Elements Checks on Financial Risks - Research Paper Example

MANAGEMENT OF FINANCIAL RISKS Introduction Risk, by definition, directly refers to the possibility of having negative outcomes or unexpected outcomes thus any action or activity leading to any type of loss qualifies to be a risk (Christoffersen, 2011). Considering business operations, risk refers to a firms inability to meet the set financial obligations (Reuvid, 2012). On the other hand, risk in financial terms is calculated based on the value of debt that a firm uses to finance the assets. Therefore, a firm is inherently in danger of three types of risks namely business risk, financial risk, and non-business risks. In this regard, business risks are the risks incurred by a business entity so as to maximize profits and add shareholder, for instance, a company undertaking high risks when launching new products in order to record higher sales (Reuvid, 2012). On the contrary, financial risks are the uncertainties involving the financial losses to the firms. In this case, a financial risk arises because of instability and imminent losses within the financial market always subject to shifts in the currencies, stock prices, and interest rates (Christoffersen, 2011). Therefore, it is imperative to discuss some of the common business and financial risks faced by firms and as such, outline the approaches that modern organizations use to minimize the risks. Business and Financial Risks Interest rate risks An interest rate risk is the loss that occurs due to changes in the charged interest rates. Simply put, an interest rate risk is an uncertainty that changes the value of the investment that occurs due to the change in the level of the interest rate (Christoffersen, 2011). The changes in the interest rates usually have a profound effect on the securities, inversely, and firms can also reduce such risks by diversifying their investments or hedging. Financial experts have on many occasions confirmed that interest rates have adverse effects on bond value since it affect the bonds directly than the stocks thus a major risk that confront all bondholders. The implication is that a rise in interest rates signals a fall in bond prices, and the reverse is the case with a drop in interest rates. The rationale behind this relationship is that an increase in interest rates decreases the opportunity cost of holding bonds because investors can switch to other investment opportunities and realize greater yields since they have higher interest rates (Christoffersen, 2011). Nonetheless, the inverse relationship between interest rates and bonds always confuse investors because bonds have lower values with an increase in the interest rates. The implication is that as interest rate levels rise, new issues are presented in the market, meaning higher yields than the older securities thus lowering the value of the older securities and this explains the lowering of their prices (Christoffersen, 2011). On the other hand, a decline in the interest rates translate to a new bond issues in the market that have lower yields relative to the older securities thus the older securities worth more and eventually their prices go up. There are various economic factors or forces attributed to the falling and rising levels of interest rates (Christoffersen, 2011). In effect, interest rates always climb during economic growth and falls with the downturn of the economy. On the other hand, higher inflation rates increase the interest rates and has been the most significant force affecting the interest rate. Foreign exchange risks By definition, a foreign exchange risk is a change in the value of an investment owing to changes in the currency rates (Christoffersen, 2011). On the other hand, the term refers to the risk that an investor must close out in the short or long position in a particular foreign currency, always at a loss, because of the adverse movements in the exchange rates. Besides, some financial experts refer to the risk as currency or risk or the exchange-rate risk. The foreign exchange risk always affects businesses that engage in exportation and importation of goods and services and also affect the investors who operate international investments. Therefore, business operations such as international trade, ownership of the foreign assets, overseas receipts and payments, pension funds, overseas remittances and receipt of the foreign stock dividends are all affected by the foreign exchange risks (Reuvid, 2012). For instance, in the event money have to be changed to the intended foreign currency so as to make an investment, then any imminent change in the particular currency affects the investment value, either increasing or decreasing it, especially during the sale of the investment and conversion of the accrued returns to the original currency. If one is an exporter, for instance, then the local currencys appreciation makes the goods more expensive relative to the foreign currency. The implication is the local currencys appreciation is never attractive for the exporters. On the contrary, for an importer, the local currencys appreciation is attractive because the importer pays more in the local currency for