Chapter 12: Risk management

Chapter learning Objectives

Upon completion of this chapter you will be able to:

• describe capital investment monitoring and risk management systems and analyse the factors which would influence the extent to which they could be established in a firm
• suggest appropriate capital investment monitoring and risk management systems in a scenario question
• define and distinguish between risk mitigation, hedging and diversification strategies
• discuss the factors which would influence the choice of risk mitigation, hedging and diversification strategies in the development of a framework for risk management
• suggest an appropriate framework for risk management in a scenario question
• describe political risk, explain how it can be measured and evaluate the strategies available to mitigate it
• describe and evaluate economic risk and describe the strategies available to mitigate it
• describe regulatory risk and describe the strategies available to mitigate it
• describe fiscal risk and describe the strategies available to mitigate it
• assess the exposure of a given firm to political, economic, regulatory and fiscal risk and suggest strategies for its mitigation
• describe the operation of the derivatives market
• explain the relative advantages and disadvantages of exchange traded versus OTC agreements
• in the context of the derivatives market explain the characteristics and relevance of standard contracts, tick sizes, margin requirements and margin trading
• explain the methods of incorporating risk in an investment appraisal, such as expected values, simulation, sensitivity analysis, and CAPM
• explain the concept of Value at Risk (VaR) and calculate the VaR at a given confidence level.

1 Risk policy formulation

An important part of the financial manager's role and responsibility is considering how risk is to be managed.

The control and mitigation of risk costs money and takes upmanagement time, so it is critical that we can understand the benefitsof risk management and compare these to the costs to assess whether arisk management strategy is worthwhile.

Paper P1 covered managing and controlling risk in some detail. Thissection initially introduces an overview of risk management in relationto capital investment projects, then explains some specific examples ofrisks. More detailed techniques for risk management, such as the use ofderivatives and Value at Risk (VaR), are covered later in the chapter.

Student Accountant article

Read Shishir Malde's "Risk Management" article in the September2010 issue of Student Accountant magazine for more details on whycompanies need to manage risk. 

Risk and stakeholder conflict

• Shareholders will invest in companies with a risk profile that matches that required for their portfolio.
• Management should thus be wary of altering the risk profile of the business without shareholder support.
• An increase in risk will bring about an increase in the required return and may lead to current shareholders selling their shares and so depressing the share price.
• Inevitably management will have their own attitude to risk. Unlike the well-diversified shareholders, the directors are likely to be heavily dependent on the success of the company for their own financial stability and be more risk averse as a consequence.

Risk and policy decisions

The financial manager will need to make policy decisions in the following areas:

• Type of business area
• Operating gearing
• Financial gearing
• Accuracy of forecasts

Risk and policy decisions

Type of business area

Based on the risk appetite of the firm, decisions must be takenabout those types of activity suitable for investment. This will involvedecisions about the acceptability of:

• economic volatility of the industry
• degree of seasonality
• intensity of competitor action.

Operating gearing

The level of operating gearing of the firm is the proportion offixed costs to variable in the cost structure. Whilst some industriesare destined to have higher levels of operating gearing than others(compare the travel industry with manufacturing for example), policydecisions about what level is acceptable will drive choices aboutfactors such as:

• outsourcing v. providing internally
• leasing v. buying
• full-time staff v. freelance providers.

Financial gearing

More fully discussed elsewhere, increasing debt levels can reducethe cost of finance but increases the risks of bankruptcy as the sametime. Directors must decide what level of gearing they are prepared toaccept.

Accuracy of forecasts

The success of any planned investment programme will rely heavilyon the accuracy of forecasts of future cash flows (in and out) and anNPV assessment also relies on an accurate calculation of the discountrate. The sensitivity of these forecasts can be calculated, and theprobability of the variation assessed, but in the end the directors mustdecide what level of risk they are willing to accept in order to acceptor reject the project.

2 The risk framework

All projects are risky. When a capital investment programme commences, a framework for dealing with this risk must be in place.

This framework must cover:

• risk awareness
• risk assessment and monitoring
• risk management (i.e.strategies for dealing with risk and planned responses should unprotected risks materialise)

Risk awareness

In appraising most investment projects, reliance will be placed on alarge number of estimates. For all material estimates, a formal riskassessment should be carried out to identify:

• potential risks that could affect the forecast
• the probability that such a risk would occur.

Risks may be:

• strategic
• tactical
• operational.

Once the potential risks have been identified, a monitoring process will be needed to alert management if they arise.

Different types of risk

Strategic risks are those affecting the overall direction andoutcome of the project, such as changes in macroeconomic factors orchanges in corporate policies.

Tactical risks affect the way the various parts of the project areinterlinked, the way resources are acquired or the way in which thebusiness functions involved in the project are run.

Operational risks are those affecting the day to day running of the project.

Test your understanding 1

Suggest strategic, tactical and operational risks that would affect the estimates on a typical investment project.

Risk assessment and monitoring

A useful way to manage risk is to identify potential risks (usuallydone in either brainstorming meetings or by using external consultants)and then categorise them according to the likelihood of occurrence andthe significance of their potential impact.

Decisions about how to manage the risk are then based on the assessment made.

