RITESH LOHIA

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Topic

ENTERPRISE RISK MANAGEMENT: A

MIXTURE OF FINANCIAL AS WELL AS

POLITICAL RISKS

Submitted by

RITESH LOHIA

ROLL NO: 262

ST XAVIERS COLLEGE

IN FULFILLMENT OF A PROJECT

FOR 3RD YEAR B.COM (HONS)


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Under the guidance of Professor

Abhik Mukherjee

I owe a great many thanks to a great many people who helped and supported me during my

project work.

Any attempt at any level cannot be satisfactorily completed without the support and

guidance of learned people. I would like to express my immense gratitude to Professor

Abhik Mukherjee for his constant support and motivation that has encouraged me to come

up with this project. He has taken pain to go through the project and make necessary

correction as and when needed.

I express my thanks to the Principal, Father Felix Raj and Vice Principal, Father

Dominic Savio, ofST. XAVIERS COLLEGE, for extending their support.

I would also thank my Institution and the faculty members of the Institution without whom

the project would have been a distant reality.

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Finally, we take this opportunity to extend our deep appreciation to ourfamily and friends,

for all that they meant to us during the crucial times of the completion of our project.

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Table of Contents

Chapt

er

Topics Page

No1 Introduction1.1 Abstract 6-81.2 Statement of problem 8-91.3 Background and rationale

of study 9-111.4 Purpose of study 11-121.5 Contribution of study 12-131.6 Research objectives 13

1.7 Research Methodology1.7.1 Research design 14

1.7.2 Data collection 141.7.3 Reliability and validity of

data

14

1.8 Tools, techniques and

technologies 15-17

1.9 Limitation of the study 182 Risk Analysis -

Conceptual Framework2.1 Introduction 19-20

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2.2 Different types of risk 20-

242.3 How Do We Manage Risk?

2.3

.1

Financial risks and their management 24-

37

2.3

.2

Political risks and their management 38-

45Case Study

a) Frightened Capital? The Case of

China

39-

40

b)The Case of Slovakia: When Political

Environment Sways Investors41

2.4 Role of the risk managers in

Multinational Corporations 46-

47

2.5 Risk management in ASIA 472.5

.1

Types and Level Of Risk In ASIA 48-

512.5

.2

Risks management practices of Asia-

based MNCs51-

533 Analysis & Findings3.1 Introduction 53-

543.2 Types of risk management

policies and their objectives

54-

56

4 Summary, conclusion and

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CHAPTER 1CHAPTER 1

INTRODUCTION

Risk management structure should be well thought-

out, as well as a cultural fit and sustainable.

(Smiechewicz, 2001)

Uncertainty is not measurable. Risk is. - Frank Knight,

Risk, Uncertainty and Profit (1921)

1.1 Abstract

Success in business, to a certain degree, requires owners and managers to take calculated

risks. The most successful business is usually managed by people who know when to push

forward and when to pull back, when to buy and when to sell, when to stand firm and when

to compromise. The successful company is managed by people who understand what risk

in business is, and how this risk should be managed and mitigated.

Risk is an undeniable reality of doing business today, whether domestically or globally. A

successful entrepreneur does not fear risk, but strives to understand it, to manage it, even to

take advantage of it. As risk management tools and techniques become more and morecomplex, however, companies require the services of a Risk Management specialist.

A growing specialty in this field, globally, is that of international accounting risk

management. International accounting professionals can contribute to the success of their

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companies must have a strong grasp of financial risk management techniques for

multinational and multilateral business transactions of great complexity.

Unfortunately, as the world of business becomes increasingly borderless, risk management

becomes, likewise, borderless, and thus more complicated. Risk management strategies that

make sense in a domestic environment do not necessarily apply in the international arena,

where business is exposed to the additional risks associated with currency prices, exchange

rates, and interest rates, as well as more intangible issues of political and cultural risk.

While not necessarily absent in the domestic arena, each of these issues becomes both more

complex and more crucial once a company is active internationally. In this context, it is

imperative that the chief financial officers (CFOs) of these companies be familiar with a

variety of accounting tools and techniques with which they can work to minimise their

companies risk exposure. Financial risk management in international accounting aims to

minimise risk of loss from unexpected changes in the prices of commodities and equities,

or changes in interest and inflation rates.

Intelligent risk management can help a company stabilise cash flows, reduce its risk of

insolvency, manage taxes better, and focus more effectively and efficiently on its primary

business risks. Effective risk management allows corporations and their lenders to weather

difficult situations and be able to survive the fall-out of loan losses or corporate accounting

scandals (Adler 2002). Intelligent risk management at the level of international and

multinational business operations must take into account a myriad of factors, from the

technical and the theoretical to the political and practical.

An effective international accountant, such as a CFO of a multinational corporation, must

comprehend the immense complexity of financial risk management. to recognize the

relationships and correlations between various risk management tools, techniques, and

systems. These tools incorporate both qualitative and quantitative analysis and the efficacy

of individual tools affect the overall success of a companys risk management program

(Rahl & Lee 2000).

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With the objective of contributing to the body of knowledge on which an effective

CFO of a multinational corporation must rely to properly fulfil his or her role; this study

explores the interplay of international accounting risk management tools and techniques

with elements of political and culture risk management. This interplay makes international

financial risk management a particularly challenging and potentially rewarding field of

study. Understanding this interplay is necessary if companies are to protect themselves

sufficiently and to compete in the international world of business with success.

1.2 Statement of problem

The problem at the core of this study is simple:

What does it take to manage risk for multinational firms withcomplex global transactions and assets successfully?

The short answer, perhaps, is that it takes a great deal of expertise in financial risk

management. Financial risk management is a specialised area of international accounting

that requires specific training, tools and techniques, if one is to be successful in mitigating

risk for an international business. As such, in this study, financial risk management was

examined entirely from the perspective of international accounting. The goal of this study

is to show how risk mitigation applies to firms with international holdings, assets, and

transactions. The study analysed the interplay of currency prices, exchange rates, and

interest rates with the technology of accounting systems, as well as the political and

cultural risks inherent in international operations.

At the end of the day, of course, risk is managed not by companies, but by people. Risk

management is usually the function of a companys senior accountants, who act as the

link between a companys business and financial operations (Tunui 2002). Therefore,

this study surveyed the risk management practices of CFOs or other company accountants

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with risk management responsibilities, and contrast the theory (or policy) of these practices

with their real-life application and practice.

The financial practices employed for risk management purposes by CFOs, including

diversification, asset allocation, and hedging was examined. For the purposes of this study,

diversification refers to the use of a combination of dissimilar investments that offset each

other. Asset allocation is defined as the use of safe or low-risk investments to mitigate

losses from high-risk holdings; and hedging comprises the use of financial contracts such

as currency futures, options or swaps to cancel out possible losses in transactions or

holdings. These practices were examined in light of their application to international

business, where accountants must cope with many more types and degrees of risk.

The areas of financial analysis that concern the firms long-term strategy, such as

investment risk, credit risk, and insurance risk were also reviewed. As considered in this

study, investment risk deals with issues such as market analysis, portfolio management,

asset price volatility; credit risk comprises both individual and corporate exposure; and

insurance risk covers property, product, and business liabilities.

