Risk and the Financial Manager

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 up management time, so it is critical that we can understand the benefits of risk management and compare these to the costs to assess whether a risk management strategy is worthwhile.

This page initially introduces an overview of risk management in relation to capital investment projects, then explains some specific examples of risks. More detailed techniques for risk management, such as the use of derivatives and Value at Risk (VaR), are covered on other pages - see links below.

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

Based on the risk appetite of the firm, decisions must be taken about those types of activity suitable for investment. This will involve decisions 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 of fixed costs to variable in the cost structure. Whilst some industries are destined to have higher levels of operating gearing than others (compare the travel industry with manufacturing for example), policy decisions about what level is acceptable will drive choices about factors 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 reduce the cost of finance but increases the risks of bankruptcy as the same time. Directors must decide what level of gearing they are prepared to accept.

Accuracy of forecasts

The success of any planned investment programme will rely heavily on the accuracy of forecasts of future cash flows (in and out) and an NPV assessment also relies on an accurate calculation of the discount rate. The sensitivity of these forecasts can be calculated, and the probability of the variation assessed, but in the end the directors must decide what level of risk they are willing to accept in order to accept or reject the project.

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 a large number of estimates. For all material estimates, a formal risk assessment 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.

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

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

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

Risk assessment and monitoring

A useful way to manage risk is to identify potential risks (usually done in either brainstorming meetings or by using external consultants) and then categorise them according to the likelihood of occurrence and the 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 time passes, so the various uncertain events on which the forecasts are based will occur. Management must monitor the events as they unfold, reforecast predicted results and take action as necessary. The degree and frequency of the monitoring process will depend on the significance of the risk to the project's outcome.

Risk management

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.

Strategies for dealing with risk

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.

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. 
• 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.

Types of risk facing the financial manager

Interest rate risk

Firms are exposed to interest rate risk in two ways:

• The cost of existing borrowings (or the yield on deposits) may be linked to interest rates in the economy. This risk exposure can be eliminated by using fixed rate products.
• Cash flow forecasts may indicate the need for future borrowings/deposits. Interest rates may change before these are needed and thus affect the ultimate cost/yield

Foreign exchange risk

  Firms may be exposed to three types of foreign exchange risk:

Transaction risk

• The risk of an exchange rate changing between the transaction date and the subsequent settlement date on an individual transaction. i.e. it is the gain or loss arising on conversion.
• Associated with exports/imports.

Economic risk

• Includes the longer-term effects of changes in exchange rates on the market value of a company (PV of future cash flows).
• Looks at how changes in exchange rates affect competitiveness, directly or indirectly.

Translation risk

• How changes in exchange rates affect the translated value of foreign assets and liabilities (e.g. foreign subsidiaries).

Political risk

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

This is obviously a particular problem for companies operating internationally, as they face political risk in several countries at the same time.

Whilst at one extreme, assets might be destroyed as the result of war or expropriation, the most likely problems concern changes to the rules on the remittance of cash out of the host country to the holding company. Typical issues include the following:

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 joint ventures with host country companies.

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

Restricted access to local borrowings by restricting or even barring foreign-owned enterprises from the cheapest forms of finance from local banks and development funds. Some countries ration all access for foreign investments to local sources of funds, to force the company to import foreign currency into the country.

Expropriating assets whereby the host country government seizes foreign property in the national interest. It is recognised in international law as the right of sovereign states provided that prompt consideration at fair market value in a convertible currency is given. Problems arise over the exact meaning of the terms prompt and fair, the choice of currency, and the action available to a company not happy with the compensation offered.

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).

Fiscal risk

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

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

It is important not only to ensure that the tax rules being applied are up-to-date, but that any potential changes in the tax rules are also considered. Investment projects may be intended to run for many years and future changes (particularly those intended to close 'loopholes' in the taxation system) could wipe out the expected benefits from the project.

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

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.

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