Session -1 Risk Case in business finance

Risk

1. Managing Risk in Global Finance

2. Learning Objectives Understand the nature and importance of risk and risk management, especially financial risk exposures. Construct and analyse a structured risk management process. Understand international trade and currency risks. Examine the operation of L/Cs, forward exchange contracts and forward rate agreements. Measure and offset bank capital adequacy risk. Examine the fundamentals of futures contracts. Consider the structure of an interest rate swap and a cross-currency swap. Understand the nature and versatility of options contracts.

3. Understanding risk Risk is the possibility or probability that an event, such as a change in interest rates, exchange rates, or economic activity, may occur that is not forecast and is therefore unexpected.

4. Understanding risk In order to manage risk successfully, an organization must establish a structured risk management process that will include: — Identification of operational and financial risk exposures. — Analysis of the impact of the risk exposures. — Assessment of the attitude of the organization to each identified risk exposure. — Selection of appropriate risk management strategies and products. — Establishment of related risk and product controls, including personnel and systems. — Implementation of the risk management strategy. — Monitoring, reporting, review and audit of the risk management process.

5. Financial risk Exposures that result in unanticipated changes in projected cash flows or the structure and value of balance-sheet assets and liabilities

6. Financial Balance Sheet risk Solvency and capital adequacy Credit/Commercial Liquidity Interest rate Market Currency Risk Exposures

7. Financial risk Exposures that result in unanticipated changes in projected cash flows or the structure and value of balance-sheet assets and liabilities, Operational risk Exposure that may impact on the normal commercial functions of a business, affecting its operational and financial performance

8. Financial Capital adequacy Credit/Commercial Liquidity Interest rate Market Currency Operational Business strategy risk Internal systems risk Technology risk Management risk Fraud Suppliers Property vbvvv Risk Exposures

9. Financial risk Exposures that result in unanticipated changes in projected cash flows or the structure and value of balance-sheet assets and liabilities, Operational risk Exposure that may impact on the normal commercial functions of a business, affecting its operational and financial performance Business risk Exposures associated with overall business environment including macroeconomic and policy/regulatory concerns

10. Financial Balance Sheet risk Solvency and capital adequacy Credit/Commercial Liquidity Interest rate Market Currency Operational Business strategy risk Internal systems risk Technology risk Management risk Fraud Suppliers Property vbvvv Business Risk Competitive risk Legal risk Policy risk Financial infrastructure Risk Exposures

11. Financial risk Exposures that result in unanticipated changes in projected cash flows or the structure and value of balance-sheet assets and liabilities, Operational risk Exposure that may impact on the normal commercial functions of a business, affecting its operational and financial performance Business risk Exposures associated with overall business environment including macroeconomic and policy/regulatory concerns Event risk Exposure to all types of exogenous risk

12. Financial Balance Sheet risk Solvency and capital adequacy Credit/Commercial Liquidity Interest rate Market Currency Operational Business strategy risk Internal systems risk Technology risk Management risk Fraud Suppliers Property vbvvv Business Risk Legal risk Policy risk Financial infrastructure Event Risks Political risk Contagion risk Banking crisis risk Systemic (country) risk Other exogenous risks Risk Exposures

13. Micro project risk Macro country risk Terms of contract Stakeholder relations Location Industrial sector Attitudes to foreign investment National origin Government stability Risk Continuum Political risk Commercial risk Bank risk Currency risk

14. Event Risk Assessment Country risk sources Political war, occupation, riots, territorial claims, ideological differences, corruption, Social civil war, tribalism, income inequalities, religious/ethnic divisions, rebellion, nationalism, Economic long-term GDP decline, strikes, productivity costs, export earnings decline, raw material price increases

15. Political Risk Unquestionably this is the biggest risk when investing abroad. “Does the foreign government uphold the rule of law?” is a more important question than normative judgements about the appropriateness of the foreign government’s existing legislation. A big source of risk is the non-enforcement of contracts. Macro Risk All foreign operations put at risk due to adverse political developments. Micro Risk Selected foreign operations put at risk due to adverse political developments.

16. Political Risk Transfer Risk Uncertainty regarding cross-border flows of capital. Operational Risk Uncertainty regarding host countries policies on firm’s operations. Control Risk Uncertainty regarding expropriation.

17. Consequences Inconvertibility Expropriation Civil strife damage War damage Contract repudiation Negative government actions Process deterioration Event intervention

18. Measuring Political Risk The host country’s political and government system. A country with too many political parties and frequent changes of government is risky. Track records of political parties their relative strength. If the socialist party is likely to win the next election, watch out. Integration into the world system. North Korea, Iran, Venezuela are examples of isolationist countries unlikely to observe the rules of the game. Ethnic and religious stability. Look at the recent civil war in Syria. Regional security South Korea is a nice country, but it’s in a questionable neighborhood.

19. Measuring Political Risk Key economic indicators Political risk is not entirely independent of economic risk. Relationships between risks: one risk affecting another risk Direct risk—the initial risk event that impacts on the operational or financial position of an organisation Consequential risks—exposures that eventuate as a result of an initial direct risk event. Severe income inequality and deteriorating living standards can cause major political disruptions. In 2002, Argentina’s protracted economic recession led to the freezing of bank deposits, street riots, and three changes of the country’s presidency in as many months.