These assessments may be time consuming and the executive will need to decide:

• how they should be carried out
• what criteria to apply to the categorisation process and
• how often the assessments should be updated.

The essence of risk is that the returns are uncertain. As timepasses, so the various uncertain events on which the forecasts are basedwill occur. Management must monitor the events as they unfold,reforecast predicted results and take action as necessary. The degreeand frequency of the monitoring process will depend on the significanceof the risk to the project’s outcome.

Specific risk assessment and monitoring methods

Internal audit

Many companies set up internal audit departments to assist them in their responsibility to monitor and manage risk.

It is not the job of the internal audit department to monitorresults and perform risk assessments, but they can provide valuablesupport in the creation and successful running of such monitoringsystems.

Information systems

Information systems play a key part in effective risk monitoring.Once risk factors have been identified, information systems must be putin place to ensure that any changes affecting project estimates are:

• recorded
• brought to the attention of the responsible manager
• dealt with in an appropriate way.

This will usually include:

• management information systems (MIS)
• executive information systems (EIS).

These systems are expensive to set up and the executive team mustdecide on the extent to which they wish to use them and the scoperequired.

The difference between them is:

• Management information systems – feeding back operational data to allow for action to prevent or mitigate risk.
• Executive information systems – bringing senior executives up-to-date with external information such as competitor action, currency fluctuations and economic forecasts as well as providing summarised operational data.

3 Risk management

Strategies for dealing with risk

Risk can be either accepted or dealt with. Possible solutions for dealing with risk include:

• mitigating the risk – reducing it by setting in place control procedures
• hedging the risk – taking action to ensure a certain outcome
• diversification – reducing the impact of one outcome by having a portfolio of different ongoing projects.

More on mitigation, hedging and diversification

Mitigation

• All companies should have in place a comprehensive system of controls. These controls play an essential role in good corporate governance and mitigate risk by working to prevent, or detect and correct potential risks before they become a problem.
• Management would be expected to implement controls over most material risks subject to the following:
  • The cost of the control should not be disproportionate to the potential loss.
  • For non-routine events it may be more practical to devise a specific strategy for dealing with the risk should it arise.

Controls are covered extensively in Papers F8 and P1.

Hedging the risk

• Hedging is a strategy, usually some form of transaction, designed to minimise exposure to an unwanted business risk, commonly arising from fluctuations in exchange rates, commodity prices, interest rates etc.
• It will often involve the purchase or sale of a derivative security (such as options or futures) in order to reduce or neutralise all or some portion of the risk of holding another security. This is dealt with in detail later in this chapter.
• A perfect hedge will eliminate the prospects of any future gains or losses and put the company into a risk-free position in respect of the hedged risk.
• This strategy may be chosen where the downside risk would have serious negative consequences for the firm, and the costs of hedging (including the chance to participate in any upside) are outweighed by the benefits of certainty.

Diversification

• This involves reducing the impact of one outcome by having a portfolio of different ongoing projects.
• Within the context of a single project, this may take the form of selling to a number of different customers to reduce reliance on a single one or sourcing from a number of different suppliers.
• For businesses operating internationally, it may involve locating key parts of the business in different countries.
• Diversification would be chosen wherever reliance on a single source of resource has been identified as a potential risk.

The 4T approach to risk management

A company can adopt four possible approaches to a risk, known as the 4T approach:

• Tolerate it.
• Transfer it.
• Terminate it.
• Treat it (i.e. by mitigating it, hedging or diversifying).

Potential risks are often categorised according to the likelihoodof occurrence and the significance of their potential impact. Anappropriate response can then be adopted. This method was covered inPaper P1 and is summarised here:

Appropriate responses would be matched to the risk as shown above.

Tolerate

Accept that the risk might occur but do not put in place anysystems to manage it. For example, a power failure may cause a seriousproduction stoppage but few firms would consider acquiring a back-upgenerator. However a call centre, heavily reliant on its computersystem, may decide that it would be worthwhile.

Transfer

The risk is passed on elsewhere. This can be achieved by activities such as:

• insuring against the risk (for example against the risk of fire)
• taking out fixed price contracts (such as with construction companies or suppliers)
• outsourcing production (buying in from a range of providers rather than relying on own production).

Terminate

This can mean deciding against the activity altogether, but in thecontext of a project, would mean identifying at what point it would bebetter to ‘bail out’ rather than proceed with the project – i.e.when the NPV of the revised future cash flows is negative.

Treat

A risk is treated when controls are in place to reduce either:

• the likelihood or
• the consequences

of the event occurring.

Illustration of the 4T approach

A leisure company has just approved a large-scale investmentproject for the development of a new sports centre and grounds in amajor city. The forecast NPV is approximately $6m, assuming a timehorizon of five years steady growth in business and constant returns inperpetuity thereafter.

(a) What would the company need to do, to ensure that the risks associated with the project were properly managed?

(b) A number of specific risks have been identified:

Suggest how these risks could be best managed.

Solution

(a)

(b) The identified risks could be mapped as shown below:

(1) The risk of a lawsuitshould be dealt with my taking out indemnity insurance. The risk is thentransferred to the insurance company.

