Spotlight Quiz. Financial Risk

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1 Spotlight Quiz Financial Risk 1 Risk and Reward One of the first things that we learn in finance is that there is a relationship between risk and reward; if you want to earn high rewards you need to accept some risk or that to justify taking some risk you need to be able to expect a high return. This translates into one of the basic principles of the rational investor : a preference for more return given a constant risk or a lower risk given a constant return. This sometimes leads us to suppose that if we expose ourselves to risk, then we must also be exposing ourselves to commensurate returns. Clearly that is not true. Our principle is based n the concept of the rational investor, who would knowingly accept risk only if the return was adequate to compensate for the risk taken. There are many examples of risk not matching potential return, which is why the rational response to such risks is to avoid exposure unless adequately compensated. Equity investors accept risk when investing in shares. They do so in the expectation of making a return that matches the risk taken. This is important for companies because they must provide a return for the investor that matches the expected risk, otherwise the investor will not invest, the share price falls if there are no buyers and the company finds it harder to raise capital. Question 1 What is the name given to the risk that determines the return that the equity investor should expect? (a) Specific risk (b) Diversifiable risk (c) Systematic risk (d) Interest rate risk The right answer is (c) systematic risk Specific risk and diversifiable risk are different names for the same thing, the risk that can be diversified away by investing in a diverse portfolio of investments. Every investment has its own potential for doing better or worse than expected, so each share can go up or down on the news specific to that company. But when the investor makes investments across the board, the good news will largely offset the bad news, the overall portfolio will react only to the news that affects the overall economy i.e. when the whole market gains or loses value. The return that the investor can expect is based on this overall market movement, which is the systematic risk, often also called

2 market risk. A risk greater than the market will produce greater returns than the market while a risk lower than the market will produce returns lower than the market on average. The theory argues that diversifiable risk is not rewarded with extra return because the investor does not have to accept exposure to it. 2 Risk management Risks can be regarded as those that are rewarded and risks that are unrewarded. This means that the first challenge for risk management is to identify which risks are rewarded and which are unrewarded. If we can identify the risks that are rewarded, then we can assess risk and the return and decide whether the return is worth the risk. If the risk is unrewarded there is clearly no judgement to be made we should avoid those risks. The first step in the risk management process is to identify as many risks that the company is exposed to as we can. Question 2 When compiling the initial register of identified risks, which are the most important relationships for the risk manager? (a) Treasury audit staff (b) Internal management accountants (c) Commercial and operational management (d) Central services management The right answer is (c) commercial and operational management The key risks for the company almost certainly lie in its dealings with the outside world: making things, providing services or selling / buying things. The only way to understand how these processes work is to form relationships with the management in those areas It is tempting to believe that the treasury or other financial staff know everything that there is to know but maybe, in this instance only, they are not best placed to help. Risk arises because commercial managers make commercial decisions, for example deciding to allow a customer to pay in USD instead of EUR, without realising the financial risk implications. If the implications aren t realised, then they cannot be transmitted to the risk manager concerned the risk manager has to be close enough to the operations to be aware when instances like this arise. In this case as far as the commercial manager is concerned, he has reduced the risk that the customer will not buy by allowing him to pay in USD. 3 Business risks versus financial risks The concept of rewarded and unrewarded risk can be very useful in deciding whether risk exposure is acceptable. One non-financial example would be the core risk of being in a particular business. The risk of being a participant in the soft drinks business is clearly acceptable to Coca Cola and Pepsi Cola: they understand the business, its competitors and how to generate profits and shareholder