1.3 Background and rationale of study

Financial risk management refers to the practices used by corporate finance managers and

accountants to limit and control uncertainty in the firms total portfolio. Financial risk

management aims to minimise the risk of loss from unexpected changes in the price of

currencies, interest rates, commodities, and equities.

In the context of international accounting, financial risk management also contains an

element of political, legal and culture risk. These latter types of risk comprise exposure

to uncertainty in the outcomes of business transactions and

asset transfers that comes with most international business operations. Risk management,

because of its predominantly financial nature, is generally the domain of a companys

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accountants. Accountants are closely involved in the analysis and evaluation of the

financial effects of currency movements and exchange rates, tax regimes and business

laws, as well as risks of hostile takeovers, expropriation and local economic downturns,

which differ in every country from Singapore and Malaysia to Japan, the United States and

beyond.

Yet intelligent risk management requires more than a grasp of numbers and the ability to

calculate acceptable odds. For a multinational corporation, or even a domestic company

involved in exports or other supplier relationships with extranational parties, firm-wide

risk [can] not be represented by market and credit functions alone(Hoffman 2000). A

risk management officer such as the CFO must combine qualitative and quantitative risk

management techniques to arrive at a workable strategy for her company. She must also be

able to asses the effectiveness, efficacy, and applicability of each individual tool.

Intelligent and effective risk management is necessary to minimise against perceived as

well as actual risksin fact, the perceived risks may harm the company more than actual

risks. When investors or shareholders, as well as the public, are comfortable with a

companys risk management practices as manifest in its risk disclosures, the result is a

decrease in market uncertainty and diversity of opinion about the implications of the risk.

That is, by employing trusted risk management practices and by disclosing its risk

management practices and predictions, the firm to a large extent controls how firm value is

affected by changes in interest rates, foreign currency exchange rates, and commodity

prices (Linsmeier et al. 2002). Risk management practices that diversity of opinion

should dampen trading volume sensitivity to changes in these underlying market rates

or prices(Linsmeier et al. 2002, p. 343).

Risk management at the international level is a much-researched field. Particularly as it is a

newer and an expanding field, there is clearly a need for more research, both qualitative

and quantitative, into issues crucial to international accounting. It is also a field that is

evolving at an incredibly fast pace. Global trendsincluding the overwhelming trend

towards globalisation of business and harmonisation of accounting practices and standards

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(Heppleston 2000)rapid advances in technology, international political and economic

events, as well as the geopolitical realities of todays world all impact risk management.

A great deal is written about specific risk management techniques and a great deal is

written about risk management models. Most of this discussion, however, takes place at a

very theoretical level. Those researchers engaged in empirical research on specific

companies or risk management strategies and practices stress that more work in a similar

vein is needed if CFOs and CEOs are to possess reliable and valid data with which to

address risk management for their companies (inter alia, Linsmeier et al. 2002; Dhanani &

Groves 2001; Mohanty 2001). There is a continuing need for more practical research that

looks at precisely how and whyand, most importantly, with what resultsmultinational

companies employ risk management techniques, how accountants understand, and use,

these tools, and how the different tools, strategies, and types of risk interplay with and

affect each other.

Finally, as are shown in the literature review, there is a particular paucity of studies in this

field, which compare the theory of risk management to the actual practice. One of the

cornerstones of this study was the comparison of companys stated policies and objectives

with its actual actions and results.

1.4 Purpose of study

The purpose of this study is two fold. On a theoretical level, a new model for risk

management strategy in the international accounting field is to be suggested.

Existing models were considered in Chapter 2: Literature Review, and their strengths and

weaknesses identified. The new model towards which would be working was based on two

assumptions.

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The first assumption was that the effectiveness and efficacy of both individual risk

management tools and overall company risk mitigation strategies ultimately was the result

of the skills and capabilities of its risk mitigation officersusually, CFOs or other senior

accounting professionals.

The second assumption was that the specialist in international accounting needs to

familiarise herself with local conditions, regulations and policies that impact each of these

areas of financein other words, that she needs to be conversant with more than numbers.

On a practical level, individuals active in this specialised area of international accounting

are provided with an accessible discussion of the tools, techniques, approaches, and

systems that should enable them to be successful in mitigating risk for international

businesses. They are the key individuals to companies ultimate success and financial

performance; hence, it is the goal of this study to marry practice and theory. To that end,

companies actual actions and risk management results were considered of more

importance than their policies and intentions.

1.5 Contribution of study

Risk management has become an integral part of international business strategy and

accountants are using a variety of quantitative tools to measure and analyse risk. Among

the tasks of the CFO lies the responsibility for identifying and addressing all types of risk,

establishing support and control mechanisms for dealing with it, and setting the course for

the risk management team in terms of its policies and objectives. This breadth of

responsibilities requires that the effective CFO be conversant with a variety of riskmanagement practices and be aware of their efficacy and appropriateness in specific

situations.

The study considered a variety of risk management practices and areas of financial analysis

against the backdrop of a volatile global market in which financial risk management must

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take into account political and cultural risks. The studys theoretical framework was rooted

in the belief that the specialist in international accounting needs to familiarize herself with

local conditions, regulations and policies that affect each of these areas of finance. She

must also bring to the table something more a sensitive, comprehensive understanding

of the culture(s) in which the company is active and a familiarity with and ability to analyse

the political forces that may affect the companys risk exposure. Moreover, she must be

able to translate her theoretical knowledge of these

concepts into practical policies and risk management strategies.

Thus, the contribution of this study is to equip the international accounting specialist with a

means of accessing and utilising this knowledge, through a discussion and analysis of both

the theoretical and the practical applications of risk management techniques.

1.6 RESEARCH OBJECTIVES

Define program risk

Describe the characteristics of risk

Describe the benefits of using risk management techniques

Describe the role of program managers

Draw risk management process

Use group techniques to identify project risks

Classify risks under people, process, or technology categories

Evaluate / prioritize risks

Develop risk handling strategies

Describe risk monitoring methods used to document and update risk and program

plans

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1.7 Research Methodology

1.7.1 Research design

This is basically a descriptive type of study in which I have focused on the impact of different types

of risk multinational companies are facing. The study was conducted with a view to describe about

the nature of risk and its relationship with different micro and macro factors of the economy. The

methodology has been adapted with a view to reach the objectives of the project. In the end to study

the framework and risk management process as drawn from the study.

1.7.2 Data collection

Books

Journals

Journals

Internet

Archives

Observations

Reports and

Records.

1.7.3 Reliability and validity of data

I collected data from more than one source, giving greater confidence in the measures of

the constructs. I also obtained information about the topic from Thesis, previous reports

and records. Thus I achieved triangulation of sources and methods triangulation.

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1.8 Tools, techniques and technologies

Intelligent risk management helps a company stabilize cash flows, reduce risk of

insolvency, manage foreign taxes and focus on its primary business in each country and

market. It is particularly critical in Southeast Asia today, where complex overseas

operations are common for resident, host and guest firms alike.

To keep track of the myriad details of a risk management system, managers now rely upon

a wide range of new tools and technologies-computer-based trading systems,

telecommunications technology, decision support systems that quantify risk factors, and so

on.

