of risk in foreign exchange. The basic objective is to come up with a policy that will minimize the impact of adverse fluctuations in exchange rates on the company’s financial position. The company has the objective of taking the necessary reasonable steps for minimization of losses emanating from consolidated earning exposure (Van Deventer, Mesler & Imai, 2011). The company has also the goal of funding its worldwide operations at the minimum after-tax cost; to ensure liquidity for world operations as well as maintain access to local credit markets. The company has also to protect its assets worldwide and maximize profits from foreign operations. Foreign exchange market risk is the fundamental risk associated with movements of exchange rates. This is the risk that points to foreign exchange market moving unfavorably. For investors who involve themselves in offshore securities, foreign exchange market risk can be offset by the use of currency options contracts (Ghosh, 2012). Traders in foreign exchange are normally advised to have a trading routine that is established as well as based on familiarity and experience with fundamental analysis of foreign exchange rates. Systematic risk is risk that emanates from the impact of widespread political and economic shocks. It can be alleviated through avoiding investments in and trading the currencies of nations with unstable economic and political environment. Sovereign risk is risk that comes from the impact of central banking authorities engaging in changes of policy hence occasioning devaluation of their foreign currency in the market of foreign exchange (Hogan et al, 2001). Systematic risk and sovereign risk occur in countries with economies that developing and hence experience changes in price frequently. The purpose of risk management and analysis is to document the degree of risk and ensure that it is within an accepted criterion that is acceptable. Techniques of risk analysis Companies are generally exposed to three types of foreign exchange risk. These risks include transaction (commitment) exposure, translation (accounting) exposure, and economic (operational) exposure. Transaction exposure Transaction exposure happens when a company borrows, trades, or lends in foreign currency, or sells fixed assets of its subsidiaries in a foreign country. The operations involve time decay from the commitment of the transaction and the delivery or receipt of the payment. Within this period interval exchange rates will likely change and the company will subsequently be exposed to a risk that can turn out to be negative or positive. For measurement of transaction exposure, three techniques can be applied. The company can measure the currency variability in which it has transactions (Levy, 1999). The first stage is identification of the currencies whereby the transactions will be settled. This provides an idea in regard to exposure. A firm has to be careful with regard to historical volatility: historical volatility cannot accurately foretell future volatility. Besides, two different exchange exposures cannot be aggregated. The measurement is founded on the relationship between two currencies is also applied. This also applies to asset correlations of a portfolio. Negative correlations are intriguing for the company because an increase in one currency is subsequently offset in another currency; consequently there is no reason of hedging the currencies. The approach has to be applied with a lot of caution since volatility of past correlations is not a straight indicator of the future correlations. Finally, a widely used technique is the Value-at-Risk model (Ghosh, 2012). By applying both simulation and past data, the firm can estimate the potential loss over the next days provided a certain confidence interval. The technique leads to aggregation of all data into a single figure. Economic exposure Economic exposure is responsible for measuring the change in the present value of the company occasioned by any change in the expected future cash flows of the company resulting from unexpected change in the exchange rates. Future cash flows can either be cash flows coming from contractual commitments or cash flows anticipated from future transactions. Economic exposure is part of transaction exposure by some means. Transaction exposure is that part of economic exposure that entails future cash flows coming from contractual commitments and denominated in a foreign currency (Crabb, 2001). Nevertheless, transaction exposure results from the company contractual commitments as well as the amounts received or paid are known. Economic exposure means that these amounts are based on estimates and are uncertain. Economic exposure can be described as the future impact of foreign exchange change on financial structure, liquidity, operations and profit. Economic risks come about, for instance, when an international firm incurs cost in one foreign currency and obtains sales in another currency. Changes in the foreign exchange rates have an impact on the competitiveness of the firm. Profits can go down when the cost currency appreciates against the sales currency. Price changes are also a component of economic exposure of the firm since they affect the future cash flows (Kidwell et al, 2010). Economic exposure can come about because the company’s competitive position is affected by volatility in exchange rate. Different aspects can affect the company’s future cash flows and therefore, its economic exposure. These aspects include internal factors like the company’s policy or external factors like political crisis in a given country. It is not easy to quantify and identify this kind of risk since it entails movements in currencies that the company is not involved in the physical dealings. It is more complex to look at economic exposure as compared to transaction exposure. Economic exposure can be evaluated through two techniques: cash flow sensitivity to exchange rates and to exchange rates. In order to measure earnings the earning sensitivity, the company has to separate each line of its income statement and subsequently analyze the impact of decrease or increase of currency. The effects of economical exposure are hard to estimate owing to the many interactions between parameters. Cash flow sensitivity may be implemented. Since the value of the firm represents the present value of future cash flows, exchange rate exposure is normally the sensitivity of the firm to changes in exchange rates (Ihrig, 2001). Exchange rate exposure can be measured as the slope coefficient between the value of the firm and changes in the exchange rate. Translation exposure Translation exposure results from conversion of financial statement expressed in foreign currencies into the country currency. When a firm consolidates the outcomes of its foreign subsidiaries, it has the mandate of presenting a final report to the shareholders and it has to be done in a single currency (Allayannis & Weston, 2001). All foreign currency denominated liabilities and assets together with costs and revenues have to be converted into a single currency prior to presentation to shareholders. Liabilities, equity, and assets on the balance sheet are normally expressed in historical values and the rate of foreign exchange at which the currencies traded at the elapse of the financial period is not likely to be the same foreign exchange rate at the initial booking of the accounts. When a firm does this conversion at a new rate of foreign exchange, exchange rate profits or loss are bound to be realized. A company has to make the decision of which foreign exchange rate to use when converting these figures. Liabilities and assets translated in prevailing exchange rate exposed, and those normally translated at historical rate are not exposed since the same rate is applied in this circumstance. The degree of exposure depends on the translation method applied. The current/non-current and monetary/non-monetary methods are the most popular methods used. Translation risk only recognizes items already on an accounting balance sheet (Hunt & Terry, 2005).  Translation exposure is normally hedged by products that entails physical exchange of currency and is some circumstances not all hedged. Translation exposure occurs when a company has foreign subsidiaries and would like to translate their earnings into the base currency. In the measurement of translation exposure, the company has to estimate future expected earnings of every subsidiary and proceed to use a sensitivity analysis for evaluating the potential impact of exchange rates fluctuations. References Allayannis, G. & Weston, J. (2001). The use of foreign currency derivatives and firm market value, Review of financial studies, 14: 243-276. Crabb, P. (2001). Multinational Corporation and Hedging Exchange rate exposure, International Review of Economics and Finance, 11 (3). Ghosh, A. (2012). Managing Risks in Commercial and Retail Banking, New York: John Wiley & Sons. Hogan, W., Avram, K., Brown, C., Ralston, D., Skully, K., Hempel, G., & Simonson, D. (2001), Management of financial institutions, Brisbane: John Wiley and Sons, Australia. Hunt, B., & Terry, C. (2005). Financial institutions and markets (4th ed.). Melbourne: Nelson Thompson. Ihrig, J. (2001). Exchange rate exposure of multinationals: Focusing on exchange rate issues, International Finance Discussion Papers. Kidwell, D.S., Brimble, M., Basu, A., Lenten, L., Thomson, D., Blackwell, D.W., Whidbee, D., & Peterson, R. (2010). Financial markets, Institutions and money (2nd ed.). Milton, Qld: John Wiley & Sons Australia. Levy, H. (1999), Introduction to investments, Cincinnati: South Western. Van Deventer, R.D., Mesler, M. & Imai, K. (2011). Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Managements, New York: John Wiley. Read More