(2) The risk of pool closureis serious and since a provision of a pool is clearly essential for thesports centre, the risk must be treated instead. This would meanputting in place a series of controls over the building process toprevent later cracks from occurring.

(3) The risk of fraud is exactly the type of risk that a good internal control system would be designed to prevent.

(4) Bad weather will alwaysbe a risk when dealing with outdoor activities and is probably bestaccepted and the lost revenues factored into the initial forecasts.

4 Specific types of risk

Political risk

Political risk is the risk that a company will suffer a loss as aresult of the actions taken by the government or people of a country. Itarises from the potential conflict between corporate goals and thenational aspirations of the host country.

This is obviously a particular problem for companies operatinginternationally, as they face political risk in several countries at thesame time.

Sources, measurement and management: political risk

Sources of political risk

Whilst governments want to encourage development and growth thereare also anxious to prevent the exploitation of their countries bymultinationals.

Whilst at one extreme, assets might be destroyed as the result ofwar or expropriation, the most likely problems concern changes to therules on the remittance of cash out of the host country to the holdingcompany.

Exchange control regulations, which are generally more restrictive in less developed countries for example:

• rationing the supply of foreign currencies which restricts residents from buying goods abroad
• banning the payment of dividends to foreign shareholders such as holding companies in multinationals, who will then have the problem of blocked funds.

Import quotas to limit the quantity of goods that subsidiaries can buy from its holding company to sell in its domestic market.

Import tariffs could make imports (from the holding company) more expensive than domestically produced goods.

Insist on a minimum shareholding, i.e. that some equity in the company is offered to resident investors.

Company structure may be dictated by the host government –requiring, for example, all investments to be in the form of jointventures with host country companies.

Discriminatory actions

Super-taxes imposed on foreign firms, set higher than thoseimposed on local businesses with the aim of giving local firms anadvantage. They may even be deliberately set at such a high level as toprevent the business from being profitable.

Restricted access to local borrowings by restricting or evenbarring foreign-owned enterprises from the cheapest forms of financefrom local banks and development funds. Some countries ration all accessfor foreign investments to local sources of funds, to force the companyto import foreign currency into the country.

Expropriating assets whereby the host country governmentseizes foreign property in the national interest. It is recognised ininternational law as the right of sovereign states provided that prompt consideration at fair market value in a convertible currencyis given. Problems arise over the exact meaning of the terms prompt andfair, the choice of currency, and the action available to a company nothappy with the compensation offered.

Measurement of political risk

When considering measurement, distinctions are sometimes made between macro and micro political risk.

Micro political risks are ones that are specific to an industry,company or project within a host country. For example, the tobaccoindustry has faced increasing global opposition since the 1970s, nowheremore so than in the USA. There are increasing threats that tobacco willbe classified as a drug and that companies supplying tobacco may facecontinuing litigation. This has been a consequence of a change in thesocial and political climate in the USA and elsewhere.

By contrast Iraq at the moment presents political risks for almostany organisation who may wish to operate there in terms of the threat ofloss of assets or personnel. This therefore represents macro politicalrisk.

Different methods may be appropriate to measuring different typesof risk. Traditional methods for assessing political risk range fromcomparative techniques such as rating and mapping systems to theanalytical techniques of special reports, expert systems and probabilitydetermination, through to use of econometric techniques of modelbuilding. More recently, option-pricing techniques (using real options)have been applied to the evaluation of political risk associated withforeign direct investment.

Some examples of methods used to measure political risk are indicated below:

• ‘Old hands’ – Experts on the country provide advice upon the risk of investment in a specific country. Experts may include those with existing businesses, academics, diplomats or journalists. The value of the advice depends on how directly it can be applied to the investment under consideration.
• ‘Grand tours’ – The home firm may send a selection of employees to the potential investment country to act as an inspection team. The employees meet government officials, business people and local leaders to gain an understanding of the country first hand. However, this technique is generally considered inferior to the use of advice from well established experts as outlined above.
• Surveys – Commercially produced country political risk indices are available. These are produced by groups of experts using Delphi techniques via the ranking of key risk variables. The experts individually answer a comprehensive questionnaire. Their answers are then collected, aggregated and returned to the experts, who have the chance to change their minds having seen the answers of their peers.
• Quantitative measures – Measures such as GNP and ethnic fractionalisation are combined to give countries an overall score.

Commercially produced indices are available such as the businessenvironment risk index (BERI). This index gives each country a score outof 100, anything below 41 indicating unacceptable business conditions.

The economist political risk Service (PRS) also allocates 100points with 33 going to economic factors such as falling per capita GDP,high inflation, capital flight, decline in productivity and rawmaterials as a percentage of exports. Fifty points go to politicalfactors such as bad neighbours, authoritarianism, staleness,illegitimacy, generals in power, war/armed insurrection. Finally 17points relate to social factors such as urbanisation, corruption andethnic tension.

Often some form of sensitivity or simulation analysis is incorporated to examine the effect of different possible scenarios.

A general risk index offers a cost effective overview of potentialinvestment climates but cannot take account of the variations in risk onindividual projects. It should also be borne in mind that the scoringsystems are essentially subjective.

Management of political risk

There are a number of ways of managing the political risk associated with an investment.

