Corporate Risk Management

With unexpected price shift, there were detrimental impacts on a number of firms. Initially responds
to instability in interest rates, exchange rate, commodity price, and equity prices by resorting to
forecasting. Price changes are random and future price cannot be predicted accurately. Now a day's
firm uses financial derivatives to tailor their exposures to currency, interest rate, and commodity
price risks.

Risk management can be called more appropriately called risk-rewards management or value
management. It explains why total risk matters, shows how risk is measured, discussed various risk
management tools, looks at risk management in practice, and suggests a set of guideline for risk
management. They are further divided into fifteen sections.

CLASSIFICATION OF RISKS

Risks can be classified in five different categories: technological risks, economic risks, financial risks,
performance risks, and legal risks.

Technological risks arise mostly in the R&D and operations stages of the value chain. High tech
industries and pharmaceutical industry are subject to high technological risks. Operating risks arises
when new technologies lead to problems in productions and delivery of services.

Economic risks arise from fluctuation in output price and demand, and raw material costs, energy
costs, and labour costs. Generally risks are related to GNP growth.

Financial risks arise from the volatility of interest rate, currency rates, stock prices, and commodity
prices. These risks are at core of financial services and have significant impact on non-financial firms.

Performance risks arise when the constricting counterparties do not fulfil their obligation.

Legal and regulatory risks arise from changes in law and regulations. Companies are subjected to law
and regulations.

WHY TOTAL RISKS MATTERS

Hedging activities aimed to reduce total corporate risk. Only systematic risks or market risks is priced
and, hence, has an influence on the required rate of return. The price of systematic risk is identical
for all the participants in the financial market; a firm does not benefit its shareholder by laying it off
in the financial market. In an efficient financial market the expected NPV of any risk hedging activity
like taking insurance cover.
As long as the unsystematic risks do not jeopardise the existence of the firm, do not hurt the share
holder this argument implies. Unsystematic risks may lower the expected cash flow.

A distraught financial condition is likely to:

Adverse Incentives: High risky investment is likely to be chosen because such investments benefits
equity shareholder, even if NPV is negative. It is done at the expense of creditors.

Here mangers are forced to abandon promising investment and liquidate them even if it is worth
continuing. This happens because of financial crunch. Creditors take decisions and can prior claim
liquidation proceeds.

Weakened Commitment: Distressed firm tend to lower its good quality. High risk firm tends to scare
away customers looking for dependable source of supply.

As customers suppliers also like to build relationship with firm with lower risks. As they give benefits
of discounts and concessions. Suppliers charge more to higher risk firms. Employees also like to work
for low risk firms as they are sure to be rewarded of their efforts.

High risk firms have difficulty in borrowing and securing credits. They have to pay higher rate of
interest and their plans of loan are rigid.

Diminished Tax shelter: It may not be able to fully exploit the tax shelter available with high variable
operating profits.

MEASUREMENT OF RISKS IN NON-FINANCIAL FIRMS

Examination of financial Statements: Balance sheet and profit and loss accounts give idea about
financial position.

High liquidity provides cushion against the instability of cash flow caused by hike in financial prices.
Low leverage ratio will also provide cushion against unpredictable change in financial prices. If the
firm is dealing with two different currencies in which it incurs expense and receives revenue then it
is definitely a cause of concern. If it is exposed to high interest then it relies on floating rate debt.

Cash Flow: With the help of firm's value, cash flow, financial price we can find firm's exposure to risk.

Sensitivity of a firm's value to exchange rate can be measured-

When Firm value t is the percentage change in the firm value in period t, Exchange rate t is the
percentage change in exchange rate of any other currency.
A firm is interested in assessing the exposure of its cash flow to change in exchange rate, interest
rate, oil price, and inflation rate-

Cash flow t = a + b exchange rate t + c interest rate t + d oil price t + e inflation rate t

Coefficient of each of the independent variable reflects the firm's cash flow exposure to that
variable.

Monte Carlo Simulation: It is a process of delivering a simulated distribution of an output variable by

1- Model the firm's value or cash flow as a function of macro-economic variables.

2- Specify the probability distribution of each of the macroeconomics variables.

3- Select a random value from the probability distribution of each of the macroeconomic variables.

4- Determine the firm's value or cash flow corresponding to the randomly generated values of
exogenous variables.

5- Repeat the 3rd and 4th step a number of time to get a large value of firm's value or cash flow.

PRINCIPLE OF HEDGING

When you want to hedge you look at two investments that are perfectly correlated. But it is
impossible to find perfect correlation between two investments in real life.

Expected value in the value of P = a + δ (change in the value of Q)

Suppose portfolio manager has short sold Rs. 10 million

Change in Reliance's stock price = a + δ

= 1.2 + 1.5 (change in the market price index)

R2 = 0.55 R2 is coefficient of determination.

The portfolio manager must make an investment of 1.50 * 10 million in market portfolio.

R2 = 0.55 means only 55% risk is market risk and the remainder is unique risk.

Here manager hedge 10 million by investing 15 million in the market portfolio.

If he wishes to create a zero value hedge he needs to borrow 5 million from bank.

Liability (Rs) Asset (Rs)

A forward contract represents an agreement between two parties to exchange an assets for cash at
a predetermined future called settlement date for a price that a specified today.

Here buy and sell have different meaning.

The unhedged risk profile

The hedged risk profile

Short position- Which commits the seller to deliver an item at the contracted price on maturity.

Long position- Which commits the buyer to purchase an item at the contracted price on maturity.
The Payoff Profile: When spot price in future exceeds the contract price, the forward buyer's gain is:
spot price - contract price and vice versa in case of loss. For seller it is the mirror image of buyer.

40.10HEDGING WITH REAL TOOLS AND OPTIONS

There are various ways of dealing with risk without using derivative contracts which include the
conventional approaches and real options.

1 Shorten the time required to get the product to market to deal with competition risk.
2 carry extra liquidity on the balance sheet to tide over difficult periods
3 Locate plants abroad to cope with currency risks.
4 Delay investment until some portion of uncertainty is resolved.
5 Contract or abandon unpromising products and projects.
6 Diversify product line and services to reduce economic risks.
7 Maintain reserve borrowing power to meet future contingencies.

Real versus Financial Options

An Indian firm earns one-half of its revenue abroad from USA, but presently has production facilities
only in India. Further the US competitor can lower the price and hurt its sales in the US.

1. Real options cost a great deal. The firm must set up plants abroad, reconfigure its supply chain,
forego economies scale, maintain surplus capacity at several plants, and incur switching costs. This is
more when the firm can leverage its existing capabilities as well its reputation in creating real
options.

2. Real options may be the only viable means to handle risks. All the business risks cannot be easily
managed with the help of financial contracts. Perhaps the option to wait before investing and the
option to abandon the project may be the only practical way to handle.
3. Real options are far less liquid than real options. It takes time to acquire as well as dispose off real
options, whereas financial contracts can be easily traded. It is based on future market conditions,
which may change over time. This benefit can turn in to liabilities if the firm is unable to carefully
monitor its traders.

4. A firm that enjoys real option may profit from assuming more risk. A firm that has a flexible
production plant can benefit more by manufacturing products subject to high price volatility.