3 value from being in that business. Investors invest in them because they believe in their ability to continue to generate that shareholder value in that business. So, Pepsi and Coke don t try to hedge their risk of being in that business (for example by diversifying), they focus on that business. Investors want exposure to their business risk because they believe in their ability to manage that risk. Conversely, investors almost never look at a company and see long term value on their ability to generate value from financial risk. Each company might get occasional lucky gains from currency or interest rate exposures, but rarely if ever is there any consistency in such gains. Question 3 A company Board has decided that they are going to accept only business risk and no financial risk whatsoever. As treasurer you are currently arranging a new term loan and have to decide which of the following you should choose to remain within this Board edict. From the following, which will be closest to the zero risk strategy? (a) A floating rate loan, because you expect rates to fall (b) A fixed rate loan, because you expect rates to rise (c) 50% of the loan fixed and 50% floating (d) Whichever is the best match for the variability of your company s performance The right answer is (d) Whichever is the best match for the variability of your company s performance There is no way to avoid taking any financial risk. As soon as you do business you are exposed to some form of financial risk. In this case, if you raise a floating rate loan, rates might rise. On the other hand if you raise fixed rate money, then rates might fall meaning that you pay more than you needed to and perhaps more than your competitors and the market value of your loan increases. Choosing 50% fixed and 50% floating is one way to try to avoid the problem, reducing the amount by which you are likely to be wrong, but the real answer is not to try to outguess the market in which way rates are going to go. It is to match the way in which your company s performance varies to the interest rate cycle to the interest basis of the loan. The classic case before the global financial crisis of recent years was of the housing market: interest rates fall and the market rises; interest rates rise and the market slows. The effect of this is that businesses that were related to the state of the housing market (fitted kitchens, carpets etc) did well when interest rates were low and suffered when rates rose. As a result floating rates were high risk for companies like this rates rise so interest cost increase just as performance falls. Unfortunately recent times have clouded the picture regarding low interest rates but that brings in other factors that affect housing such as certainty of future income etc. 4 Economic exposure Risks to do with currencies come in different guises. Sometimes they can appear without any obvious link to currency.

4 Question 4 The Heartbreak Hotel is a large hotel in London. Some years ago they decided to reduce their marketing cost by marketing exclusively to US holidaymakers. This added focus to their marketing and to the way that they organised their hotel; menus and decor was designed to US tastes. They source all of their supplies locally and all of their revenue is in GBP. Which of the following describes the hotel s currency risk? (a) They have a transaction risk exposure to the USD (b) They have a translation exposure to the USD (c) They have an economic exposure to the USD and other currencies (d) They have no currency exposure because all of their cashflows are in their home currency The right answer is (c) they have an economic exposure to the USD and other currencies Even though the hotel has no foreign currency transactions it does have a risk exposure. US travellers choose London as a destination for many reasons. Some of those reasons will be very powerful, but few will overcome any price difference between GBP and other potential destinations. For instance, a variation in the GBP/EUR rate may make Rome or Dublin more or less attractive as destinations because the cost of the holiday may be lower than London. If the USD is particularly weak, then the number of US holidaymakers may decline as more people decide to stay at home rather than meet the extra cost of travelling abroad. The point here is that companies are exposed to currency risk if there are competitors or buyers or suppliers whose home currency is different to yours. There are very few businesses that do not fit that description; clearly Heartbreak Hotel is exposed. In fact it is hard to think of businesses without international competition. The term economic exposure describes a risk that is longer term and associated with the value of revenues in home currency or the ability to project current performance into profits/cashflows over the long term. Transaction risk is the short term equivalent; concerned with home currency values of known cashflows, typically those that have already been invoiced. Economic risk is concerned with uninvoiced flows that can be expected in future years. In the case of a hotel, if fewer tourists travel or if they travel elsewhere, then the hotel s performance will suffer. If travel decisions are swayed by currency rates, then this is a currency exposure for a hotel catering for foreign travellers. 5 Identifying critical risks Currency risks can be categorised into transactional, translational and economic currency risks. In a company or group where all of these exist it may be necessary to identify which one or ones are most critical and take steps to manage them even if some residual risks remain. Question 5