buying an equivalent amount of the foreign currency for the payment of the overseas suppliers. Therefore, the bottom is that failure to reduce or eliminate the foreign exchange risk affects the business negatively. Credit Risks A credit risk can be defined as the loss of financial rewards stemming from the failure of a borrower to repay a particular loan implying that the counterparty fails to meet the contractual obligations (Christoffersen, 2011). Therefore, such risks occur when borrowers expect to use their future cash flows for the payment of the current debts. However, in most cases, firms compensate investors through interest payments from the borrowers. On the other hand, credit risks are closely related to the return of investment, for instance, yields on bonds are firmly related to the perceived credit risk. Nonetheless, the higher rate of the perceived credit risks imply that the interest rates will go up thus investors will charge high for the interests for lending or injecting their capital into the particular business entity. Besides, the credit risks are always calculated based on the overall ability of the borrowers to repay. Moreover, the calculation is inclusive of the collateral assets, taxing authorities and revenue-generating ability (Christoffersen, 2011). For businesses, credit risks involve the failure of the creditors to repay their loans (Reuvid, 2012). However, for banks, large loans are the obvious credit risks, and they can be both on-balance sheet and on-balance sheet. Operations risks Operational risk, by definition, refers to the overall risk that a firm or a company must undertake when attempting to operate within a particular industry or field (Reuvid, 2012). On the other hand, it is the risk that is not part of the financial, systematic or the market-wide risk. Thus, the operational risk remains after a firm has determined the financing as well as systematic risk. In this case, such risks include those resulting from the breakdowns in the entire internal processes of the organization, systems and the people within the organization. Nonetheless, it is accurate to infer that operational risks are the human risks, implying that these are the uncertainties emanating from human error (Reuvid, 2012). Moreover, operational risks are industry specific; thus changes from one industry to the other. Therefore, such risks are essential elements to consider when making or considering potential investment decisions. Briefly, industries characterized by lower human interactions have least operational risks compared to those with higher levels of human interactions (Reuvid, 2012). Some forms of the operational risks include employee errors, systems failure, fraud and other criminal activities and events that disrupt the entire business operations (Reuvid, 2012). Therefore, in most cases, organizations do accept the interaction between people and processes will result in errors thus contributing to the ineffectiveness of the business operations. In this regard, evaluation of the potential risks should focus on the elimination of the exposures as well as making sure that there is a success in response to such issues (Christoffersen, 2011). The implication is that poor management of risks has the potential of hurting the reputation of an organization and can also cause financial damages. Commodity Risks Commodity risks, simply put, are the uncertainties over the expected levels of profits from the purchase as well as the sale of products (Reuvid, 2012). On the other hand, the risk refers to the threat brought about by the change in the price of an input of production used by producers of particular commodities. Therefore, the commodity production inputs are the raw materials including cotton, wheat, corn, oil, copper, steel, aluminum, sugar and soybeans among others (Reuvid, 2012). Some of the factors or risks affecting prices of commodities include regulatory and political changes, weather, market conditions and seasonal variations. However, the commodity risks are always hedged by the primary consumers of the particular goods. Nonetheless, the unexpected changes in prices of the commodities reduce the profit margins of the producers and as such make it difficult to budget (Reuvid, 2012). However, there are myriad of opportunities available for the producers to protect themselves against such risks. For instance, they can protect themselves from the dangers of fluctuation by implementing or using financial strategies that have the potential to guarantee minimization of the commodity prices (Christoffersen, 2011). On the other hand, organizations or the producers, in this case, use futures and options to hedge the risk of the commodity prices. How organizations measure risks and manage financial risks After the recent financial crisis, characterized by systematic risks as well as high volatility in the market, many financial markets and economies are currently strengthening their risk management approaches. The implication is that there has been an increased reassessment of the business risks as well as the re-evaluation of the business models to help manage the risks effectively (Mikes, 2011). Therefore, there is a