• Planned local ownership

  Target dates can be set on which proportions of company ownership will pass to the local nationals. These should be spread into the long term so that local authorities can see the eventual benefits that will be gained through allowing successful foreign investments.

• Pre-trading/concession agreements

  Prior to making the investments, agreements should be secured with the local government or other authority regarding rights, responsibilities, remittance of funds and local equity investments. This attempts to solve anticipated problems and prevent misunderstandings at some later date.

  The biggest problem with this policy is that host governments in developing countries are very volatile; consequently, agreements made with previous administrations can be repudiated by the new government.

  Wells (1977) argues that the terms of concession agreements will normally change even with the same host government as:

  The terms and conditions required to entice a company to invest in a particular country are different from the terms and conditions required to a company remain, once it has committed and developed its investment. (Remember sunk costs)

  If the multinational is more successful than both parties anticipated in the beginning of the investment, thus the government may want their share of the windfall.

  The agreement will cover transfer of capital, transfer of remittances, transfer of products, access to local capital markets, transfer pricing, taxation and social and economic obligations.

• Political risk insurance

  It may be possible to transfer the risk by taking out insurance. In the UK, the export credits guarantee department (ECGD) provides protection against various threats including expropriation and nationalisation, currency inconvertibility, war and revolution.

During investment

Political risk can be managed on a continuous basis through consideration of the following areas:

• Production strategies

  The decision here is to find the balance between:

  • contracting out to local sources (local sourcing) and losing control
  • producing directly in the host country (increasing investment in host country)
  • importing from outside the host country (foreign sourcing).

  By using local materials and labour it becomes in the interest of the country for the company to succeed. However, following success the locals may then have the knowledge to continue operations alone. Chrysler in Peru imported 50% of components from abroad and thus avoided expropriation of its plant because the plant was worthless without the foreign sourced Chrysler parts.

• Control of patents and processes

  Coca Cola is a prime example of how control of patents reduces political risk. The secret ingredient in Coca Cola has never been divulged. Therefore, Coca Cola can quite happily set up bottling plants worldwide, as the plants are worthless to any host government as they would not be able to create ‘the taste of Coca Cola’. Patents can be enforced internationally.

• Distribution control

  Control and development of such items as pipelines and shipping facilities will deter expropriation of assets.

• Market control

  Securing markets through copywriting, patents and trademarks deters political intervention as the local markets come to depend on ‘protected’ goods.

• Location

  Oil companies frequently mine oil in a politically unstable area but refine it in western Europe. Expropriation of assets would not therefore benefit the less stable countries.

Financing decisions

Political risk may be mitigated by choosing the right location for raising funds:

• Local finance

  As the foreign investment grows, further finance can be raised locally to maintain the authorities’ interest in the success of the business – any damaging intervention would also damage the local institutions. Also the wealthier locals who provide this finance often have considerable power. As a result there is less likelihood of others expropriating the assets. However, the cost of such funds may be relatively more expensive and many governments restrict the ability of multinational to borrow from local money and capital markets.

• Borrow worldwide

  A multinational also has the option of financing worldwide, using institutions from several countries. This discourages expropriation because if the host government intervenes in the company’s operations, default on the loans may cause a diplomatic backlash from a number of countries, not just the multinational’s own parent country. However, it is important to take account of the new risks associated with, for example, foreign exchange and tax, that may be introduced where funds are borrowed overseas.

Economic risk

Economic risk is the variations in the value of the business (i.e.the present value of future cash flows) due to unexpected changes inexchange rates. It is the long-term version of transaction risk which iscovered in detail in the hedging chapters.

In a broader sense, economic risk can also be defined as the riskfacing organisations from changes in economic conditions, such aseconomic growth or recession, government spending policy and taxationpolicy, unemployment levels and international trading conditions.

It affects:

• the affordability of exports and therefore competitiveness
• the affordability of imports and therefore profitability
• the value of repatriated profits.

Examples and management of economic risk

Economic risk is the possibility that the value of the company (thepresent value of all future post-tax cash flows) will change due tounexpected changes in future exchange rates. The size of the risk isdifficult to measure as exchange rates can change significantly andunexpectedly. Such changes can affect firms in many ways:

• Consider the example of a US firm, which operates a subsidiary in a country that unexpectedly devalues its currency. This could be ‘bad news’ in that every local currency unit of profit earned would now be worth less when repatriated to the US. On the other hand it could be ‘good news’ as the subsidiary might now find it far easier to export to the rest of the world and hence significantly increase its contribution to parent company cash flow. The news could, alternatively, be neutral if the subsidiary intended to retain its profits to reinvest in the same country abroad.
• An exporter may suffer different forms of economic risk:

  Direct: If the firm’s home currency strengthens, foreign competitors are able to gain sales at their expense because their products become more expensive (unless the firm reduces margins) in the eyes of customers both abroad and at home.

  Indirect: Even if the home currency does not move vis-à-vis the customers’ currency the firm may lose competitive position. For example, suppose a South African firm is selling into Hong Kong SAR and its main competitor is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong SAR dollar, the South African firm has lost some competitive position.

