Risk Management: Techniques for Covering Risk Research Paper

1. The balances to both intra-group and third party are matched. The companies match the inflows and outflows in different currencies covered by business, so that it is only necessary to deal on the currency markets for the unmatched proportion of the total transactions. It ensures that purchases and sales in each currency and deposits, given and taken in each currency, are in balance by amount and by maturity.
2. Leads and Lags: the acceleration or slowing payments or receipts when a change in currency rates is expected
3. Invoicing currency: importers and exporters of goods and services charge in the currency with favorable rate.
4. Insurance: a company covers for a sudden change or total impasse in the availability of foreign currency on the maturity date.
5. Futures: is a contract based on an order, placed in advance, to buy or sell an asset or commodity. The price will be fixed when the order is placed, but payment for the asset is not required until the delivery date. In this case, the buyer puts aside some cash as form of assurance that he will pay or have the ability to pay when time comes.
6. Spot foreign exchange is a binding obligation to buy or sell a certain amount of currency at the current market rate for settlement in two business days
7. Option is the right to purchase or to sell a certain asset at a preset price on or before a specified date.
8. Swap is an agreement exchange specified assets or cash flows at fixed intervals, with the terms initially set so that its present value is zero
9. Netting: involves associated companies that trade with each other and refers to potential flows within the group of companies The companies calculate the total exposure by offsetting the receivables and payables, in the same currency, for the same dates

From the techniques discussed, the company will use almost all of the above since Australia has active foreign exchange market.

Political risks

Some countries may experience major political instability, which could result in defaults on payments, exchange transfer blockages, nationalization or confiscation of property. Civil disorder may affect personal security. Unlike third world countries, Australia is a country with predictable political risks. There are very few political risks.

Market risk

Finding stock prices falling from time while a company’s earnings are risking and vice versa, is not uncommon. The price of the stock may fluctuate widely within a short span of time even though earnings remain unchanged. The causes of this phenomenon are varied, but it is mainly due to change in investor’s attitude towards equities in general, or towards certain types or groups of securities in particular. Variability in return on most common stocks that is due to basic sweeping changes investor expectations is referred to as market risk.

Market risk is caused by investor reaction to tangible as well as intangible events. Expectations of lower corporate profits in general may cause the lager body of common stocks to fall in price. Investors are expressing their judgment that too much is being paid for earnings in the light of anticipated events. The basis for the reaction is a set of the real, tangible events –political, social ,or economic.

Intangible events are related to market psychology. Market risk is usually touched off by a reaction to revel events., but the emotional instability of investors acting collectively leads to snow billing over reaction. the initial decline in the market can cause the fear of loss to grip investors, and a kind of herd instinct builds as all investors make for the exit. these reactions to reactions frequently culminate in excessive selling pushing prices down far out of the line with fundamental value. With a trigger mechanism such as the assassination of the politician, the threat of war, or an oil shortage, virtually all stocks are adversely affected. Like wise, stocks in a particular industry goes “out of fashion”

This discussion of market risks has emphasized adverse reactions. Certainly, buying panics also occur as reactions to real events, however, investors are not likely to think of sharp price advances as risk.

Two other factors, interest rates and inflation, are an integral part of the real forces behind market risk and are part of the lager category of the systematic or uncontrollable influences. Let us turn our interest rates. This risk factor as it’s most direct effect on bind investments.

Interest – Rate Risk

Interest- rate risk to the uncertainty of future market values and of the size of the future income, caused by fluctuations in the general level of the interest rate. the root cause of the interest –rate risk lies in the fact that, as the rate of interest paid on U.S. government securities (USGs) rises or falls , the rates of return demanded on alternative investment vehicles, such as stocks and bounds issued in the private sector ,rise or fall. in other words, As the cost of money changes for nearly risk-free securities (USGs) the cost of money to more risk- prone issuers (private sector)will also change.

Investors normally regard USGs as coming closest to being risk free. The interest rates demanded on USGs are thought to approximate the pure rate of interest, or the cost of hiring money at no risk. Changes in rates of interest demanded on USGs will permeate the system of available securities, from corporate bonds down to the riskiest common stock.

Interest rates on USGs shift with changes in the supply and demand for government securities. For example, a large operating deficit experienced by the U.S government will require financing. Issuance of added amounts of USGs will increase the available supply. Potential buyers of this new supply may be induced to buy only if interest rates are somewhat higher than those currently prevailing on out standing issues, if rates on USGs advance from, say 9 percent to 9 ¼ percent investors holding out standing issues that yield 9 percent will notice a decline in the price of the securities. Because the 9 percent rate is fixed by the contract on these ‘old’ USGs ,a potential buyer would be able to realize the competitive 9 ¼ percent rate only if the current holder “marked down” the price. As the rate on USGs advances, they became relatively more attractive. Consequently, bond purchasers will buy government instead of corporate. This will cause the price of corporate to rise.rising corporate bond rates will eventually cause preferred –and common stock prices to adjust downwards as the chain reaction is felt through out the system of the security yields. (the exact nature and the extent of this markdown process and the relationships between rates, prices, and maturity.

