FINANCIAL MANAGEMENT : Managing financial risks
Managing risk inside a company has become a hot issue: regulations are much stricter, investors ask for more transparency and top management spends more time on it.
Risk management requires identification of risks, setting up controls, measuring the residual risk and lastly choosing a hedging strategy.
Risk is characterised by frequency and intensity.
We can identify five major risks:
- market risk – i.e. exposure of the company to unfavourable changes in interest and exchange rates or prices of raw materials or shares;
- counterparty risk – i.e. the loss of repayments of a debt in the event of default of the creditor;
- liquidity risk – i.e. the inability of a company to make its payments by their due date;
- operating risk – i.e. the losses caused by errors on the part of employees, systems and processes;
- political risk - i.e. the impacts on importers, exporters and companies that invest abroad.
Market risks are accurately measured with the notion of position and value at risk (VaR). Liquidity is measured by comparing debt repayment and expected cash receipts. Techniques for measuring other risks are still in their infancy.
When confronted with risk, a company can:
- decide to do nothing and take its own hedging measures. This will only apply to small risks or some very large corporates;
- lock in prices or rates for a future transaction by means of forwardation;
- insure against the risk by paying a premium to a third party which will then assume the risk if it materialises. This is the same idea that underlies options;
- immediately dispose of the risky asset or liability (securitisation, defeasance, factoring, etc.).
The same types of product (forward buying, put options, swaps, etc.) have been developed to cover the five different risks and are traded either on the OTC markets or on stock exchanges. On the OTC market, the company can find products that are perfectly suited to its needs, but there is the counterparty risk of the third party that provides the hedging. This problem is eliminated on the futures and options markets, although the price paid is reduced flexibility in tailoring products to companies' needs.