  Although economic exposure is difficult to measure it is of vital importance to firms as it concerns their long-run viability. Economic exposure is really the long-run equivalent of transaction exposure, and ignoring it could lead to reductions in the firm’s future cash flows or an increase in the systematic risk of the firm, resulting in a fall in shareholder wealth.

Managing economic risk

Note that the recommended methods of mitigating economic exposure, are also suggested as ways of mitigating political exposure:

• Diversification of production and supply.
• Diversification of financing.

If a firm manufactures all its products in one country and thatcountry’s exchange rate strengthens, then the firm will find itincreasingly difficult to export to the rest of the world. Its futurecash flows and therefore its present value would diminish.

However, if it had established production plants worldwide andbought its components worldwide (a policy which is practised by manymultinationals, e.g. Ford) it is unlikely that the currencies of all itsoperations would revalue at the same time. It would therefore findthat, although it was losing exports from some of its manufacturinglocations, this would not be the case in all of them. Also if it hadarranged to buy its raw materials worldwide it would find that astrengthening home currency would result in a fall in its input costsand this would compensate for lost sales.

Diversification of financing

When borrowing internationally, firms must be aware of foreignexchange risk. When, for example, a firm borrows in Swiss francs it mustpay back in the same currency. If the Swiss franc then strengthensagainst the home currency this can make interest and principalrepayments far more expensive. However, if borrowing is spread acrossmany currencies it is unlikely they will all strengthen at the same timeand therefore risks can be reduced. Borrowing in foreign currency isonly truly justified if returns will then be earned in that currency tofinance repayment and interest.

International borrowing can also be used to hedge off the adverseeconomic effects of local currency devaluations. If a firm expects tolose from devaluations of the currencies in which its subsidiariesoperate it can hedge off this exposure by arranging to borrow in theweakening currency. Any losses on operations will then be offset bycheaper financing costs.

Regulatory risk

Regulatory risk is the potential for laws related to a given industry, country, or type of security to change and affect:

• how the business as a whole can operate
• the viability of planned or ongoing investments.

Regulations might apply to:

• businesses generally (for example, competition laws and anti-monopoly regulations)
• specific industries (for example, catering and health and safety regulations, publishing and copyright laws).

Managing regulatory risk

Whilst larger companies may have the resources to set up a permanent regulatory team, smaller firms may:

• incorporate the role within the internal audit department
• consult a firm specialising in regulatory risk.

In practice, research suggests that many firms do not commitsufficient resources to this area and are exposed to a high degree ofregulatory risk.

Associated with regulatory risk is compliance risk.

Compliance risk is the risk of losses, such as fines or eventemporary closure, resulting from non-compliance with laws orregulations.

Measures to ensure compliance with rules and regulations should bean integral part of an organisation’s internal control system.

Fiscal risk

Fiscal risk from a corporate perspective is the risk that thegovernment will have an increased need to raise revenues and willincrease taxes, or alter taxation policy accordingly. Changes intaxation will affect the present value of investment projects andthereby the value of the company.

Managing fiscal risk

The primary requirement of a fiscal risk management strategy is anawareness of the huge impact tax can make to the viability of a project.Tax should be factored in to the calculations for all significantinvestment appraisal projects.

It is important not only to ensure that the tax rules being appliedare up-to-date, but that any potential changes in the tax rules arealso considered. Investment projects may be intended to run for manyyears and future changes (particularly those intended to close ‘loopholes’ in the taxation system) could wipe out the expected benefitsfrom the project.

Many larger firms will maintain a full time taxation team withinthe finance function to deal with the tax implications of investmentplans. Smaller companies are more likely to employ external tax experts.In either case, a relevant tax expert should always be involved in theanalysis of the project and its sensitivity to the taxation assumptionsshould be carefully modelled.

Test your understanding 2

M plc is a mineral extraction company based in the UK but with plantsbased in many countries worldwide. Following recent discovery ofmineral reserves in Mahastan in Central Asia, M plc has acquired alicence to extract the minerals from the recently elected Mahastanigovernment and plans to commence work on the plant there within the nextsix months.

In the past ten years, Mahastan has seen significant unrest,following the deposing of the previous dictator in a military coup.However, the recent election of the newly fledged democracy is hoped tobe the beginning of a new era of stability in the region. The currencyof Mahastan is the puto. It is not traded internationally and thepreferred currency for international business is the US dollar. Thereare currently no double tax treaties between Mahastan and the rest ofthe world, but the prime minister has signalled his intention to developthem within his first term of office to encourage inward investment.

Assess the exposure of M plc to political, economic, regulatory and fiscal risk and suggest how these risks may be mitigated.

Other types of risk

It is important to read the financial press to keep abreast of recent developments in risk management.

Risk management is a constantly evolving process. Financial managers need to understand the threats from emerging risks such as:

• global terrorist risk
• computer virus risks
• spreadsheet risk - for example, Fannie Mae's $1 billion-plus underestimate of total stockholder equity in 2003 was the result of errors in a spreadsheet used in the implementation of a new accounting standard.

Policies will need to be kept up to date, so that these newer risks are managed properly.

