In this lesson, you’re expected to learn about:
– interest rate risk and inflation
– mitigating market risk
– credit and foreign exchange risk
– off-balance-sheet, operating, and liquidity risk
Business finance is filled with risk. In this lesson, we’ll look at some of the more common forms of risk encountered, including those associated with interest rates, inflation, credit and foreign exchanges.
Risk is an inherent, and therefore unavoidable, part of every financial decision that a company makes.
The goal of managing financial risk is to assess the degree of risk associated with each potential option for a given decision, mathematically calculate the probability of it occurring and determine whether the potential losses and probabilities associated with that risk exceed the potential returns.
You can think of risk as a form of cost. No business can avoid 100% of risk all the time and whenever something goes wrong, the company loses money resolving the problem.
The total amount of losses due to the risky nature of financial transactions influences how competitive your business is, the price you should charge for goods, and your company’s profitability.
In general, risk falls into the following categories:
· Interest rate / inflation risk: the risk that interest rates or inflation will exceed your returns.
· Market risk: the risk that the entire economy may do poorly.
· Credit risk: the risk that borrowers won’t repay their loans.
· Off-balance-sheet risk: the risk that something not included on the balance sheet is influencing the value of the company.
· Foreign exchange risk: the risk of losing value through fluctuations in foreign exchange rates.
· Operating risk: risks associated with corporate operations.
· Liquidity risk: the risk of not having enough money available when bills become due.
Types of Risk
1) Interest Rate Risk & Inflation Risk
The majority of products available for investment that yield interest offer fixed rate returns so that when you purchase, say, an investment that offers a 1% annual interest rate, you’re going to earn 1% annually.
When you earn a fixed 1% interest on an investment, no matter how high inflation rates go or whether interest rates go up or down during that period, you still earn only 1%.
This risk of losing value on assets, because the interest rates you earn have the potential to lag behind market rates or inflation rates, is called interest rate risk.
The risk that inflation will surpass your assets is often categorized as a special type of interest rate risk known as inflationary risk.
2) Minimizing Market Risk
A company chooses only the best customers and best investments, uses derivatives only to mitigate potential losses, diversifies clients and investments, and does everything right to reduce the risk associated with every dollar.
However, no matter how successful you are at managing the risk of your company, the possibility is always present that the nation in which you’re operating experiences total economic meltdown, which is known as market risk.
The majority of company owners and managers have no idea how to recognize the warning signs of a recession in the near future. But a company can take steps to mitigate the amount of loss associated with market risk such as implementing international diversification or the use of derivatives.
An advantage for companies of these recessionary periods is that the pool of potential employees all competing for a limited number of jobs increases. This competition allows your company to acquire labor at cheaper prices, helping to decrease costs during an otherwise difficult period.
3) Evaluating the Risk of Extending Credit
Credit is a form of loan. Companies frequently provide their goods or services to customers on credit, which means that they expect to get paid at some later date. Extending credit is common for car dealerships and other companies that deal in goods that are considered expensive for customers to purchase.
Offering credit sounds like a great idea for the company. More expensive items can be quite difficult to purchase all at once, so allowing customers to make purchases on credit improves their ability to afford the company’s products. This strategy also helps companies generate revenues by earning interest on those sales made on credit.
Credit risk is typically assessed on an individual basis, with customers being evaluated on the following criteria:
– book value: ensures that if they default, collateral is available to pay back the loan.
– cash flow: determines whether they have the cash to pay off the loan.
– payment history: checks how they paid back previous loans.
Most companies determine the interest rate they charge based on the level of risk incurred. On average, a customer who’s a higher credit risk incurs greater costs for the company and so the company charges a higher interest rate to make up for the higher costs.
This strategy is debatable because the higher interest rate also increases the risk that the person defaults.
Many financial activities and transactions don’t influence the balance sheet as much as the actual transaction may imply.
These instances of off-balance-sheet activity are typically considered to be contingent assets and contingent liabilities, which are only realized if some future event takes place to trigger the transaction.
This problem can cause financial mismanagement on the part of the company and misled investments on the part of investors. When doing balance-sheet analysis using ratios, always take into account any off-balance-sheet transactions, which you can find within the accompanying notes to the balance sheet.
Different countries use different currencies. These different types of money change value at different rates and so the value of money in one nation can change compared to the value of another nation’s currency.
For instance, we know that exchange rates change. That is one result of a change in the value of a currency. Another result when money changes value is a change in the value of everything measured using that currency. The change in value creates a special class of risks called foreign exchange risk, where a change in the value of money between nations causes a change in the value of exchanges or a change in the value of foreign-held assets.
Transaction risk is the risk that a transaction loses value at some point before it’s complete.
Translation risk is the risk that a change in exchange rates makes your foreign-held assets worth less when exchanged into your home nation’s currency.
– If a company expects to repatriate its foreign cash assets by bringing them back to its home nation and then exchanging them into the home nation’s currency, the company gets less currency than it expected prior to the change in the foreign exchange rate.
– A fluctuation in exchange rates can have a significant impact on the balance sheet of a company. Any assets denominated in a foreign currency cause a decrease in the book value of the company as a whole if that currency depreciates against the home currency. This depreciation has the ability to alter the ability of a company to attract capital because the proportion of debt to total assets increases when the total asset value decreases.
Two other forms of risk are associated with holding foreign assets:
i) Convertibility risk: you may have a foreign currency on hand but you may not be able to convert it into another currency. Some currencies can be extremely difficult to exchange for more common currencies simply because no one wants them.
ii) Repatriation risk: reflects the possibility that a foreign government may decide to cap or even prohibit any assets from leaving the nation. This policy is usually adopted by nations with very small or volatile economies.
For our purposes, operating risk is the probability of any non-value-added costs being incurred as a result of a company’s internal operations.
This occurs when you have money owed to you but not enough to pay your bills in the meantime. The most extreme form of liquidity risk, insolvency, occurs when a company is completely incapable of paying the money it owes and must enter into administration (to restructure or minimize debt), sell its operating assets to make the payments it owes or simply go out of business by way of liquidation (which means that an insolvency practitioner sells off the company’s assets to pay creditors).
Insolvency doesn’t necessarily occur when a company is doing poorly. In fact, it can happen just as easily when a company is too successful.
Liquidity risk can also be derived simply from poor financial management. If a company generates too much of its capital from debt, it may find itself in a position where it can no longer afford to make the interest payments and needs to consider raising equity to decrease the interest payments.
This led to many of even the largest banks becoming insolvent as a result of liquidity risk. Many banks went out of business and some of the largest banks in the world required government assistance, most at the taxpayers’ expense.