Risk Management Long Answer Type Questions

Question 1.
Explain nature and importance of risk management.
Answer:
In today’s world, managing corporate risks is a daunting task. The last few decades have seen a substantial increase in the average rate, as well as the volatility, of inflation. The increased uncertainty about inflation has been followed by greater volatility in interest rates, exchange rates, and commodity prices. Global competition has intensified in the wake of reduced tariff barriers.

The entire process of identifying, evaluating, controlling and reviewing risks, to make sure that the organisation is exposed to only those risks that it needs to take to achieve its primary objectives, is known as ‘risk management.’ Risk management is a proactive process, not reactive. In different markets or sectors there are different types of risks and so, the risk management procedures and techniques vary in their application ways but the target is same; putting the risks under control and accomplishing the mission as expected.

Risk cannot be eliminated. However, it can be:

Transferred to another party, who is willing to take risk, say by buying an insurance policy or entering into a forward contract.
Reduced, by having good internal controls.
Avoided, by not entering into risky businesses.
Retained, to either avoid the cost of trying to reduce risk or in anticipation of higher profits by taking on more risk.
Shared, by following a middle path between regaining and transferring risk.

There are various tools available to the management to manage risks. Some of them being, derivative products like Forwards, Futures, Options and Swaps. The others involve having better internal controls in place, due diligence exercises, compliance with rules and regulations, etc.

In coping with the challenge of risk management, the following interrelated guidelines should be considered:

Understanding the firm’s strategic exposure
Employing a mix of real and financial tools
Proactively managing uncertainty
Aligning risk management with corporate strategy
Learning when it is worth reducing risk

Managing risk is considered important; it comes next only to minimizing borrowing costs and maintaining / improving the firm’s, credit. Firms often reduce some exposures, leaving others unhedged, the principal emphasis being on hedging transaction exposures.

Question 2.
Discuss classification of risk.
Answer:
Risks are Classified into Major Categories
(1) Systematic Risks are out of external and uncontrollable factors, arising out of the market, nature of the industry and the state of the economy and a host of other factors.

(2) Unsystematic Risks emerge out of the known and controllable factors, internal to the issuer of the securities or companies.

Examples of Systematic Risks:
(i) Market Risk: This arises out of changes in Demand and Supply pressures in the markets, following the changing flow of information or expectations. The totality of investor perception and subjective factors influence the events in the Market which are unpredictable and give rise to risk, which is not controllable.

(ii) Interest Rate Risk: The return on an investment depends on the interest rate promised on it and changes in market rates of interest from time to time. The cost of funds borrowed by companies or stockbrokers depend oh interest rates. The market activity and investor perceptions change with the changes in interest rates.

(iii) Purchasing Power Risk: Purchasing power risk is also known as inflation risk. This risk arises out of change in the prices of goods and services and technically it covers both inflation and deflation periods. During the last two decades, it has been seen that inflationary pressures have been continuously affecting the Indian economy.

Examples of Unsystematic Risks:
(i) Business Risk:
This relates to the variability of the business,-sales, income, profits etc. which in turn depend on the market conditions for the product . mix, input supplies, strength of competitors, etc. This business Risk is sometimes external to the company due to changes in govt, policy or strategies of competitors or unforeseen market conditions. They may be internal due to fall in production, labour problems, raw material problems or inadequate supply of electricity etc. The Internal Business Risk leads to fall in revenues and in profit of the company, but can be corrected by certain changes in the company’s policies.

(ii) Financial Risk:
This relates to the method of financing, adopted by the company, high leverage leading to larger debt servicing problems or short¬term liquidity problems due to bad debts, delayed receivables and fall in current assets or rise in current liabilities. These Problems could no doubt be solved, but they may lead to fluctuations in earnings, profits and dividends to shareholders. Sometimes, if the company runs into losses or reduced profits, these may lead to fall in returns to investors or negative returns. Proper financial planning and other financial adjustments can be used to correct this risk and as such it is controllable.

(iii) Default or Insolvency Risk:
The borrower or issuer of securities may become insolvent or may default, or delay the payments due, such as interest instalments or principal repayments. The borrower’s credit rating might have fallen suddenly and he became’default prone and in its extreme form it may take to insolvency or bankruptcies. In such cases, the investor may get no return or negative returns. An investment in a healthy company’s share might turn out to be a waste paper, if within a short span, by the deliberate mistakes of Management or acts of God, the Company became sick and its share price tumbled below its face value.

Other Risks:
(i) Industry risk: Changes in the environment of a particular industry may introduce a great deal of risk and cause securities connected to that industry to decline. Diversification can help to counter this risk because industries don’t usually all underperform simultaneously.