New computer-based tools are being introduced all the time, with recently developed

systems aimed at the specific needs of international accounts. The technologies available to

international accountants today quantify the financial risks associated with interest-rate

movements, volatile foreign-exchange rates and erratic commodity-price movements.

Many are effectively complete methodology, software package and data set (Sessit 1999).

This study does not focus specifically on the use of specific systems or technologies.

However, it is important to consider which technologies international accountants use

because the relationship between system used and strategy followed is a two-way one.

Differences in risk management strategies are associated largely with the types of toolsincluding systemsthat are used. While strategies should dictate the selection of tools,

sometimes the availability of certain systems dictates strategy. Differences among

multinational corporations regarding their concerns in choosing derivatives have been due

to driven to some extent by differences in the accounting treatment internationally

(Lee etal.2001).

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A recent study that surveyed the risk management practices of multinational companies

originating in the United Kingdom, the United States, and Asia Pacific, found surprisingly

little difference in these practices across the different regions. Although a number of

interregional differences in the organisation of risk management were identifiedfor

example, a greater emphasis on decentralized structures in the Asia Pacific and less formal

board control over risk management in the United Stateslittle variation was found in the

methods of forecasting exchange rates. The researchers found that the majority of the

multinational corporations, regardless of region, used a central risk management system.

Centralization is in and of itself neither bad nor goodits efficiency and efficacy are

ultimately tested by the appropriateness of its systems. Centralization is likely to continue

to increase as rapid advances in computing and information technology increase the pace of

financial market globalization and sophistication. It is imperative that the financial

instruments used in international accounting keep pace with these developments.

Effective instruments need to reflect the economic effects of entities investment and risk

management decisions so that the potential efficiency gains from globalization can be fully

realized and the risk of greater market volatility can be ameliorated (Heppleston 2000, p.

4).

The nature of international operations frequently provides the tools that mitigate the risks

inherent in that nature. Currency risk is frequently managed using foreign exchange

derivatives. Recent evidence suggests that large companies use of foreign exchange

derivatives increases with the level of foreign currency exposure as well as with the degree

of geographic concentration, which is indicative of using less natural hedging (Makar,

DeBruin & Huffman 1999). Basic exchange rate risk mitigation is frequently offered by

companies banks (Tunui 2002).

Among the tools for addressing political risk is the purchase of political risk insurance

(PRI). Companies may choose to purchase PRI, or they may be required to purchase it by

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their banks or financial institutions. Conservative by nature, certain banks will not finance

projects in regions perceived to have high political risk without PRIthe banks own risk

management technique (Wagner 2002). Rates of PRI purchase seem to be directly related

to traumatic regional and world events, such as the September 11, 2001 terrorist attacks on

the United States or the more recent events in Bali and Indonesia. At such times, as demand

potentially outstrips supply, prices for PRI are very high.

The above is merely a sampling of some of the tools available for risk mitigation.

These tools are both qualitative and quantitative in nature and their specific efficacy and

applicability were treated in further detail in Chapter 2. However, tools are not enough.

Evidence from China suggests that lack of adequate supporting infrastructure, manifested

in excessive earnings management (i.e. ways of doing financial reporting in which

managers intervene intentionally in the financial reporting purposes to produce some

private gains) and low quality auditing, continues to affect the performance of Chinese

companies. Even though there are, utilization of sophisticated tools and attempts to comply

with the harmonized international accounting standards (Chen, Sun & Wang 2002).

Tools have to be used with care and they have to fit the backgroundfinancial, economic,

political, and culturalin which they are operating.

What does the above mean for todays international accounting

professionals?

Simply, that there as many if not more risk management tools as there are risks and

business risk situations. An effective international accountant must know which tool is

appropriate for assessing which risk.

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1.9 Limitations of the Study:

No proper assurance of right information.

Time Constraint in relation to collection of matters and preparation for the project.

Anticipating and avoiding problems

The project mainly focuses on the financial and political risks. But there are other

different types of risks companies are exposed to. The study has been restricted and

also the discussion basically has been confined to Asia-based Multinational

Corporations.

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CHAPTER 2 Risk Analysis - Conceptual

Framework

2.1 Introduction

What Is Risk?

Risk provides the basis for opportunity. The terms risk and exposure have subtle

differences in their meaning. Risk refers to the probability of loss, while exposure is the

possibility of loss, although they are often used interchangeably. Risk arises as a result of

exposure. Exposure to financial markets affects most organizations, either directly or

indirectly. When an organization has financial market exposure, there is a possibility of

loss but also an opportunity for gain or profit. Financial market exposure may provide

strategic or competitive benefits.

Risk is the likelihood of losses resulting from events such as changes in market prices.

Events with a low probability of occurring, but that may result in a high loss, are

particularly troublesome because they are often not anticipated. Put another way, risk is the

probable variability of returns. Since it is not always possible or desirable to eliminate risk,

understanding it is an important step in determining how to manage it. Identifying

exposures and risks forms the basis for an appropriate financial risk management strategy.

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Financial risk management is the practice of creating economic value in a firm by using

financial instruments to manage exposure to risk, particularly credit risk and market risk.

Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks,

etc. Similar to general risk management, financial risk management requires identifying its

sources, measuring it, and plans to address them. Financial risk management can be

qualitative and quantitative. As a specialization of risk management, financial risk

management focuses on when and how to hedge using financial instruments to manage

costly exposures to risk.

Turning Uncertainty into Risk Politics influences how markets operate. Often the most

unpredictable economic events are political in origin, the result of flagging political

willingness.

The Political Risk Assessment is a systematic approach to understanding and anticipating

how current and future political events could materially affect a companys organisation,

and thereby helps the company better manage its international exposures. Globalisation is a

process of rising acceptance of political risk in search of greater economic rewards.

Economic success has bred acceptance of ever-greater political-risk exposure. Turning

Uncertainty into Risk Politics influences how markets operate. Often the most

unpredictable economic events are political in origin, the result of flagging political

willingness.

2.1 Different types of risk

The first step in this process lies in identifying the different types of risk. For the purposes

of this study, risks were divided into two broad categories: general financial risks

experienced in the international arena and political/cultural risks. The former categorycomprises interest rate and debt-related risk as well as currency and exchange rate risk.

These as well as the political risks are outlined below. The purpose is to provide an

overview of the many different types of risks that multinational corporations faced. This

list was not comprehensive, and additional financial risks were discussed in the literature

review.

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2.1.1 Interest risk and debt-related risk

Interest rate risk is important in both domestic and international operations, but

multinational companies are more exposed to it. Interest rate risk is usually defined as the

degree of uncertainty for the rate of return from a bond or any other convertible debt

instrument or derivative. Interest rate risk is also concerned with the changes in profits,

cash flows, or valuation of the firm to changes in interest rates. Viewed from the

perspective of this definition, the firm should analyse how its profit, cash outturns, and

value change in response to changes in interest rate levels.

Determining the risk in an interest-rate return is a complex process. The three primary

factors that are considered when calculating this risk;

(1)Risk of the bond issueri.e. is it a corporation or a government and what are its risk

management policies and thresholds,

(2) The liquidity of the bondi.e., how easy is it to cash in; and

(3) The level of income taxes applied to the bond in the regione.g., is the interest

income taxable, untaxed, or tax deferred.