Thus a rational, highly interconnected structure of security yields exists. Shift in the pure cost of money will ripple through the structure.the direct effect of increases in the level of interest rates is to cause security prices to fall across a wide span of investment vehicles. Similarly, falling interest rates precipitate price mark ups on outstanding securities.

Financial Engineering

Financial engineering is the structuring of finance designing, modeling, analysis of financial products to offer competitive advantage for an investor and it involves mathematical calculations. It may involve the construction of financial construct using modern technologies that is mathematics and computer programs to suit the enterprises objectives. Financial engineering will include using modern methods in security analysis, portfolio analysis and investment analysis for the company and individuals. financial engineering uses computer programs it also used in operations and research.examples of financial programming includes linear programming ,decision tree analysis.

It may involve the construction of instruments and processes that will enhance stakeholders wealth, it involves the use of modern innovation, insecurity innovation, innovating financial solutions and processes for the organizations problems. It involves pulling of risks using options futures and other exotic derivatives. It uses simulations and the calculation of the company, there are ten areas involved in financial engineering they are academicals research, risk management, cost reduction and taking tax advantages. The development of financial technologies as helped in the trading in the stock exchange.

Financial Technologies

The development of technology and its use in trading has helped in speeding up transactions among trading partners in the recent past. The introduction of internet and intranet has made information of various companies and businesses available in stock exchanges in various countries to be readily available for international investors. This has helped in the globalization and has reduced transactional cost among trading partners. It is easier now than ever for an investor to put his money in New York stock exchange with ease and at a reduced cost because of reduce of intermediaries. Some stock exchanges i.e. electronic stock markets are easily available online thus allowing investors to directly access the required information and determine the best price at which a security can be purchased.

This technological development has been combined with security stock exchange dignitary changes which have led to the growth in electronic trading. The purchase of goods and services has not been spared by technological changes that have taken place in the U.S and other parts of the world. It’s now easier than ever for a stock or any other security investor to get information from the market from her/his purchases. Technology has allowed institutions to deal with stock, real time without each other meeting and the use of credit cards has also increased chances of trading without meeting. Transactional cost has also reduced, making business transactions cheap thus reducing commissions and carry over and increasing efficiency and quality of service. There is easier trade as compared to the past as large orders are easily transmitted but with limitation.

Technology which has led to changes in the stock market greatly and does not affect the American market only but also the European market. There is an increase in the sales volume from the stocks market. The following are the ethics of technology to trading¹.

1. A level of playing field. All the information is available real time for all investors and brokers at the same time. The only way insiders can get information is through accessing vital information which is otherwise not available for the public anywhere. Therefore technology offers affair deal of information. It is now believed that there is fairness in the trade of securities since all the information is available to all and discriminatory. Unlike in the open cry method where the trading in the stock was majorly dependent upon the trader. If the trader was, dishonest then the customer would get the same. This was due to scandals involving documents in the front office immediately after the verbal transactions. The electronic has harmonized these trading in equities and made it simple.
2. Speed. Transactions are processed instant and trade is quickly completed. Through a click of the mouse information is exchanged. There is convenience among investors as there is high speed in processing the stock transactions. There is also huge data credit by the electronic investors involving vendors, investors, intermediaries to enable easy access of information for the purpose of trading. This keeps a register which enabled east access of traders in the market. It is easier to speed up negotiation as one has details of the customer or the trader dealing with the shares.
3. Transparency. There is transparency in the transactions of buying and selling of stock in the market. Unlike in the past where information was only accessed by a few individuals it is now available to all. Investors can now get information about the stock prices of the shares they want to buy, therefore the broker cannot make extra money from transactions carried out in the market apart from their commissions.
4. Technology has also made trading flexible to many investors by extending the trading hours thus making the market accessible to many in long hours.
5. It has made the market reliable, efficient, simple and predictable. It is easier today for an investor to know with some degree of certainty the price that may prevail the following day. Technology which has made trading reliable has provided information which is used easily by investors. Unlike in the open cry method where information was available at the hands of the few.
6. It has allowed investors to trend in decimals instead of fractions which were used before technology.