5 Incorporating risk into investment appraisal

Overview of methods

The input variables in an investment appraisal are all estimates oflikely future outcomes. There are several methods of incorporating riskinto an investment appraisal, for example:

• expected values
• use of the CAPM model to derive a discount rate
• sensitivity analysis, and simulation

These methods have all been covered in paper F9, but some more details on sensitivity and simulation follow below.

Sensitivity analysis

Sensitivity analysis measures the change in a particular variablewhich can be tolerated before the NPV of a project reduces to zero.

It can be calculated as

(NPV of project) / (PV of cashflows affected by the estimate) × 100%

Illustration of sensitivity analysis

AVI Co is evaluating a new investment project as follows:

Sensitivity to sales

= (NPV/PV of cashflows affected by the estimate of sales) × 100%

= [430 / (1,000 × (1-0.30) × 3.170)] × 100%

= 19.4%

i.e. if sales were to fall by 19.4% (to $806,000 per annum) then the NPV would be zero.

Sensitivity to tax rate

= (NPV/PV of cashflows affected by the estimate of tax rate) × 100%

= [430 / ((45-120) × 3.170)] × 100%

= 181%

i.e. if the tax rate were to rise by 181% (from 30% to 30 × 2.82 = 84.6%) then the NPV would fall to zero.

Sensitivity to discount rate

This cannot be calculated using the standard formula. Instead, theIRR of the project is calculated and the difference between the existingcost of capital and the IRR indicates the sensitivity to the discountrate.

Interpretation of sensitivity calculations

AVI Co would initially be inclined to accept the project due to itspositive NPV. However, before making a final decision, thesensitivities would be considered. Any factors with small percentagesensitivities will have to be carefully assessed, because if theestimates of these factors turn out to be incorrect, the result may be anegative NPV.

Simulation

The main problem with sensitivity analysis is that it only allowsus to assess the impact of one variable changing at a time. Simulationaddresses this problem by considering how the NPV will be impacted by anumber of variables changing at once.

Simulation employs random numbers to select specimen values foreach variable in order to estimate a ‘trial value’ for the projectNPV. This is repeated a large number of times until a distribution ofnet present values emerge.

By analysing this distribution, the firm can decide whether toproceed with the project. For example, if 95% of the generated NPVs arepositive, this might reassure the firm that the chance of suffering anegative NPV are small.

Monte Carlo simulation assumes that the input variables areuncorrelated. However, more sophisticated modelling can incorporateestimates of the correlation between variables.

More details on Monte Carlo simulation

The assessment of the volatility (or standard deviation) of the netpresent value of a project entails the simulation of the financialmodel using estimates of the distributions of the key input parametersand an assessment of the correlations between variables.

Some of these variables are normally distributed but some areassumed to have limit values and a most likely value. Given the shape ofthe input distributions, simulation employs random numbers to selectspecimen values for each variable in order to estimate a ‘trialvalue’ for the project NPV.

This is repeated a large number of times until a distribution of net present values emerge.

By the central limit theorem the resulting distribution willapproximate normality and from this project volatility can be estimated.

In its simplest form, Monte Carlo simulation assumes that the inputvariables are uncorrelated. However, more sophisticated modelling canincorporate estimates of the correlation between variables.

Other refinements such as the Latin Hypercube technique can reducethe likelihood of spurious results occurring through chance in therandom number generation process.

The output from a simulation will give the expected net presentvalue for the project and a range of other statistics including thestandard deviation of the output distribution.

In addition, the model can rank order the significance of each variable in determining the project net present value.

6 Value at Risk (VaR)

The meaning of VaR

Value at risk (VaR) is a measure of how the market value of an asset or of a portfolio of assets is likely to decrease over a certain time, the holding period (usually one to ten days), under ‘normal’ market conditions.

VaR is measured by using normal distribution theory.

It is typically used by security houses or investment banks to measure the market risk of their asset portfolios.

VaR = amount at risk to be lost from an investment under usualconditions over a given holding period, at a particular "confidencelevel".

Confidence levels are usually set at 95% or 99%,

i.e. for a 95% confidence level, the VaR will give the amount that has a 5% chance of being lost.

Illustration 1

A bank has estimated that the expected value of its portfolio intwo weeks’ time will be $50 million, with a standard deviation of$4.85 million.

Using a 95% confidence level, identify the value at risk.

Solution

A 95% confidence level will identify the reduced value of the portfolio that has a 5% chance of occurring.

From the normal distribution tables, 1.65 is the normaldistribution value for a one-tailed 5% probability level. Since thevalue is below the mean,  â€“ 1.65 will be needed.

z = (x - μ)/σ

(x - 50)/4.85 = -1.65

x = (-1.65 × 4.85) + 50 = 42

There is thus a 5% probability that the portfolio value will fall to $42 million or below.

A bank can try to control the risk in its asset portfolio by settingtarget maximum limits for value at risk over different time periods (oneday, one week, one month, three months, and so on).

Link between Monte Carlo Simulation and VaR

In the above Illustration, the expected portfolio value in twoweeks' time was presented as a normal distribution with a mean of $50m.

This distribution may well have been created by running a Monte Carlo simulation on the likely outcome over the next two weeks.

Alternatively, the future expected value may have been forecasted by using historical data.