Associated with interest-rate risk are debt-related risks. Debt-related risk usually takes the

form of interest-rate risk for long-term debt instruments the company issues, which by their

term have greater risk exposure than short-term issues. In general, prices and returns forlong-term bonds are more volatile than those for shorter-term bonds and can generate

capital gains and losses creating substantial differences between their real return and the

yield to maturity known at the time of the purchase (Mishkin 1995, p. 90).

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2.1.2 Currency and exchange risk

Volatility in currency prices and exchange rates is of crucial importance to multinational

corporations. Their risk management officers must apprise themselves of the risks in world

currency and derivatives markets. The corresponding rapid fluctuations in currency

exchange and interest rates in the international capital markets are amplified by the huge

size of some of the transactions these firms engage in. For example, should the corporate

treasurer of a large U.S. firm decide to transfer a very large amount of money from regular

dollar accounts to Eurodollar deposits in some non-American banking centre, e.g. in Hong

Kong, he or she may be able to instantly gain a substantial interest rate advantage.

However, in doing so, the domestic dollar market is immediately reduced and the

Eurodollar market inflated, corresponding to the size of the money move. A $10 million

deposit might not affect money rates in either realm, but it would affect liquidity and

interest rates within the selected banking circles involved, and these effects would be felt

all the way through the financial chain of related companies a fact financial officers need to

be aware of.

A sub-group of exchange rate risk is the so-called strategic exchange rate risk, a risk

resulting from long-term movements in exchange rates. This form of exchange rate risk is

frequently characterized as the most important form of exchange risk (Dhanani & Groves

2001).

2.1.3 Other financial risks

Current risk-based capital standards account primarily for credit risk, interest rate risk and

market risks. However, non-credit risks, including asset concentrations and liquidity risk,

can significantly affect the performance of companies (Mohanty 2001). Indeed, several

studies suggest that non-credit risks that lead to the insolvency of banks and financial

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institutions (ibid.). The above discussed risks are the primary concerns of most CFOS, but

it is stressed they are not the only ones. Moreover, in addition to these clearly monetary,

financial and quantifiable risks, multinational corporations have to deal with cultural and

political risks.

2.1.4 Political and cultural risk

Political risk can be defined as the exposure to a change in the value of an investment ofcash position resultant upon government actions. Political risk, to a certain degree, exists in

virtually every country, and certainly exists in every country in Asia (Wagner 2001). Areas

of concern include currency inconvertibility, political violence, and contract frustration.

Multinational companies doing business in political hotspots are concerned with

ensuring smooth conversion and transfer of currency and having confidence that

government payment and performance obligations are honoured(Wagner 2001;see

Appendix A1). Governments intervene in their national economies and, in so doing,

increase the level of political risks that the multinational firm faces. Political risks ranges

from exposure to changes in tax legislation, through the impacts of exchange controls to

restrictions affecting operation and financing in a host currency. Multinational Companies

are concerned with the measurement and management of political risk. There are various

approaches to the measurement of political risk most of them are subjective in nature.

One of the factors that cannot be quantified about political risk is that it is to a large part

perception-driven (Wagner 2002). For example, in Southeast Asia,

Indonesia has been traditionally seen as the country with the highest political risk in the

region, as borne out by rates of political risk insurance. China, being a country with a great

dominance of trade in the region, is perceived as a much safer place with minimum level of

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political risks, while Singapore and Malaysia are generally not even on the radar

screen of political risk analysts. However, worldwide reporting of the arrest of 13-

suspected terrorists in January 2002 increased Singapores political risk rating to the

equivalent of the much more potentially volatile South Korea (Wagner 2002; see Appendix

A2).

Associated with political risk, is cultural risk. Cultural risk is perhaps best defined as

comprising the rules of engagement for business in a particular culture.

McDonalds recent announcement that it is closing 135 of his franchisesmost in the

Middle Eastcan be seen as cultural risk in action.

2.2 How Do We Manage Risk?

2.2.1 Financial risks and their

management

INTRODUCTION

Although financial risk has increased significantly in recent years, risk and risk

management are not contemporary issues. The result of increasingly global markets is that

risk may originate with events thousands of miles away that have nothing to do with the

domestic market. Information is available instantaneously, which means that change, and

subsequent market reactions, occur very quickly. The economic climate and markets can be

affected very quickly by changes in exchange rates, interest rates, and commodity prices.

Counterparties can rapidly become problematic. As a result, it is important to ensure

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financial risks are identified and managed appropriately. Preparation is a key component of

risk management.

How Does Financial Risk Arise?Financial risk arises through countless transactions of a financial nature, including sales

and purchases, investments and loans, and various other business activities. It can arise as a

result of legal transactions, new projects, mergers and acquisitions, debt financing, the

energy component of costs, or through the activities of management, stakeholders,

competitors, foreign governments, or weather. When financial prices change dramatically,

it can increase costs, reduce revenues, or otherwise adversely impact the profitability of an

organization. Financial fluctuations may make it more difficult to planand budget, price goods and services, and allocate capital.

There are three main sources of financial risk:

1. Financial risks arising from an organizations exposure to changes in market prices,

such as interest rates, exchange rates, and commodity prices.

2. Financial risks arising from the actions of, and transactions with, other organizations

such as vendors, customers, and counterparties in derivatives transactions.

3. Financial risks resulting from internal actions or failures of the organization,

particularly people, processes, and systems.

What Is Financial Risk Management?

Financial risk management is a process to deal with the uncertainties resulting from

financial markets. It involves assessing the financial risks facing an organization and

developing management strategies consistent with internal priorities and policies.

Addressing financial risks proactively may provide an organization with a competitive

advantage. It also ensures that management, operational staff, stakeholders, and the board

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of directors are in agreement on key issues of risk. Managing financial risk necessitates

making organizational decisions about risks that are acceptable versus those that are not.

The passive strategy of taking no action is the acceptance of all risks by default.

Organizations manage financial risk using a variety of strategies and products. It is

important to understand how these products and strategies work to reduce risk within the

context of the organizations risk tolerance and objectives.

Strategies for risk management often involve derivatives. Derivatives are traded widely

among financial institutions and on organized exchanges. The value of derivatives

contracts, such as futures, forwards, options, and swaps, is derived from the price of the

underlying asset. Derivatives trade on interest rates, exchange rates, commodities, equity

and fixed income securities, credit, and even weather. The products and strategies used by

market participants to manage financial risk are the same ones used by speculators to

increase leverage and risk. Although it can be argued that widespread use of derivatives

increases risk, the existence of derivatives enables those who wish to reduce risk to pass it

along to those who seek risk and its associated opportunities.

The ability to estimate the likelihood of a financial loss is highly desirable. However,

standard theories of probability often fail in the analysis of financial markets. Risks usually

do not exist in isolation, and the interactions of several exposures may have to be

considered in developing an understanding of how financial risk arises. Sometimes, these

interactions are difficult to forecast, since they ultimately depend on human behavior.