variety of risk management methods that businesses can use to mitigate or avoid uncertainties. Some of the primary methods include risk or exposure avoidance, loss reduction, loss prevention and risk financing (Christoffersen, 2011). Exposure avoidance is undoubtedly the best and simple method of avoiding risks as it entails avoiding the products as well as services with high potential for losses. On the other hand, financial risk management is the main focus of modern business entities where firms can pay for the risks by retaining or in some cases, transferring the incurred costs though if there are no available options then a company takes up to incur the losses (Reuvid, 2012). Before venturing into new business opportunity, organizations use various quantitative tools to measure risks. One of the commonly used tools of risk evaluation and measurement is the sensitivity analysis, a tool that measures the NVP of the investment decision and evaluates how it changes with the variation in the input variables, though other factors are always held constant (Mikes, 2011). In this case, the technique uses ‘‘what if questions. A classic example is the determining what happens when sales drop below the expected levels, say 20%. On the other hand, an organization can evaluate and measure what happens when the unit selling price of a commodity falls. In this case, the method measures how long the changes impact on the corporate earnings to the investors. Another equally important tool for measuring risks is using the scenario analysis approach where the approach considers both the sensitivity in variable changes and also the range of values of the variables (Mikes, 2011). Therefore, the organization measures both worst and best scenario of the particular variables and in return compares this to the required rate of return expected by the investor. The analysis makes it possible to derive a risk-premium above the rate of the return on investment that the investor thinks is attractive (Mikes, 2011). Finally, organizations can use the decision tree analysis to measure risks. In this case, the technique is applicable where the particular decision can give out several specified outcomes. On the other hand, the method integrates all the results gotten from both sensitivity and scenario analysis where the quantitative numbers are shown in a tree sequence with an indication of one branch leading to another investment decision (Mikes, 2011). In return, the tool makes an organization to determine the possibility of losing a given amount of money when a certain investment decision is made. Global Incentives for managing financial risks Collateral usage is one of the global incentives for managing risks in financial markets (Brigham & Ehrhardt, 2013). In this case, the method entails using collaterals, in the form of cash or government securities and thus reduces risk exposure especially when a counterparty defaults the credit obligation. On the other hand, use of collaterals allows the financial institutions to free up their credit facilities that may be unavailable in the real sense. Conversely, payment initiatives are also available in the form of international payment systems (Brigham & Ehrhardt, 2013). In this case, such initiatives help organizations to manage effectively risks, especially from the interconnected global financial communities. There are also the capital adequacy initiatives where there are set capital requirements as the threshold that financial institutions must maintain relative to the banking activities (Brigham & Ehrhardt, 2013). The rationale for capital adequacy is that the most risky activities should be allocated more capital. Accounting and regulatory initiatives are also providing checks on financial risks through international accounting standards (Brigham & Ehrhardt, 2013). In this case, the regulatory initiatives are set to reduce the possible fraudulent activities and financial reporting. Conclusion In a nutshell, there are various business and financial risks that organizations, especially profit organizations must consider before making their investment decisions. From the discussion, it is evident that business must be confronted by foreign exchange risks, credit risks, commodity and operational risks among others. However, businesses are equally equipped with tools for measuring risks including sensitivity analysis, scenario analysis, and decision tree. On the other hand, there are a myriad of opportunities in the global financial markets to help manage possible risks. In this regard, incentives like Collateral usage, payment initiatives, capital adequacy initiatives, as well as accounting and regulatory initiatives are useful in managing global financial risks. References Brigham, E., & Ehrhardt, M. (2013). Financial management: theory & practice. Cengage Learning. Christoffersen, P. F. (2011). Elements of financial risk management. Academic Press. Mikes, A. (2011). From counting risk to making risk count: Boundary-work in risk management. Accounting, Organizations and Society, 36(4), 226-245. Reuvid, J. (2012). Managing Business Risk: A practical Guide to Protecting Your Business. Kogan Page Publishers. Read More