Test your understanding 3

A bank has estimated that the expected value of its portfolio in 10days’ time will be $30 million, with a standard deviation of $3.29million.

Using a 99% confidence level, identify the value at risk.

7 Introduction to hedging methods

The use of derivative products

Hedging methods relating to currency risk and interest rate riskare covered in separate later chapters. Many of the hedging methods use"derivatives" (e.g. futures contracts) to reduce the firm's exposure torisk.

This section introduces some basic terms relating to derivatives.

The operation of the derivatives market

• A derivative is an asset whose performance (and hence value) is derived from the behaviour of the value of an underlying asset (the ‘underlying’).
• The most common underlyings are commodities (e.g. tea, pork bellies), shares, bonds, share indices, currencies and interest rates.
• Derivatives are contracts that give the right and sometimes the obligation, to buy or sell a quantity of the underlying or benefit in some other way from a rise or fall in the value of the underlying.
• Derivatives include the following:
  • Forwards.
  • Forward rate agreements (‘FRAs’).
  • Futures.
  • Options.
  • Swaps.
• Forwards, FRAs and futures effectively fix a future price. Options give you the right without the obligation to fix a future price.
• The legal right is an asset with its own value that can be bought or sold.
• Derivatives are not fixed in volume of supply like normal equity or bond markets. Their existence and creation depends on the existence of counter-parties, market participants willing to take alternative views on the outcome of the same event.
• Some derivatives (esp. futures and options) are traded on exchanges where contracts are standardised and completion guaranteed by the exchange. Such contracts will have values and prices quoted. Exchange-traded instruments are of a standard size thus ensuring that they are marketable.
• Other transactions are over the counter (‘OTC’), where a financial intermediary puts together a product tailored precisely to the needs of the client. It is here where valuation issues and credit risk may arise.

These features of derivative products were introduced in paper F9.

Futures contracts

Introduction

• A futures contract is an exchange traded forward agreement to buy or sell an underlying asset at some future date for an agreed price.
• There are two ways of closing a position:
  • Deliver the underlying on the maturity date – RARE.
  • If futures contracts have been bought, then equivalent contracts can be sold before maturity, resulting in the company having a net profit or loss (and no obligation to deliver).
• Hedging is achieved by combining a futures transaction with a market transaction at the prevailing spot rate.

Illustration 2: TAL

TAL Inc is a sugar grower looking to sell 3,000 tonnes of white sugar in August and wants to fix the price via futures.

Suppose that the quoted futures price today on LIFFE for whitesugar for August delivery is $221.20 per tonne and that each contract isfor 50 tonnes.

TAL would agree to sell 60 futures contracts at a price of $221.20.

Suppose the market price in August (on the final day of thecontract) has risen to $230. The futures price would also equal $230.

TAL thus has two transactions:

• TAL would sell their sugar in the open market (i.e. not via the futures contract) for $230/tonne.
• Separately TAL would buy 60 futures contracts for August delivery for $230 per tonne, making a loss on the futures of $8.8 per tonne.

This gives an overall (fixed) net receipt of $221.2 per tonne.

Note: Futures do not always give a perfect hedge because of

(1) Basis risk.

(2) The size of contracts not matching the commercial transaction.

Tick sizes

• A ‘tick’ is the standardised minimum price movement of a futures or options contract.
• Ticks are useful for calculating the profit or loss on a contract.

Illustration 3: TAL continued

For the sugar futures contract in the above example, a tick is$0.01 per tonne. Given that a contract is for 50 tonnes, each tick isworth $0.50 per contract.

The overall movement of $8.80 per tonne would be expressed as 880 ticks.

The total loss on the contracts would thus be:

60 contracts × 880 ticks × $0.50 per tick = $26,400

As detailed below, this amount would not be collected in one amountwhen the position is closed but instead daily ‘marking to market’occurs.

Margins

A potential problem of dealing in futures is that having made aprofit, the other party ‘to the contract’ has therefore made a lossand defaults on paying you your profit. This is termed ‘counter partycredit risk’.

• However the buyer and seller of a contract do not transact with each other directly but via members of the market.
• Therefore the markets Clearing House is the formal counter party to every transaction.
• This effectively reduces counter party default risk for those dealing in futures.
• As the Clearing House is acting as guarantor for all deals it needs to protect itself against this enormous potential credit risk. It does so by operating a margining system, i.e. an initial margin and the daily variation margin.

The initial margin

• When a futures position is opened the Clearing House requires that an initial margin be placed on deposit in a margin account to act as a security against possible default.
• The objective of the initial margin is to cover any possible losses made from the first day's trading.
• The size of the initial margin depends on the future market, the level of volatility of the interest rates and the risk of default.
• For example, the initial margin on a £500,000 ‘3 month sterling contract’ traded on LIFFE is £750, i.e. £750/£500,000 = .0015%.
• Some investors use futures for speculation rather than hedging. The margin system allows for highly leveraged ‘bets’.