The process of financial risk management is an ongoing one. Strategies need to be

implemented and refined as the market and requirements change. Refinements may reflect

changing expectations about market rates, changes to the business environment, or

changing international political conditions, for example. In general, the process can be

summarized as follows:

Notable Quote

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Whether we like it or not, mankind now has a completely integrated, international

financial and informational marketplace capable of moving money and ideas to any

place on this planet in minutes.

Source: Walter Wriston of Citibank, in a speech to the International

Monetary Conference, London, June 11, 1979.

Risk Management Process

The process of financial risk management comprises strategies that enable an organization

to manage the risks associated with financial markets. Risk management is a dynamic

process that should evolve with an organization and its business. It involves and impacts

many parts of

Hedging and Correlation

Hedging is the business of seeking assets or events that offset, or has weak or negative

correlation to, an organizations financial exposures. Correlation measures the tendency oftwo assets to move, or not move, together. This tendency is quantified by a coefficient

between 1 and +1. Correlation of +1.0 signifies perfect positive correlation and means that

two assets can be expected to move together. Correlation of 1.0 signifies perfect negative

correlation, which means that two assets can be expected to move together but in opposite

directions.

The concept of negative correlation is central to hedging and risk management. Risk

management involves pairing a financial exposure with an instrument or strategy that is

negatively correlated to the exposure. A long futures contract used to hedge a short

underlying exposure employs the concept of negative correlation. If the price of the

underlying (short) exposure begins to rise, the value of the (long) futures contract will also

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increase, offsetting some or all of the losses that occur. The extent of the protection offered

by the hedge depends on the degree of negative correlation between the two.

TIPS & TECHNIQUES

The risk management process involves both internal and external analysis. The first part of

the process involves identifying and prioritizing the financial risks facing an organization

and understanding their relevance. It may be necessary to examine the organization and its

products, management, customers, suppliers, competitors, pricing, industry trends, balance

sheet structure, and position in the industry. It is also necessary to consider stakeholders

and their objectives and tolerance for risk. Once a clear understanding of the risks emerges,appropriate strategies can be implemented in conjunction with risk management policy.

For example, it might be possible to change where and how business is done, thereby

reducing the organizations exposure and risk. Alternatively, existing exposures may be

managed with derivatives. Another strategy for managing risk is to accept all risks and the

possibility of losses.

There are three broad alternatives for managing risk:

1. Do nothing and actively, or passively by default, accept all risks.

2. Hedge a portion of exposures by determining which exposures

can and should be hedged.

3. Hedge all exposures possible.

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Diagram 1: Risk management processes

as described by Standards Australia

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Risk ManagementInstitute of AustraliaRisk management http://www.rmia.org.auStandards Australia Risk management standard (AS/NZS 4360)

http://www.standards.org.auFactors that Impact Financial Rates

and Prices

Financial rates and prices are affected by a number of factors. It is essential to understand

the factors that impact markets because those factors, in turn, impact the potential risk of an

organization.

Factors that Affect Interest Rates

Interest rates are a key component in many market prices and an important economic

barometer. They are comprised of the real rate plus a component for expected inflation,

since inflation reduces the purchasing power of a lenders assets. The greater the term tomaturity, the greater the uncertainty. Interest rates are also reflective of supply and demand

for funds and credit risk. Interest rates are particularly important to companies and

governments because they are the key ingredient in the cost of capital. Most companies and

governments require debt financing for expansion and capital projects.When interest rates

increase, the impact can be significant on borrowers. Interest rates also affect prices in

other financial markets, so their impact is far-reaching. Other components to the interest

rate may include a risk premium to reflect the creditworthiness of a borrower. For example,

the threat of political or sovereign risk can cause interest rates to rise, sometimes

substantially, as investors demand additional compensation for the increased risk of

default.

Factors that influence the level of market interest rates include:

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Expected levels of inflation

General economic conditions

Monetary policy and the stance of the central bank

Foreign exchange market activity

Foreign investor demand for debt securities

Levels of sovereign debt outstanding

Financial and political stability.

Yield Curve

The yield curve is a graphical representation of yields for a range of terms to maturity. For

example, a yield curve might illustrate yields for maturity from one day (overnight) to 30-year terms.Typically, the rates are zero coupon government rates. Since current interest

rates reflect expectations, the yield curve provides useful information about the markets

expectations of future interest rates. Implied interest rates for forward-starting terms can be

calculated using the information in the yield curve. For example, using rates for one- and

two-year maturities, the expected one-year interest rate beginning in one years time can be

determined. The shape of the yield curve is widely analyzed and monitored by market

participants. As a gauge of expectations, it is often considered to

be a predictor of future economic activity and may provide signals of a pending change in

economic fundamentals.

The yield curve normally slopes upward with a positive slope, as lenders/investors demand

higher rates from borrowers for longer lending terms. Since the chance of a borrower

default increases with term to maturity, lenders demand to be compensated accordingly.

Interest rates that make up the yield curve are also affected by the expected rate of

inflation. Investors demand at least the expected rate of inflation from borrowers, in

addition to lending and risk components. If investors expect future inflation to be higher,

they will demand greater premiums for longer terms to compensate for this uncertainty. As

a result, the longer the term, the higher the interest rate (all else being equal), resulting in

an upward-sloping yield curve. Occasionally, the demand for short-term funds increases

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substantially, and short-term interest rates may rise above the level of long term interest

rates. This results in an inversion of the yield curve and a downward slope to its

appearance. The high cost of short-term funds detracts from gains that would otherwise be

obtained through investment and expansion and make the economy vulnerable to

slowdown or recession. Eventually, rising interest rates slow the demand for both short-

term and long-term funds. A decline in all rates and a return to a normal curve may occur

as a result of the slowdown.

Theories of Interest Rate

Determination

Several major theories have been developed to explain the term structure of interest rates

and the resulting yield curve:

Predicting Change

Indicators that predict changes in economic activity in advance of a slowdown are

extremely useful. The yield curve may be one such forecasting tool. Changes in consensus

forecasts and actual short-term interest rates, as well as the index of leading indicators,

have been used as warning signs of a change in the direction of the economy. Some studies

have found that, historically at least, a good predictor of changes in the economy one year

to 18 months forward has been the shape of the yield curve.

TIPS & TECHNIQUES

Expectations theory suggests forward interest rates are representative of expected future

interest rates. As a result, the shape of the yield curve and the term structure of rates are

reflective of the markets aggregate expectations.

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Liquidity theory suggests that investors will choose longerterm maturities if they are

provided with additional yield that compensates them for lack of liquidity. As a result,

liquidity theory supports that forward interest rates possess a liquidity

premium and an interest rate expectation component.

Preferred habitat hypothesis suggests that investors who usually prefer one maturity

horizon over another can be convinced to change maturity horizons given an appropriate

premium. This suggests that the shape of the yield curve depends on the policies of market

participants.

Market segmentation theory suggests that different investors have different investment

horizons that arise from the nature of their business or as a result of investment restrictions.

These prevent them from dramatically changing maturity dates to take advantage of

temporary opportunities in interest rates. Companies that have a long investment time

horizon will therefore be less interested in taking advantage of opportunities at the short

end of the curve.