(ii) Stock-specific risk: Events that impact a particular company can have a monumental effect on the company’s stock. The potential problems that can arise at-a given company can infuse a great deal of risk into a particular stock. Again, this type of risk can be combated by diversification because not all companies experience problems at the same time.

(iii) Liquidity risk: An investment may need to be sold before its maturity in order to extract the invested funds. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from it. There can also be significant fees associated with liquidating some investments before a certain time. By the same token, the need to liquidate will eliminate the possibility of earning returns that would have been expected if the investment were held as long as expected.

(iv) Principal risk: There is always the possibility that through some set of circumstances, invested money will decrease or completely disappear. In this case, principal is lost in addition to returns and expected returns. If the invested money is essential, it will have to be replaced in some way.

(v) Currency risk: If money must be exchanged to make a certain investment, changes in the value of the currency relative to the American dollar will affect the total loss or gain on the investment when the money is converted back. This risk usually affects businesses, but it can also affect individual investors who make international investments.

(vi) Inflation risk: Although all investing decisions involve risk, simply not investing is not the answer. Inflation causes money to decrease in value at some rate. So inflation risk occurs whether you invest or not. It is up to you to choose investments that outpace inflation; otherwise, invested money will gradually lose value even if the principal invested is increasing at some rate. Thus theoritically risk can be minimised and eliminated but practically risk can be minimised but not totally eliminated in investment.

Question 3.
Explain the techniques of risk analysis.
Answer:
Three modern methods of risk analysis:

Sensitivity Analysis
Probability Analysis
Expected Values

1. Sensitivity Analysis:
Sensitivity analysis is a simulation technique in which key variables are changed and the resulting change in the rate of return or [the NPV] is observed. Some of the key variables are cost, prices, project life, market share, etc. The most practical way to do this is to select those variables whose estimated values may contain some significant errors or an element of uncertainty and then to calculate the effect of errors of different sizes on the present value of the project.

The common operating mechanism would be to vary each strategic variable by certain fixed percentages in both positive as well as negative directions in turn, say plus or minus 10% or plus or minus 5% etc. and study the effect of change on the rate of return [or on NPV].
It is an effective tool to handle risk in project appraisal. However, there are certain limitations in using this tool.
(a) Unless the combined effect of change in a set of Inter-correlated variables is examined, single variable sensitivity testing could be worse than useless. It may lead to wrong conclusions. Hence, it is a very difficult task.

(b) The second limitation lies in the fact that the values of the variables are generally changed in an arbitrary manner by say 5% or 10% to examine the effect on the returns. Unless it is done in a meaningful manner, it might mislead the investor.

2. Probability Analysis:
Probability may be defined as a measure of some one’s opinion about the likelihood that an event (cash flow) will occur. The likelihood of occurrence normally ranges from 1 to 0 i.e., 100 per cent certainty to 100 per cent uncertainty. In this analysis, in the place of one single estimate a range of estimates and their associated probabilities are calculated. A probability distribution in its simplest form could be with a few estimates such as “optimistic”, “pessimistic” and “most likely”.

The real problem; however, is how this probability distribution can be obtained. Two types of probabilities which include objective and subjective are normally used for decision-making under uncertainty.

The objective probability is the probability estimate, which is based on a very large number of observations. Subjective probabilities are those probability measures, which are based on the state of belief of a person rather than the objective evidence of a large number of trials. As the capital expenditure decisions are mostly non-repetitive and not made under identical situations, only.subjective probabilities are useful.

3. Expected Values [EV]:
EV is the sum of products of estimated outcomes and their respective probabilities. In advance, while uncertainty refers to a situation where such probability distribution cannot be objectively known, but only guessed. However, in the case of investment decisions, such a theoretical distinction is hypothetical and may not serve much useful purpose in practice. Even the best estimates of the project manager regarding the probability of the expected cash flows materializing and their magnitude are only subjective guesses. Hence, both risk and uncertainty are used interchangeably to mean the same thing.

Some of the factors, which add to the degree of risk or uncertainty of an investment, are the possibilities of –

The process or product becoming obsolete
Declining demand for the product
Change in government policy on business
Price fluctuations
Foreign exchange restrictions
Inflationary tendencies

Question 4.
Explain briefly exchange rate fluctuations.
Answer:
Exchange rate fluctuations are the increases or decreases in the value of a currency as against the other currency at international levels. These fluctuations are a part of international financial markets. The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market. The changes in the value of one currency against another country’s currencies is termed to be exchange rate fluctuations.