20. The risk management process Effective management of risk exposures requires a structured risk management process. Although the range of risks varies by organisation, models exist to deal with country risk.

21. Economist Model Country Risk: political, social, economic Not correlated to financial loss Criteria Neighbors Authoritarianism Staleness Illegitimacy Generals in Power War/Armed Conflict Urbanization Islamic Fundamentalism Corruption Ethnic Tension BERI Model Internal Political fractionalization Ethnic fractionalization Restrictive measures Mentality Social conditions Radical left government External Dependence Negative regional forces Political Risk Societal conflict Instability ICRG Model PRS Model

22. Identify operational and financial risk exposures Requires full understanding of the business, including operations, personnel, competitors, regulators, legislative requirements, stakeholders, cash flows and balance sheet structure Also need to understand interrelationships and causal links between the above categories The risk management process

23. Identify operational and financial risk exposures Requires full understanding of the business, including operations, personnel, competitors, regulators, legislative requirements, stakeholders, cash flows and balance sheet structure Also need to understand interrelationships and causal links between the above categories Analyze the impact of the risk exposures A business impact analysis is used to document each risk exposure and measure the operational and financial impacts should the risk event occur. Need to consider both quantitative and qualitative risks The risk management process

24. Assess the attitude of the organization to each identified risk exposure Not all risks will be mitigated or removed. The risks to be avoided, controlled, transferred or retained should be documented. Select appropriate risk management strategies and products An integrated process to analyse the risk management options available. Generally, several risk management strategies available, the choice between them to be subject to cost–benefit analysis. All risk management processes and strategies should be periodically audited. The risk management process

25. High Impact Low Impact Low Probability High Probability Impact-Probability Risk Chart

26. Establish related risk and product controls Ensure adequate controls established, documented and circulated among personnel These include procedural controls and system controls Procedural controls document risk management products that can be used by the organisation System controls cover all electronic product delivery and information systems relating to the identification, measurement, management and monitoring of risk management The risk management process

27. Implement the risk management strategy Obtain written authority to proceed with implementation. Check that time lags between the commencement of this process and the implementation of the strategy have not impaired the effectiveness of the strategy. Risk strategies are developed for different planning periods. Monitor, report, review and audit As risk management is ongoing, the strategies must be continuously monitored to ensures they achieve the expected risk management objectives and outcomes. The risk management process

28. Exposure management systems An exposure management system involves structured procedures that enable a firm to effectively measure and manage risk, including: forecasting Know the current structure of its balance sheet and forecast future changes in its assets, liabilities and equities with regard to: future business activity growth, future interest rates, future financing needs and use of debt financing strategies and techniques specified proportions of fixed-interest versus floating-interest debt, with remaining portion available to take advantage of forecast changes monitoring and adjusting the maturity structure of assets and liabilities, taking into account the term structure of interest rates liability diversification—where a firm raises funds from a range of different sources, thereby reducing its exposure to potential interest changes in a particular market. management reporting systems the type of information to be reported frequency of reports report hierarchy delegation and staff responsible to act on the reports the need for audit and review of policies and procedures

29. Key Players External Regulatory authorities Prescriptive approach – limit scope of activities via regulation Market oriented approach – common objectives ensured via market pressure Supervisory authorities Monitoring risk General Public Media Analysts Internal Shareholders Board of Directors Managers Managerial opportunism Diversification Managerial risk Agency costs Incentive costs Monitoring costs Enforcement costs Financial losses Principal-agent problem

30. Hedging Political Risk Avoidance Deterrence (political risk) Process Management Compensation Protection (operational risk) Offset

31. Hedging Political Risk Geographic diversification Simply put, don’t put all of your eggs in one basket. Minimize exposure Form joint ventures with local companies. Local government may be less inclined to expropriate assets from their own citizens. Join a consortium of international companies to undertake FDI. Local government may be less inclined to expropriate assets from a variety of countries all at once. Finance projects with local borrowing. Community indebtedness Political alliances Physical protection

32. Hedging Political Risk Insurance Government-owned organizations (OPIC, SACE , COFACE) offer insurance against: The inconvertibility of foreign currencies. Expropriation of home-owned assets. Destruction of home-owned physical properties due to war, revolution, and other violent political events in foreign countries. Loss of business income due to political violence https://www.sace.it/en/about-us

33. Micro project risk Macro country risk Terms of contract Stakeholder relations Location Industrial sector Attitudes to foreign investment National origin Government stability Risk Continuum Commercial Risk

34. Commercial Risk

35. Credit/Commercial Risk Possibility that counterparty will not be willing or able to perform according to terms specified in contract or otherwise expected.