Factors that Affect Foreign ExchangeRates

Foreign exchange rates are determined by supply and demand for currencies. Supply and

demand, in turn, are influenced by factors in the economy, foreign trade, and the activities

of international investors. Capital flows, given their size and mobility, are of great

importance in determining exchange rates. Factors that influence the level of interest rates

also influence exchange rates among floating or market-determined currencies. Currencies

are very sensitive to changes or anticipated changes in interest rates and to sovereign risk

factors. Some of the key drivers that affect exchange rates include:

Interest rate differentials net of expected inflation

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Trading activity in other currencies

International capital and trade flows

International institutional investor sentiment

Financial and political stability

Monetary policy and the central bank

Domestic debt levels (e.g., debt-to-GDP ratio)

Economic fundamentals

Key Drivers of Exchange Rates

When trade in goods and services with other countries was the major determinant of

exchange-rate fluctuations, market participants monitored trade flow statistics closely for

information about the currencys future direction. Today, capital flows are also very

important and are monitored closely. When other risk issues are considered equal, those

currencies with higher short-term real interest rates will be more attractive to international

investors than lower interest rate currencies. Currencies that are more attractive to foreign

investors are the beneficiaries of capital mobility. The freedom of capital that permits an

organization to invest and divest internationally also permits capital to seek a safe,

opportunistic return. Some currencies are particularly attractive during times of financial

turmoil. Safe-haven currencies have, at various times, included

the Swiss franc, the Canadian dollar, and the U.S. dollar. Foreign exchange forward

markets are tightly linked to interest markets. In freely traded currencies, traders arbitrage

between the forward currency markets and the interest rate markets, ensuring interest rate

parity.

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Theories of Exchange Rate

Determination

Several theories have been advanced to explain how exchange rates are determined:

Purchasing power parity, based in part on the law of one price, suggests that exchange

rates are in equilibrium when the prices of goods and services (excluding mobility and

other issues) in different countries are the same. If local prices increase more than prices in

another country for the same product, the local currency would be expected to decline in

value vis--vis its foreign counterpart, presuming no change in the structural relationship

between the countries.

The balance of payments approach suggests that exchange rates result from trade and

capital transactions that, in turn, affect the balance of payments. The equilibrium exchange

rate is reached when both internal and external pressures are in equilibrium.

The monetary approach suggests that exchange rates are determined by a balance between

the supply of, and demand for, money. When the money supply in one country increases

compared with its trading partners, prices should rise and the currency should depreciate.

The asset approach suggests that currency holdings by foreign investors are chosen based

on factors such as real interest rates, as compared with other countries.

Financial Risk Management: A

Selective History

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No discussion of financial risk management is complete without a brief look at financial

market history. Although this history is by no means complete, it illustrates events and

highlights of the past several hundred years.

Early Markets

Financial derivatives and markets are often considered to be modern developments, but in

many cases they are not. The earliest trading involved commodities, since they are very

important to human existence. Long before industrial development, informal commodities

markets operated to facilitate the buying and selling of products. Marketplaces have existed

in small villages and larger cities for centuries, allowing farmers to trade their products for

other items of value. These marketplaces are the predecessors of modern exchanges. The

later development of formalized futures markets enabled producers and buyers to guarantee

a price for sales and purchases. The ability to trade product and guarantee a price was

particularly important in markets where products had limited life, or where products were

too bulky to transport to market often. Forward contracts were used by Flemish traders at

medieval trade fairs as early as the twelfth century, where lettres de faire were used to

specify future delivery. Other reports of contractual agreements date back to Phoenician

times. Futures contracts also facilitated trading in prized tulip bulbs in seventeenth-centuryAmsterdam during the infamous tulip mania era. In seventeenth-century Japan, rice was an

important commodity. As growers began to trade rice tickets for cash, a secondary market

began to flourish. The Dojima rice futures market was established in the commerce center

of Osaka in 1688 with 1,300 registered rice traders. Rice dealers could sell futures in

advance of a harvest in anticipation of lower prices, or alternatively buy rice futures

contracts if it looked as though the harvest might be poor and prices high. Rice tickets

represented either warehoused rice or rice that would be harvested in the future.

Trading at the Dojima market was accompanied by a slow-burning rope in a box suspended

from the roof. The days trading ended when the rope stopped burning. The days trading

might be canceled, however, if there were no trading price when the rope stopped burning

or if it expired early.

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North American Developments

In North America, development of futures markets is also closely tied to agricultural

markets, in particular the grain markets of the nineteenth century. Volatility in the price of

grain made business challenging for both growers and merchant buyers. The Chicago

Board of Trade (CBOT), formed in 1848, was the first organized futures exchange in the

United States. Its business was non-standardized grain forward contracts. Without a central

clearing organization, however, some participants defaulted on their contracts,

leaving others unhedged. In response, the CBOT developed futures contracts with

standardized terms and the requirement of a performance bond in 1865. These were the

first North American futures contracts. The contracts permitted farmers to fix a price for

their grain sales in advance of delivery on a standardized basis. For the better part of a

century, North American futures trading revolved around the grain industry, where large-

scale production and consumption, combined with expense of transport and storage, made

grain an ideal futures market commodity.

Turbulence in Financial Markets

In the 1970s, turbulence in world financial markets resulted in several important

developments. Regional war and conflict, persistent high interest rates and inflation, weak

equities markets, and agricultural crop failures produced major price instability. Amid this

volatility came the introduction of floating exchange rates. Shortly after the United States

ended gold convertibility of the U.S. dollar, the Bretton Woods agreement effectively

ended and the currencies of major industrial countries moved to floating rates. Although

the currency market is a virtual one, it is the largest market, and London remains the most

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important center for foreign exchange trading. Trading in interest rate futures began in the

1970s, reflecting the increasingly volatile markets. The New York Mercantile Exchange

(NYMEX) introduced the first energy futures contract in 1978 with

New Era Finance

The 1990s brought the development of new derivatives products, such as weather and

catastrophe contracts, as well as a broader acceptance of their use. Increased use of value-

at-risk and similar tools for risk management improved risk management dialogue and

methodologies.

2.2.2 Political risks and their

management

Why Political Risk Matters

Enterprise Risk Management (ERM) has entered the mainstream of corporate

consciousness over the past decade. Corporations and financial institutions globally have

spent a great deal of money to develop and implement systems

and processes to assess and manage risk more effectively. The basic no surprises mission

of ERM is to help protect companies from preventable losses. Identifying, measuring, and

continuously monitoring risks are the core

competencies of ERM. Yet, beyond capital protection, ERM can serve a more

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strategic function. In understanding clearly where and how risk arises in a business,

management can drive higher-quality returns to the bottom line.

Now for the first time, PricewaterhouseCoopers (PwC), a market leader in the field of

ERM, and Eurasia Group, a leader in political-risk research and consulting, have joined

forces to develop a framework to help executives understand the political-risk dimension

within the context of ERMs core competencies.

