Introduction
Over the last two decades, financial systems have faced many challenges in terms of business risks and unforeseen market changes that lead to losses. These circumstances led to better insight and research into the risks that face financial institutions. Focus was put on three main areas of risk: Risk analysis, risk assessment and business impact analysis.
Risk analysis entails identifying the possible threats to a corporation and finding out the loop holes that might expose the corporation to these threats. Risk assessment on the other hand entails assessment of the mitigation measures put in place to counter the threats against the organization or corporation. Business impact analysis deals with analysis of the overall performance of the organization (Risk analysis techniques 1997).
The risks faced by financial institutions over the years have been liquidity, market, foreign exchange, interest rates and credit (Forlani 2002).These risks have been greatly reduced due to development of modern risk management techniques.
These techniques are vital for risk management but bring along several advantages and disadvantages. It is therefore a matter of striking a suitable balance between the pros and cons in ensuring that the most effective risk management technique is employed. The paper puts into focus the risks, some the most common and effective mitigation techniques and their pros and cons.
Risk of Foreign exchange
The foreign exchange market is where financial institutions trade in different world currencies. Foreign exchange rate is the price at which one currency is exchanged for another. A foreign exchange rate of 75Kenya shillings to 1 US Dollar just means that you would have to pay 75 Kenya shillings to get 1 US Dollar.
The value of one currency relative to other world currencies varies subjectively rather than objectively because it is dependent upon speculation more than any fixed standards (BMO capital markets 2008).
This variation in value therefore leads to currency risks because the import and export businesses in the countries in question are affected. A stronger US Dollar would mean higher product value for Kenyan exporters because they get more shillings for each Dollar; on the other hand, this would mean higher expenses for importers who would have to pay more for each Dollar.
Financial analysts try to analyze and predict these movements in the foreign exchange rate with their principle objective being to minimize any losses that may be incurred due to unfavorable movements in foreign exchange. This analysis ensures that company value in terms of liabilities, assets and cash flow is protected as this can also greatly change with the prevailing exchange rate (Dew & Wiltbank 2009).
Profits could also be greatly increased with proper risk analysis. As illustrated above, an exporter in Kenya could hold his product when the value of the Dollar is at say 65Kshs and wait to sell when the Dollar gains value to say 78Kshs.
This would mean an extra 13Kshs for every Dollar worth of product, gained purely out of speculation.It should however be noted that there exists the risk of loosing if the value of the Dollar drops to for example 55Kshs.
Techniques are used to hedge against foreign exchange risk
Non-Hedging Foreign exchange Risk Management Techniques
This is a simple method of risk management where if the exporter and importer countries have currencies with relatively similar value, then they need not change their money into world leading currencies like the US Dollar (Money matters 2005). This reduces the currency risk associated with foreign exchange fluctuations.
FX Forward Hedges
This is perhaps the most direct means of hedging foreign exchange risk. Here, an exporter and importer get into contract to trade at a fixed forex rate for a given period with the facilitation of a financial institution.
If a Kenyan exporter sells to an American importer goods worth 1 million Dollars at an exchange rate of 75 USD to 1Ksh, the Kenyan exporter may get into contract with a financial institution to deliver 1 Million Dollars in Exchange for payment of 75millionKshs over 90 days.
This acts as a form of insurance to the exporter as within the given time frame, he can exchange his 1 million Dollars for 75millionKshs irrespective of what happens to the exchange rate. The exporter must however deliver the 1 million Dollars even if the American fails to pay on time (International Trade Administration 2008).
Foreign exchange Options Hedges
Foreign exchange options are used if a foreign currency deal is carried out without a specific date of completion or delivery. The option holder buys the right to buy domestic currency at an agreed upon exchange rate within the time period that the option is valid.
The investor is protected against losses in case the foreign currency drops and has the option of selling the option back to the lender if the foreign currency goes up substantially (Miller 2007). The options therefore provide more flexibility than forward hedges but come with a higher cost.
Credit risk
Credit risk is the risk that a debtor of a corporation will not pay all or part of his debt within the agreed upon period (Ruefli, Collins & Lacugna 1999).Analysis into these risk aims at reducing losses due by finding out as much as is possible to help the managers make informed decisions about whom to lend.
Credit risk mitigation techniques
There are many varying ways of reducing credit risks. Some common ones used by banks include checking loan repayment history, demanding some collateral and trying to recover as much from the debtor as possible incase they fail to pay up (when dealing with individuals) (Kidwell et al 2007).
When choosing and managing loan portfolios, banks reduce credit risks by designing different loan products for different target clientele (Kidwell et al 2007).The banks could also put in place internal mechanisms to help them monitor their credit risks more accurately.