In India, RBI acts as the Exchange Control Authority. Its one of the important functions is maintenance of external value of the rupee. The dealings in foreign exchange and foreign securities in India, payments to person resident outside and export and import of currency notes, bullion or precious stones etc. are subject to general or special permissions of RBI or are prohibited. The types of transactions that are controlled by the RBI and the government of India are in general and include the following important items :

Purchase and sale and other dealings in foreign exchange and maintenance of balances at foreign centres by residents.
Procedure for realisation of proceeds of exports of goods and services.
Payments to non-residents or to their accounts in India for imports and others.
Transfer of securities as between residents and non-residents and acquisition and holding of foreign securities.
Foreign travel
Export and import of currency, cheques, drafts, travellers cheques and other financial instruments, securities, gold, jewelleries etc.
Trading commercial and industrial activities in India of. foreign companies, employment etc.
Acquisition, holding and disposal of immovable property in Or outside India by foreigners or Indian residents.

Question 5.
What is foreign exchange exposure? Discuss the three kinds of exposures.
Answer:
Foreign exchange Exposure is sensitivity of real value of an undertaking’s, assets, liabilities, or operating incomes, expenses in its functional currency to unanticipated changes in Exchange rates.

The three kinds of exposures are explained as follows:
(i) Economic exposure: Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Any anticipated changes in. exchange rates would have been already discounted and reflected in the firm’s value.. The changes’ in exchange rates can have a profound effect on the firm’s competitive position* in the world market and thus on its cash flows and market value.

(ii) Transaction exposure: Transaction exposure can be defined as the sensitivity of realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Transaction exposure arises from fixed price contracting in a world where exchange rates are changing randomly.

(iii) Translation exposure: Translation exposure refers to the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates. Consolidation involves translation of subsidiaries’ financial statements from local currencies to the home currency.

Question 6.
Explain the various tools and techniques of foreign exchange risk management.
Answer:
Foreign exchange risk management is linked with unexpected fluctuations in the value of currency. It consists of spot, forward and future market. The various tools and techniques of foreign exchange risk management are as follows:
(i) Managing transaction exposures: A transaction exposure arises, when even a company is committed to a foreign currency denominated transaction entered into before the change “in exchange rate. So it basically refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuation.

The various methods of managing transaction exposures are:

Forward market hedge
Money market hedge
Options market hedge
Exposure netting.

In a forward market hedge, a company that is long in a foreign currency will sell the foreign currency forward, where as a company that is short in a foreign currency will levy the currency forward. In this way the company can fix the dollar value of future foreign currency cash flow.

A money market hedge involves simultaneous borrowing and lending activities in two different currencies to lock in the home currency- value of a foreign currency cash flow. Currency option nullify the uncertainty which the firms faces, whether they should yo for hedging of foreign currency cash inflows or outflows.

Lastly, exposure netting involves off-setting exposures in one currency with exposures in the same or other currency, where exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure.

(ii) Exchange exposures: There are various methods available by which a firm can hedge exchange exposures if it wishes.
There is no thumb rule that firm should hedge. But at the corporate level there are various resource available in favour of exposure management:

Information asymmetry: Management is aware about the firm’s exposure position much better than share holders, so management should manage exchange exposure.
Transaction cost: The firm is in a better position to acquire low cost hedges and hence transaction costs can be significantly reduced.
Default cost: In corporate hedging, profitability of default is significantly lower. This in turn, can lead to a better credit rating and lower financing costs.

(iii) Managing economic exposures: Economic exposure refers to the extent to which the economic value of a company can decline due to changes in exchange rate. It is basically the overall impact of exchange rate changes due to changes in exchange rate.

Managing economic exposure is very important in the long run health of an for the organisation than managing transaction or translation exposure. The following are some proactive marketing and production strategies which a firm can pursue in response to anticipate or real exchange rate changes

Marketing Initiatives:
(i) Marketing selection: Market selection is the main important factor for an exporter. Foreign currency devaluation and home currency depreciation should be taken care of.

(ii) Pricing strategy: Pricing strategy is another very crucial aspect of managing economic exposure. A firm selling overseas should follow a standard economic proposition of setting the price that maximizes dollar profit.

(iii) Product strategy: Exchange rate changes can also be responded by using the new product development strategy which consists of two major components –

Product line decisions
Product innovations

(iv) Promotional strategy: Promotional strategy should be taken into consideration for anticipated exchange rate changes. A key issue in any marketing programme is the size of the promotional budget.