While many companies have developed metrics that estimate how their profitability might

be impacted under varying financial scenarios, most have struggled to find a comparative

and rigorous means of incorporating the range of outcomes that might arise from the

political risk inherent in their international business activities. Political risk relates to the

preferences of political leaders, parties, and factions, as well as their capacity to execute

their stated policies when confronted with internal and external challenges. Changes in the

regulatory environment, local attitudes to corporate governance, reaction to international

competition, labour laws, and withholding and other taxes, to name but a few, may all be

influenced by hard to discern shifts in the political landscape. Political risk even

incorporates a governments capacity and preparedness to respond to natural disasters.

PwC and Eurasia Group have brought together a team of experts to build a Political Risk

Assessment (PRA) diagnostic and monitoring methodology that enables companies to

isolate and assess the contribution of political risk to their overall risk profile. The

complete Political Risk Assessment also incorporates recommendations that enhance a

companys internal capacity to manage these risks, as well as to identify and capitalise on

unexploited opportunities. The interrelation and interdependencies of global markets will

continue to increase. Businesses that reach for new manufacturing and sales opportunities

in countries far from their home base and experience are truly at the forefront of

globalisation. At the same time, they are vulnerable to the reactions of countries that seek

to temper the pace and impact of globalisation on their institutions and workforce. PwC

and Eurasia Groups political-risk assessment offering helps business leaders to understand

the nature of political risk and its impact on their international investments, and to seize the

opportunities it affords.

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Political Risk as Opportunity

Globalisation is a rising acceptance of political risk in search of greater economic

rewards. Economic success has bred acceptance of ever-greater political-risk exposure.

Frightened Capital? The Case of China

Economic theory argues that capital should chase the highest return on investment, and

returns should be highest in countries with relatively low levels of capital stock where

investment is needed. Why then do emerging markets like

China enact policies that send funds to capital-rich countries like the United States?

Two explanations are commonly given to account for this trend, and both are driven by

politics.

First, money flows to wealthy countries because political risks are lower in established

democracies with predictable regulatory and political processes.

Second, high savings in emerging markets is increasingly used to balance current

accounts across the Pacific Ocean. By bolstering the dollar, China is preserving American

consumers ability to buy their goods.

But the key explanation is likely rooted in domestic Chinese politics. By sending dollars

back to cover the United States global current account imbalance rather than convertingthem into renminbi, China is serving its export-oriented sector and protecting its fragile

financial industry with a weaker currency. The political consequences of correcting this

imbalance could be tremendous, but over time it will have to happen. Political dynamics

will steer the impacts of the correction.

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Why Politics in Business Matters:

Turning Uncertainty into Risk

Politics influences how markets operate. Often the most unpredictable economic events are

political in origin, the result of flagging political willingness or capacity to maintain a

consistent and predictable economic environment.

The Case of Slovakia: When PoliticalEnvironment Sways Investors

Central and southeastern European companies compete head-to-head for lucrative Western

investments. Their proximity to Western Europe and comparable labour costs often

mistakenly make them seem broadly similar. However, differences in each countrys actual

cost structures and political developments can have far-reaching effects on companies

location decisions. Beginning in 1998 and continuing following his re-election in 2002,

Slovakian Prime Minister Mikulas Dzurinda was able to form a multi-party center-right

coalition favourable to pro-growth policies. This political development allowed Slovakia to

make a decisive break with the authoritarian and anti-integration prerogatives of the

previous government. The Dzurinda government delivered a series of key market reforms,

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reducing the corporate income tax in 2002 from 40 percent to 25 percent, and instituting an

across-the-board flat-tax structure in 2004. In addition to the benefits of the 19 percent

income-tax rate, the new system was seen as less complex than those in countries like

Poland. For Kia Automotive, which chose to locate a manufacturing facility in Slovakia

instead of Poland, the predictability and clarity of the system was an important factor.

Several large-capitalisation companies have had success in negotiating attractive incentives

in central and southeastern Europe. Yet, in Slovakias case, it was the broader political

climate that enabled the construction of a pro-growth coalition, which in turn instituted

business-friendly policies. At the same time, one election is not enough to guarantee that a

favourable business climate endures. House Co

Integrating Political Risk into an

Enterprise Risk Management Process

No matter how local a business, global politics can have an effect on success. By

integrating political risk into the companys ERM process, executives can better understandthe global exposures and balance the companys risk appetite against achievement of

corporate objectives.

The Political Risk Assessment PricewaterhouseCoopers and Eurasia Group have joined

together to offer a Political Risk Assessment (PRA) diagnostic and monitoring

methodology, which helps executives monitor their international exposures. The PRA is a

systematic approach to understanding and anticipating

how current and future political events could materially affect a companys organisation,

and thereby helps the company better manage its international exposures.

The PRA has three phases:

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Risk Assessment Analysts look at the companys current and future international

investments, global supply chains, and key foreign commercial relationships. They map

these against global trends, macro-level country risks, and industry- specific risks to create

a comprehensive picture of risk exposure. This phase also provides a check against the

companys internal assessment of risk.

Impact Analysis Analysts assess the companys vulnerability to risks and the potential

economic and strategic impacts of risks on costs and revenues. Advisors work with the

organisation to test qualitative and quantitative risk scenarios and strategic responses.

Recommendation Advisors work with the company to develop a plan for mitigating

identified risks, pursuing potential opportunities, or seeking alternative strategies. Strategy

shifts may include improving risk-management processes or decisions to enter or exit

markets or to shift sourcing strategies. PwC and Eurasia Group complement this phase with

ongoing monitoring of political risks and business-compliance issues.

Political-Risk Analysis Strategies

Global corporations, governments, and others concerned with the impact of a transnational

issue, such as terrorism or energy supply, need methodical, system-wide analysis to

complement country-specific coverage. One of the main challenges for leaders confronting

global issues is identifying from the overwhelming body of available information the

specific indicators of risk. To address this, political risk analysts have built customised

frameworks for organising complex, cross-national phenomena into manageable,

actionable typologies. Scenario planning is also employed to help leaders plot strategy in

situations where there may be a variety of outcomes. By leveraging the intellectual capital

of economists, political analysts, and social scientists around the world, political-risk

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analysts can generate forward-looking analysis on political risk in emerging and developed

markets.

A) Scenario Planning

Corporate investors take a long-term view when they enter a new market. They seek

analysis that provides insight into what the global political and social landscape may look

likenot just in the next few weeks or months but in the years ahead. Scenario planning is

a tool analysts use to map out potential political, economic, and social trajectories, thus

allowing companies to consider a range of strategic scenarios and identify critical risks as

well as opportunities. Scenarios dont attempt to predict the future. Instead, they help

companies anticipate challenges and opportunities by serving as a roadmap. Looking to the

future, there are many potential ways to get from point A to point B, but the road taken will

be characterised by its own set of landmarks. Scenarios attempt to enable the user to

recognise critical signposts as they occur.

Key to the process of scenario planning is a determination of driving forces that maypropel global affairs down a particular path. These drivers may include market factors,

social trends, technology developments, and patterns of coercion or regulation by the state.

Mapping out scenarios involves assessing the impact of drivers along with other

certainties that are known about the future, such as population trends and gross national

product projections. What emerge are very different stories about the future, depending on

the particular dominance of certain drivers and the available trade-offs.