Internal analysis by banks can greatly reduce credit risks because control measures can be expanded to include credit exposures that may come about by settling credit trades or by including properly measured credit settlement exposures under identical controlled environments in the control mechanisms (Selim & McNamee 1999).
Systems can be built to renew current and any future unsettled exposures and monitor them through the settlement process. This ensures that there is accurate and timely information that pertains to credit risk settlement exposure (Chang & Thomas 1989).
For international banks dealing with many currencies and trading across wide geographic areas, this can only be effective with the help of a merged risk management system (Settlement Risk In Foreign Exchange Transactions 1996).
The banks then apply agreed upon credit controls to all their credit risk settlements which help them keep their credit exposure within acceptable limits. Banks can considerably cut credit risks without necessarily reducing the amount of credit trading by fine tuning their means of settlement (Miller 1998).
Interest rate risk
This risk lies in the fact that interest rates may change and affect the flow of cash in different financial vehicles (Fenzel & Scholz 2008).Reinvestment income could also be adversely affected by changing interest rates (Kidwell et.al 2007).Dipping interest rates will mean lower returns for the lender.
Interest risk analysis is aimed at minimizing vulnerability to changing interest rates to ensure that the organization makes profit and if there are any losses, then they should be minimal (Kidwell et.al 2007).This risk is particularly two sided as if the interest rates go high, one party is bound to benefit as the other incurs losses due to reduced earnings.
Mitigation Techniques used to reduce interest rate risk
It is essential that the risk likely to be brought about by changing interests be fully understood for proper interest risk management to be effected (Henkel 2009).Organizations ought to put in place mechanisms to measure the potential effects of a change in the interest rates (Torben, Denrell & Bettis 2007).
Gap analysis, duration analysis and VAR are the most common methods used by organizations to measure this. Gap analysis is done by comparing the difference between assets earning interest and interest bearing liabilities during a given period. A greater difference is an indication that the organization is more exposed to interest rate variation (Baucus & Cooper 1993)
Duration gap analysis measures the duration of the organizations assets and the duration of its liabilities; keeping a smaller difference between these two protects the organizations balance sheet in value subject to interest rate changes (Kidwell et.al 2007).
VAR is the most often used method of measuring risk. It is a statistical representation of the worst economic loss expected from a change in market due to prevailing conditions, at a specific confidence level and period (Miller & Reuer 1996)
. For example 79% implies that 79 out of every100 observations won’t be more than the VAR number.The VAR results are presented as a % of the total capital to show the ability of the organization to take the computed loss (Bank of Jamaica 2005).
Futures, options and swaps are some common derivative techniques used to help minimize interest rate risk and ensure profit or minimum losses.
Financial futures contracts
Financial futures are employed with the aim or reducing interest rate risks. The price of these futures goes up when the prevailing interest rates are low and subsequently drops when the interest rates rise. A good illustration of this is in the banking industry; when the bank risks a drop in profits due to rise in interest rates, it offsets this risk by selling financial futures (Palmer &Wiseman 2007).
Options on financial futures
Caps, floors and collars on interest rates can be created by use of financial futures which act to reduce interest rate risks. A cap acts as a shield against increasing interest rates while a floor shields the organization against dipping interest rates(Kidwell et.al 2007).
Caps put a limit to the extent to which the cost of a product can rise and a floor gives the lower limit of the product price. Though at a cost, this provides some of balance and ensures that interest rate losses are minimized.
Swaps
While options and financial futures mitigate against interest risks in the short run, swaps are better suited for mitigating against long term interest rate risk exposures. Swaps allow banks to trade funds at a variable rate for a fixed cost of funds (Juttner et.al 1997).
As an illustration, if a financial institution speculates that interest rate will go up, they can get into a swap where they will pay at a fixed rate but receive floating. This ensures minimum losses and more stable earnings.
Conclusion
It was established that the main risks affecting most markets and financial institutions are credit risks, foreign exchange risks and interest rate risks. These risks could bring about huge losses both in reduced earnings and company value depreciation if not regularly and effectively managed.
These risks have however been greatly reduced due to development of modern risk management techniques over the years. The most common and effective ones include swaps, financial futures, options and forward hedges. All these have been discussed in the paper and their pros and cons highlighted.
Different financial institutions, individual investors and corporations all face the above mentioned risks at different degrees and situations; one situation may bring about losses to one party yet benefit the other.
Although the risks are different and each party experiences them under unique circumstances, all parties need some degree of analysis to ensure that any losses resulting from these risks are minimal, if present at all. Different techniques are employed but financial institutions similar techniques to hedge against the risks.
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