36. Credit/Commercial Risk Asymmetric information Adverse Selection Actions before the commitment that produce negative outcome Moral Hazard Actions after the commitment that produce negative outcome

37. Credit/Commercial Risk Portfolio Management Limit total outstanding obligations/loans Geographic limits Concentration limits Category limits Type limits Maturities Loan pricing Appraisals Impairment/Provisioning

38. Credit/Commercial Risk Z-Score X 1 : working capital/total assets X 2 : retained earnings/total assets X 3 : EBIT/total assets X 4 : market value of equity/book value of total assets X 5 : sales/total assets Z = 1.2 X 1 + 1.4 X 2 + 3.3 X 3 + 0.6 X 4 + 0.999X 5 Z>3: unlikely to default 2.7<Z>3: on alert 1.8<Z>2.7: likely default Z<1.8: very high

39. Credit Ratings Standard & Poor's, Moody's, Fitch evaluate creditworthiness based on the same criteria as for domestic issues.  No consideration is given to ex-rate risk, just default risk.  Moody's 19 categories (9 general and 3 specific, e.g. A1, A2, A3) S&P has 20 categories (using + and - for AA to CCC) from AAA (almost no chance of default) to D (bond is in default - late, partial or no coupon payments) The top four categories (AAA, AA, A, BBB) are Investment Grade, the other categories are Speculative Grade/High-Yield/Junk bonds.  The International Bond market is mostly an investment grade market - very large MNCs with excellent credit, brand name recognition, etc.    S&P and Moody‘s ratings for foreign countries, cities, utilities, etc.  Official borrowing (central banks, local and national governments) is about 10% of international bond market Important because it usually establishes the benchmark for any entity in that country. 

40. Dun & Bradstreet Accounts receivable data D&B Credit gives data and tools to be smart, strategic growth drivers. Segmentation capabilities and customized alerts Mine the world’s largest commercial database through an intuitive interface, analytics, and scores. Monitor customer financial health and protect business with customized daily alerts. Organize, monitor and report on customer base with flexible tagging options that allow to segment companies by characteristics

41. What Does a Credit Report Include? The information that appears on a credit report includes: Personal information : Your name, including any aliases or misspellings reported by creditors, birth date, Social Security number, current and past home addresses, phone numbers, and current and past employers. Accounts : A list of your credit accounts, including revolving credit accounts, such as credit cards, and installment loans, such as mortgages or auto loans. The list includes creditor names, account numbers, balances, payment history and account status (including whether or not the account is past due). Public records: Court judgments, bankruptcies and tax liens. Recent inquiries : Who has recently asked to view your credit report and when.

42. Offsetting Commercial Risk in International Trade

43. A Typical Foreign Exchange Transaction Over the years, (centuries, really) an elaborate process has evolved for handling exports and imports.

44. Preference of the US Exporter French Importer American Exporter 1. Importer Pays for Goods 2. Exporter Ships Goods After Being Paid

45. Preference of the French Importer French Importer American Exporter 1. Exporter Ships the Goods 2. Importer pays after the Goods are Received

46. The Use of a Third Party French Importer American Exporter 1. Importer Obtains Bank’s Promise to Pay on Importer's Behalf 5. Bank Gives Merchandise to Importer Bank 3. Exporter Ships “to the Bank.” Trusting Bank’s Promise to Pay 2. Bank Promises Exporter to Pay on Behalf of Importer 6. Importer Pays Bank 4. Bank Pays Exporter

47. Letter of Credit A guarantee from the importer’s bank that it will act on behalf of the importer and pay the exporter for the merchandise if all relevant documents specified in the letter of credit are presented according to the terms of the letter of credit. In essence, the importer’s bank is substituting its creditworthiness for that of the importer. The main advantage of the letter of credit is that both parties to the transaction are likely to trust a reputable bank even if they do not trust each other

48. Draft A draft , also called a bill of exchange , is the instrument normally used in international commerce for payment A draft is simply an order written by an exporter instructing an importer, or an importer's agent, to pay a specified amount of money at a specified time A sight draft is payable on presentation to the drawee while a time draft allows for a delay in payment - normally 30, 60, 90, or 120 days

49. Bill Of Lading The bill of lading is issued to the exporter by the common carrier transporting the merchandise It serves three purposes: it is a receipt it is a contract it is a document of title

50. Banker’s Acceptances The exporter’s bank presents the shipping documents and the time draft to the importer’s bank. After taking the title for the goods via the bill of lading, the importer’s bank accepts the time draft. At this point the banker’s acceptance is created. It is a negotiable money market instrument. A secondary market exists for banker’s acceptances.

51. Process of a Typical Foreign Trade Transaction Importer’s Bank Exporter’s Bank Importer Exporter Money Market Investor Purchase order 1 L/C application 2 Letter of Credit 3 L/C notification 4 Shipping documents and time draft 6 Payment discounted value of B/A 9 5 Shipment of goods Payment face B/A 14 Signed promissory note for face value of B/A 10 Shipping documents 11 Shipping Documents and time draft accepted 7 Payment-discounted value of B/A 8 B/A 12 PV B/A 13 Face Value B/A 16 B/A presented at maturity 15 $100 x 10% = 110 $100 $100 $110 $100 $110 $110 $100 x 12% = 112