Production Initiatives:
(i) Product sourcing: MNC’s with worldwide production systems can allocate production among their several plans in line with the changing home currency cost of production, increasing production in a notion whose currency has devaluated and -decreasing production in a country where there has been a revaluation.

(ii) Plant location: A firm whose currency has devaluated and who exports to other countries find suitable to establish in the third country.

(iii) Input mix: Out sourcing is one of the solutions for devaluing currency and it gives flexibility to shift purchases of intermediate inputs towards suppliers which is least affected by exchange rate changes.

(iv) Raising productivity: Raising productivity through closing inefficient plants, automating heavily and negotiating wage and work rule concession is another alternative to manage economic exposure.

Question 7.
Explain the nature of country risk analysis. OR Discuss the various country risk indicators.
Answer:
Country risk is an indispensable tool for asset management as it requires the assessment of economic opportunity against political odds.
The factors that affect the country risk can be divided into two parts:

Political Factors
Economic factors

The various indicators of political and economic factors are discussed below:
I. Political risk Indicators : Political risk indicators are very difficult to measure for a particular country. Some of the common forms of political risk indicators include:
(i) Stability of local political environment: The political risk of each of the nations are analysed here. Measures like cognizance of changes in the government, levels of violence, internal and external conflict etc. are used.

(ii) Consensus regarding priorities: This measures the degree of agreement and unity on fundamental objectives of government policy and the extent to which this consensus cuts across party lines.

(iii) Attitude of host government: A variation will be when the MNC’s satisfy the needs, wants and demands of the local people, but faces the hostile attitude of the host government.

(iv) War: If war is possible, then the safety of hired people/employees would be affected and at the same time the cash inflows will be uncertain in nature.

(v) Mechanisms for expression of discontent: This is related to the ability of effecting peaceful change, providing internal continuity to alter direction of policy without major changes of political system.

II. Economic Risk Indicators: Economic factors also should be considered while assessing country risk: Some of the economic factors can be as follows –
(i) Inflation rate: Inflation rate is used to measure the economic instability, disruption and government mismanagement and also affects the purchasing power of consumers.

(ii) Current and potential state of country’s economy: The company, which is having a subsidiary to another country and/or exports is highly concerned, with the country’s demand for the product, as this demand is strongly influenced by country’s economy.

(iii) Resource Base: The resource base of a country consists of its natural, human and financial resources. Effective and efficient use of these resources will have less economic risk and vice versa.

(iv) Adjustment of external shocks: The ability of a country to handle external shocks is another important factor in economic analysis.

Question 8.
Explain the risk return trade-off for current asset financing.
Answer:
A firm can adopt different financing policies in relation to current assets. Three types of financing may be distinguished.
Long Term Financing – The sources of long term financing include ordinary share capital, preference share capital, debentures, long term borrowings from financial institutions and retained earnings.

Short Term financing: It is obtained for a period less than one year. It is arranged in advance from banks and other suppliers of short term finance in the money market.

Spontaneous financing: It refers to the automatic sources of short term funds arising in the normal course of a business. Trade credit and outstanding expenses are examples of this type.

Short Term Vs Long Term Financing: A Risk – Return Trade – off. A firm should decide whether or not it should use short term financing. If short term financing has to be used, the firm must determine its portion in total financing. This decision of the firm will be guided by the risk-return trade – off. Short term financing may be preferred over long term financing for the reasons: (i) the cost advantage and (ii) flexibility. But short term financing is more risky than long term financing.

Cost: The justification for the higher cost of long term financing can be found in liquidity preference theory. This theory state that since lenders are risk averse, and risk generally increases with the length of lending time, most lenders would prefer to make short term loans. The only way to induce these lenders to lend for longer periods is to offer them higher rates of interest. Both short term and long term financing have a leveraging effect on shareholder’s return. But the short term financing ought to cost less than the long term financing; therefore it gives relatively higher return to shareholders.

Flexibility: It is relatively easy to refund short term funds when the need for funds diminishes. Long term funds such as debentures cannot be refunded before time.

Risk: Although short term financing may involve less cost, it is more risky than long term financing. If the firm uses short term financing to finance its current assets, it runs the risk of renewing, borrowings again and again.

It may be difficult for the firm to borrow during stringent credit periods. At times, the firm may be unable to raise any funds and consequently, its operating activities may be disrupted. In order to avoid failure/the firm may have to borrow at most inconvenient terms. These problems are much less with long term funds.

Risk-Return Trade-off: Thus, there is a conflict between long term and short term financing. Short term financing is less expensive but at the same time involves greater risk than long term financing. The choice between long term and short-term financing involves a trade off between risk and return.