Introduction: Financial Risk Management

Hello everyone and welcome back. We are now in our fourth week and at the mid-way point of the course. Last week we discussed the legal principles surrounding risk management and touched on how to plan for handling risk. This week we will explore financial risk management. Some of this week’s content may make your head spin, but just stay with the content and join the class in the discussions to better understand the material!

Scope of Risk Management

In recent years, risk management programs have expanded to cover all risks the company may face, loss exposures, personnel risks, liability risks, and financial risks. Financial risk management is the “identification, analysis, and treatment of speculative financial risks” (Rejda, 2014, p. 63). These financial risks include commodity price risk (potential loss of money should the price of a commodity – corn, grain, bacon, etc., change), interest rate risk (loss of money when loan rates change), and currency exchange rate risk (loss of value from one country to another). For Risk Managers to make a decision involving cash flows in different time periods, they use the time value of money. The Time Value of Money can also be applied in risk management decision making, like analyzing insurance coverage bids or risk-control investment decisions.

In previous courses, many students have asked “What is the point of commodity risk?” To put it simply, there is little difference between one commodity from a particular producer versus the same commodity coming from another producer. The price of corn from one agricultural organization is typically the same price as from another. Traditional commodities include beef, oil, grains, natural gas, gold, and now recently foreign currencies. Aspects that can affect commodity prices include regulatory or political changes, weather, market conditions, seasonal variations, and technology. Commodities can be bought with “futures” on a commodity exchange to lock in a specific price for a sale on that commodity at a future date. Any unexpected changes in the commodity prices can reduce a producer’s profit margin and make their budgeting more difficult.

Credit Risk

The term credit risk might be unusual to some of you, but it is a major risk concept for retailers. Credit arises when an individual is authorized to obtain a product or service prior to payment, with a contractual understanding that payment will be made in the future. The credit risk measures the probability the money owed will be paid. Think about your personal credit score. This is based on the amount of loans or debt you currently hold and your past payment history. If you owe creditors a lot of money and are chronically late on payments, then your “credit risk” would be high. The same holds true for companies. If a retailer wants to invest in a new fleet of trucks to deliver their products to their stores at a more reliable pace, they may need a loan advancement in order to purchase those trucks. The bank will look at their credit risk before approving or denying the funds. Or maybe the trunk manufacturing leases those vehicles to the retailer directly. Payment terms on the lease are associated with the credit risk of the retailer. The same holds true if your company distributes products, like a toy manufacturer. If a retailer orders 100,000 unites of a certain type of toy, this can be bought on credit where the order is placed and payment is made within 30-90 days depending on the payment terms of the contract. The toy distributor will weigh the credit risk of the retailer. If the retailer has a history of late payments, the toy manufacturer may be hesitant on allowing a large order or may want money up front to help mitigate any potential future losses

Foreign Exchange Risk

Why might the exchange of the US dollar with a foreign currency matter to an American retailer? (You were not expecting a financial crash course were you?) Foreign exchange risk occurs when a financial transaction is documented in a currency other than the foundation currency of the company. For example, an American company dealing with financial transactions in China, Greece, or another foreign country. Foreign exchange risk usually only affects companies that import and/or export their goods and services. A U.S. company with a wool supplier from New Zealand can cut their costs if the New Zealand dollar weakens against the U.S. dollar. Being able to understand the value of your home country’s currency in relation to foreign currencies will allow you to make smarter investments priced in foreign dollars.

Risk managers might use a Risk Management Information System, or RMIS, to calculate and track financial risk issues. An RMIS is a computerized database that allows risk managers to store, update, and analyze risk data and to turn that data into future predicted loss levels.

Wow! That was a very brief overview of some complex financial risk issues that risk managers and businesses face on a regular basis. Do I expect you all to know the ends and outs of each fully? Not at all. This course is designed to get you thinking like a risk manager and to understand the concepts associated with a risk manager position. I would like you all to read your text content further and then to take to the discussions to not only answer the discussion question, but to generate a discussion on these financial risk matters. Ask questions if you do not understand concepts or provide examples if you have real-world examples. I look forward to reading your responses and input.

According to Rejda (2010), "Traditionally, risk management was limited in scope to pure loss exposures, including property risks, liability risks, and personnel risks. An interesting trend emerged in the 1990s, however, as many businesses began to expand the scope of risk management to include speculative financial risks. Some businesses have gone a step further, expanding their risk management programs to consider all risks faced by the organization (p. 63)."

Scope of Risk Management

I. The Changing Scope of Risk Management

A. Financial Risk Management - refers to the identification, analysis, and treatment of speculative financial risks.

1. Commodity Price Risk
2. Interest Rate Risk
3. Currency Exchange Risk

II. Loss Forecasting - A risk manager needs to identify the risks an organization faces and analyze the potential frequency and severity of those loss exposures.

To help in predicting loss levels, risk managers can use the following techniques:

A. Probability Analysis

B. Regression Analysis

C. Forecasting with Loss Distributions

III. Financial Analysis in Risk Management Decision Making - For Risk Managers to make decision involving cash flows in different time periods, they use the time value of money. The Time Value of Money can also be applied in risk management decision making, like analyzing insurance coverage bids or risk-control investment decisions.

A. The Time Value of Money

B. Financial Analysis Applications

IV. Other Risk Management Tools

A. Risk Management Information Systems (RMIS) - "a computerized database that permits the risk manager to store, update, and analyze risk management data and to use such data to predict and attempt to control future loss levels" (Rejda, 2014, p. 79).

B. Risk Management Intranets

C. Risk Maps - "grids detailing the potential frequency and severity of risks faced by the organization" (Rejda, 2014, p. 79).

D. Value at Risk (VAR) Analysis - this is the "worst probable loss likely to occur in a given time period under regular market conditions at some level of confidence" (Rejda, 2014, p. 80).

Reference

Rejda, G.E. (2014).Principles of Risk Management and Insurance. 12th Edition. Englewood Cliffs, NJ: Prentice Hall.