Cost. The cost of trading especially transactional cost has been reduced by a significant matching. The electronic flow has made trading quick, fast and reliable reducing the cost associated with open cry method. This reduction ion cost is associated with a number of factors such as elimination of office space for the brokers or trading agents to engage in trading in. there is also a single trading center or system reducing many systems which added cost. There is also sharing of clearing and making system which is done at the same time. One will not forget the speed at which settlement process is carried uot through the same system that reduces the cost. The open book and data dissemination process becomes quick, reducing the cost. This economies of salary reduces the cost and keeps it ,low. The cost reduction associated with introduction of information technology is estimated to be enormous

Intrest and Exchange Rate

Foreign exchange involves things like currency shortages, depreciation, and increase of public debt or exchange rate fluctuations. Proper strategies should be adopted to cover against this risk. If the risk is not well covered, it will affect the cash inflows and outflows and eventually profitability or even operations of an enterprise. Strategies adapted can be Strategic actions, operational tactics, and financial tactics.

Several instruments are used to cover against this risk although not available in all markets. Their availability in the market depends solely on the development of the economy in question that is financial infrastructure and services offered by the banks operating within it. Therefore, a risk management strategy requires one to be effective, have a good understanding of financial instruments and above all in emerging issues in the economy where you are investing. It is important to access these risks thoroughly, identifying the potential risks and assessing the strategy available to reduce them.

Exchange rates are influenced by several factors including inflation rates, income levels, interest rates, government policies, expectations of economic events or changes, natural disasters or events and the effects of currencies fluctuations can have impacts at different levels.

Operational Research

As an approach, management science, Operations Research refers to the attitude with which management scientists view, analyze and solve management problems. The essence of this approach is, first problems must be expressed in quantity and second, that symbolic modes of expression and reasoning one to be preferred. To the extent possible, problems are examined with a systems orientation and in practice.

Management develops uses of scientific models that project the consequences of alternative causes of action. That incorporates the elements of chance, rise and uncertainty in order to help managers make rational decisions and choose optional policies.

There are two decision models:

• Descriptive model
• Normative model

In the domain of descriptive model, the focus of study is how people behave and make decisions not on how they ought to behave. The purpose is to describe the process by which managers in full go about making decisions.

Normative decision models which are the main focus of economies and statistics deal with how decisions should be made. These models prescribe for the manager the most courses of action.

Most managers would rather live with a problem they can not solve than use a solution they can not understand because they have fear of uncertainties and risk for instance if they make a large order quantities for inventory, the no of orders would go down thus ordering costs will go down, because you are not processing. The order, relatively, carrying, storage, holding cost will go up. One needs larger warehouses, insurances will be required

Probability is the quantification of uncertainty. Uncertainty may also be expressed as ‘likelihood’, ‘chance’ or ‘risk’. Probability can only take values ranging from 0, i.e. impossibility, to 1, i.e. certainty. The probability of managers living with a problem they can’t solve than using the solution they don’t understand is 0.

It is under risk, involves alternative action whose payoffs depend on the random states of nature. The difference between making a decision under uncertainty is that in the case of uncertainty, the probability distribution associated with the state is either unknown or can not be determined. This lack of information has led to development of the following criteria for analyzing decision problem:

• Laplace
• Minimax
• Savage
• Hurwicz

They differ on the degree of conservatism the decision makes exhibits in the face of uncertainty.

Refferences

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Bell R. and Cover T.,(1980) “Competitive optimality of logarithmic investment,” Math. of O.R

Brick, J.R..H.K.Baker, And J. A. Haslem.(1986); Eds Financial Markets Instruments and concepts. 2d ed. Redston Publishing.

Fabozzi F.J. Bond makers (1993); Analysis and Strategies. Englewood Cliffs, N J.: prentice Hall

Gilbert, C.L and H.A Rijken (2006),’How is Futures Trading Affected by the move to A Computerized Trading System? Lessons from the LIFE FTSE 100 Contracts’, Journals of Business Finance and Accounting.

Hakansson N. and T. Liu,(1970); “Optimal growth portfolios when yields are serially correlated,” Rev. Economic. Statist.,

Hakansson ,N. (1971); “Capital growth and the mean-variance approach to portfolio selection,” J. Financial and Quantitative Anal.,

Latane,H. (1959) “Criteria for choice among risk ventures,” J. Politic.Economy,

Sprinkel,B. (1971; Money and Markets: A Monetarists view, Homewood, III.: Richard D. Irwin.

Van Horne, J.C. (1983); Financial market rates and flows. 4^th ed. Englewood cliffs, N.J.: Prentice Hall.

Footnotes

1. Gilbert , C.L and H.A Rijken (2006),’How is Futures Trading Affected by the move to A Computerized Trading System? Lessons from the LIFE FTSE 100 Contracts’, Journals of Business Finance and Accounting.