The variation margin

• At the end of each day the Clearing House calculates the daily profit or loss on the futures position. This is known as ‘marking to market’.
• The daily profit or loss is added or subtracted to the margin account balance. The margin account balance is usually maintained at the initial margin.
• Therefore if a loss is made on the first day the losing party must deposit funds the following morning in the margin account to cover the loss.
• An inability to pay a daily loss causes default and the contract is closed, thus protecting the Clearing House from the possibility that the party might accumulate further losses without providing cash to cover them.
• A profit is added to the margin account balance and may be withdrawn the next day.

Test your understanding 4

Peter Ng is a wealthy speculator who believes that oil prices willfall over the next three months. Oil futures are quoted with thefollowing details:

• Futures price for 3 month delivery = $68.20.
• Contract size = 1,000 barrels.
• Tick size = 1 cent per barrel.
• Initial margin = 10% of contract.

Peter decides to set his level of speculation at 10 contracts.

(a) Compute Peter’s initial margin.

(b) Calculate the cash flow the next day if the futures price moves to $68.35.

8 Chapter summary

Test your understanding answers

Test your understanding 1

Strategic:

• brand awareness in the new sector
• risk of recession
• political changes

Tactical – changes to forecasts based on:

• supply chain changes
• major payment timings
• intended sales of machinery
• contractor overruns on time or amounts spent.

Operational – changes occurring because:

• production breakdown
• breakdown of the supply chain
• failure of the distribution network
• failure to recruit staff with the necessary skills.

Test your understanding 2

Political risks

Possible ramifications would include:

• revocation of the licence
• significant increase in the licence fee
• company subject to regulations designed to prevent the company taking profits earned from the country:
  • imposition of punitive taxes
  • restrictive exchange controls.
• seizure of control of the plant
• expropriation of the extracted minerals
• total disruption to operations from further coup attempts.

Economic risks

In terms of exchange risk, the primary risk will be caused bychanges in value between UK sterling and the US dollar. Although somepayments (such as employee wages) will presumably be made in putos and Mplc will therefore be subject to some risk associated with fluctuationsbetween the puto and the dollar, it is unlikely to have any significantimpact on the long term viability of the project.

Regulatory risk

As M plc are based in the UK, which can be expected to have afairly stringent set of regulations covering mineral extraction, it isnot anticipated that the Mahastan project will present any significantspecific regulatory risk.

However, new regulations imposed on all foreign companies operatingin Mahastan may come into force once the new government finds its feet.This could affect the ability of the company to operate effectively.

Fiscal risk

The uncertainty over the double tax position is an obvious risk forM plc. In addition, the country’s tax legislation may not be wellestablished and may be changed as the prime minister looks to encourageinvestment.

Risk mitigation

The recent political instability in Mahastan and the newness of the government, make this investment a very high-risk project.

Political risk

M plc already have a licence for the extraction of the minerals.They could attempt to negotiate further terms surrounding matters asdiverse as levels of price increases, transfer of capital, transfer ofremittances, transfer of products, access to local capital markets,transfer pricing, taxation and social and economic obligations.

However no matter what is negotiated the risk that the agreementwill be not be honoured by this government (or subsequent ones should itfail) remains high.

The political risks can be best mitigated by gaining the goodwillof the community and ensuring that the wealth generated by the mineralextraction is not perceived to be entirely the preserve of M plc.Solutions may include:

• employing local workers where possible
• paying fair wages
• considering joint ventures with local companies over some parts of the construction or extraction processes
• investing some part of the profits in local opportunities.

It may be worth considering political risk insurance. However where the risk is so high the premiums may be prohibitive.

Economic risk

Since M plc has an international presence, the economic risk of theproject will already be mitigated by their diversification. However, ifmany of the areas in which it operates also trade in dollars then thebenefits are reduced. Consideration should also be given to financingusing dollar-based loans.

Regulatory risk

The risk that onerous regulations may be imposed on M plc cannot beeasily avoided. The methods of mitigating political risk mentionedabove, would also apply here, although they are unlikely to help withregulations aimed at all organisations.

M plc must ensure that they consistently monitor the changingregulatory environment and consider the impact on their firm. As thegovernment is keen to encourage inward investment, it would be worthattempting to identify key ministers and open up lines of communicationwith them. Being viewed as an important stakeholder may mean that M plcis consulted on major regulatory changes before they are implemented.

Fiscal risk

Given the considerable uncertainty, fiscal risk may be best managedby assuming worst case tax treatment (based on current information) andonly accepting the project if the NPV is still positive. Again constantmonitoring of the situation and reforecasting as necessary will also berequired.

Test your understanding 3

A 99% confidence level will identify the reduced value of the portfolio that has a 1% chance of occurring.

From the normal distribution tables, 2.33 is the normaldistribution value for a one-tailed 1% probability level. Since thevalue is below the mean –2.33 will be needed.

z = (x - μ)/σ

(x - 30)/3.29 = -2.33

x = (-2.33 × 3.29) + 30 = 22.3

There is thus a 1% probability that the portfolio value will fall to $22.3 million or below.

Test your understanding 4

(a) Initial margin = 10% × 10 contracts × 1,000 barrels × $68.20 = $68,200.

(b) Price has increased so Peterwill make a loss of $0.15 per barrel or 15 ticks. This equates to atotal loss (which will need to be paid into the exchange) of

Loss = 10 contracts × 15 ticks × $10 per tick = $1,500.

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