5 You are advising a UK-based hotel group whose activities are financed by equity and debt in the UK. It has a subsidiary in the UK which operates but does not own a large hotel in the UK. The group also owns a subsidiary in New York which operates and owns a large US hotel. As a result, the assets are heavily weighted towards the US by the US hotel. The earnings split is heavily weighted towards the UK because the US is operating on fine margins to build a market position. Any US earnings are likely to be re-invested into the hotel facilities for the next several years. As a relatively small group, you had to accept several covenants as part of a recent GBP loan agreement, including a gearing covenant. Which of the following best describes the currency risk to which the group is exposed? (a) Each of the subsidiaries is self contained so there is minimal currency risk (b) The main currency risk is translation risk, due to the gearing covenant (c) Translation risk is unimportant because it does not involve cash (d) Balance sheet risks don t matter because they only refer to year-end rates; they will swing back The right answer is (b) the main risk is translation risk, due to the gearing covenant The two subsidiaries are largely self-contained and, depending on the origin of hotel guests, the cashflows appear to be almost all internal to each territory. The exception might be the servicing of the GBP loan based on GBP and USD revenues. There is potential for a risk here, but it was not one of the alternatives. There is significant risk in the potential for gearing to change as the GBP/USD rate changes. If the balance sheet asset split is heavily weighted towards USD, then as the USD declines in value relative to GBP, the consolidated balance sheet will reflect the declining value of USD assets. The consolidated balance sheet total assets will decline at roughly the rate of the USD decline again, if the total assets are heavily weighted towards USD. In turn, if the total assets decline, then something must decline on the other side of the balance sheet and that will be shareholders funds. The net effect is that debt will remain constant (because it is in GBP) while equity shrinks, resulting in gearing increasing, and potentially breaching the covenant. Of course, the way around the problem is to put the debt into USD. Then the following year when USD regains all the ground lost the equity will be protected as total assets grow and all of the growth on the liability side of the consolidated balance sheet will concentrate onto... USD debt. The result again is that gearing increases! A careful splitting of the overall debt into a GBP proportion and a USD proportion can avoid the problem by ensuring that gearing can be protected but only if the problem is identified and understood beforehand. A translation risk could exist on the US earnings when they are consolidated back into sterling accounts, but we are told they are relatively low. Any cash flow remitting dividends back to the UK is another area of risk but for the moment cash is being reinvested in the US.

6 6 The Risk Framework The ACT has endorsed the concept of a risk framework as shown in the diagram below. This framework guides the process through from the initial identification of risk and the broad assessment of whether each risk can be categorised as on a scale such as life-threatening through to trivial, to the detailed evaluation of the more important risks and the decisions about how to manage and report risk. Perhaps the most important aspect of this framework, though, is the feedback loop that links from the end of the process back to the beginning. This link is vital for two reasons: first because the situation never remains the same, changes in the competitive environment or the economic environment affect the risks to which we are exposed. But secondly and more importantly, as soon as we respond in any way to a perceived risk, we change the net risk position. As a result we need to go back to the start to make sure that we understand the new situation. Question 6 We are expecting to need funds for a specific period of time next year. We are confident of our ability to borrow, but we do not know what the cost of that borrowing will be. As we operate on fine margins, we are concerned about the potential for interest rates to rise before we need to borrow. We are also very concerned about our key competitor who will also need to borrow next year, and we want to make sure that we do not pay more than them. Which of the following is FALSE? (a) Leaving the exposure open means we are exposed to rising rates (b) Leaving the exposure open while the competitor fixes means we are exposed to rising rates (c) Fixing the forward rate while the competitor leaves his exposure open, means that we lose out on falling rates (d) Fixing the forward rate means that we remove all risk The right answer is (d) fixing the forward rate means that we remove all risk

7 We correctly identified that our exposure to interest rates next year was a risk. However, responding to that risk changes the nature of our exposure. The only thing that is certain, in this case, is that nothing can remove all of the risk. What we should be trying to do, as risk managers, is to ensure that we understand the risks to which we are exposed and that we are comfortable with the potential outcomes.