B) Timing Risk: Capitalising on

Market Misreading of Relative

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Political Risk

Capitalising on market misreading of relative political risk offers opportunities for

cheaper, more profitable investments. Following potential changes in government, either

through elections or other means, is one way to time opportunities or to anticipate future

difficulties. Such analysis requires committed, continuous coverage combined with

detailed historical and institutional knowledge of prominent political actors as well as the

incentives and constraints they face.

Preparing for Uncertainties

By understanding the underlying context for each story, companies can better anticipate

how the world might adjust when uncertainties are introduced. For example, an uncertainty

such as a terrorist attack might stimulate increased state regulation and a prioritisation of

security measures over social equities. Such a shift has immediate financial and legal

effects, as well as implications for consumer and market behaviour. When the baseline

model for such a scenario is mapped out in advance, companies are better prepared to

recognise the trajectory toward which they are moving and can likewise identify the

potential impact of uncertainties as they occur. As such, they will be better able to adjust

their business strategies in response to uncertainties.

Examples of the Drivers of Key Risks

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2.3 Role of Risk Managers in

Multinational Corporations

An expatriate, on international business travel most of the times, arrives on the British AirWays flight, rents a Toyota at Hertz, drives down-town to Hilton hotels and reaches the

room, flips on to Sony TV and catches the glimpse of the same flashing signs of Coca-

Cola and BMW etc. Then suddenly while watching the news on BBC a sense of

disorientation sets in and they try to remember where they are Sydney, Singapore,

Stockholm or Seattle. This has become a common experience, thanks to the MNC

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phenomenon. Multinational Corporations (MNC) account for 40% of the worlds

manufacturing output and almost a quarter of the world trade. About 85% of the worlds

automobiles, 70% of computer, 35% of toothpaste and 65% of soft drinks are produced and

marketed by MNCs (Bartlett et al, 2003, p3).

However, most of the MNCs have come up in recent times of change and globalisation. It

is evident in the changed definition of MNC i.e. till 1973 the United Nations defined MNC

as an enterprise which controls assets, factories, mines, sales offices and the like in two or

more countries (Bartlett et al, 2003). However, the scope of what the term Multinational

Corporation covers has changed and required two crucial qualifications vis--vis first

qualification requires an MNC to have substantial direct investment in foreign counties and

not just an export business. While the second requisite for a true MNC would be a

company engaged in the active management of these offshore assets rather than simply

holding them in a passive financial portfolio (Bartlett et al, 2003).

One of the most important motivations for companies to expand their operation

internationally is the low-cost factors of production in developing countries like China and

India (Papers4you.com, 2006). This has had a tremendous influence on the economies of

the developing countries, acting as a catalyst in their growth process. However, entering a

new market in a different nation is not as easy as it sounds, with factors like local culture

and local market knowledge presenting as obstacle initially. There are various ways in

which a company can decide to enter the market, one such model being the Uppsala model,

which suggests a company should make an initial commitment of resources to the foreign

market through which it gains the local market know-how on the basis of which further

evaluations can be made (Bartlett et al, 2003). However, there are many companies who do

not follow such models and take a short cut to building the market knowledge by investing

in or acquiring a local partner for instance Wal-Mart entered the UK by buying the

supermarket chain Asia (Papers4you.com, 2006).

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However, in recent times most companies have recognised the need to be responsive to

local markets and political needs and the management styles followed by multinationals are

gradually shifting towards a trans-national strategy ofThink global, act local.

2.4 Risk Management in ASIA:

Common factors that affect risk management in the Asian region includes:

a) The type and level of risk that are confronted by Multinational Corporation in the

region.

b) The governments impact on risk and risk management

c) The availability of risk management options that will enable CROs or other

financial officers to manage risk in the Asian region and

d) The risk management practices of Asia-based Multinational Corporation.

2.4.1 Types And Levels Of Risk In ASIA

In spite of the widespread availability of credit risk options in financially sophisticated

Asian countries, the Asian region has become increasingly susceptible to operational and

political risks. For instance recent events such as the bombing in Bali has seriously

undermined the risk weighting of neighbouring countries such as Singapore.

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Euromoneys annual country risk survey of the countries in the Asia-Pacific region in

terms of political and financial risks offer valuable information for comparing the type and

risk associated with each country. However, it is evident that considering the current

instability in the global environment, the ranking of these countries will need to be adjusted

in near future. Yet, in spite of uncertainity of the unexpected events such as terrorist

attacks, comparatively more stable systemic factors should also be considered in assessing

the countrys risk. For instance, Australia (a country in the Asia-Pacific) is considered to

have low risk because of the continuous stability of its legal and judicial system as cited in

Haddock 2002.

In its assessment of the following countries risk profile Euromoney used the following

criteria: Total Score, Political Risk, Economic Performance, Debt

Indicator, Debt in Default or Rescheduled, Credit Ratings, Access to Bank Finance and

access to Capital Market as quantified by Haddock in 2002.

TABLE 1

COUNTRY RISK SURVEY AS OF SEP2002

Countries Global

Rank

Total

Score

(100)

Political

Risk

(25)

Economic

Performance

(25)

Debt

Indicator

(10)

Australia 16 90.39 23.13 18.56 10.0

Singapore 17 90.24 23.25 18.84 10.0

Japan 18 88.68 21.5 19.26 10.0

New Zealand 22 86.69 22.35 15.44 10.0

Taiwan 25 82.60 21.14 15.31 10.0

Hong Kong 27 81.55 19.86 17.80 10.0South Korea 34 69.46 18.34 12.06 9.41

Malaysia 47 63.05 16.72 10.23 9.39

China 58 56.39 16.97 9.39 9.68

Thailand 59 56.28 14.73 8.77 8.91

India 61 55.10 14.79 7.68 9.44

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Countries Debt in

Default or

Rescheduled

(10)

Credit Rating

(10)

Access to Bank

Finance

(5)

Access to

Capital Market

(5)

Australia 10.0 8.96 5.0 5.0

Singapore 10.0 9.79 5.0 4.0

Japan 10.0 8.75 5.0 4.5

New Zealand 10.0 8.96 5.0 5.0

Taiwan 10.0 8.13 5.0 4.0

Hong Kong 10.0 7.29 5.0 3.33

South Korea 10.0 6.46 0.98 3.50

Malaysia 10.0 5.21 1.21 3.50

China 10.0 5.83 0.01 2.0

Thailand 10.0 4.38 0.34 2.0

India 10.0 3.13 0.03 2.75

Adapted from Haddock F.2002, Managing risk in a riskier world- Risk- Financial

and Physical-has shot into the consciousness of companies around the globe,

Asiamoney, vol.13, no.11, pg 21.

In early 1997 just prior to the onset of the Asian economic crisis, a survey was conducted

by the POLITICAL AND ECONOMIC RISK CONSULTANCY Co. Ltd. The survey

of US headquarters in which they asked middle and senior managers of these companies

with responsibilities for Asia to indicate that how much weight they felt should be given to

political risks in assessing total risks of a particular company.

On the other hand, if the respondents felt political risk overshadowed everything else,

political risk should have received a 100% weighting. If political and economic risk were

felt to be of equal concern, the ratio should be 50:50. The PERC received between 25 and

40 responses per country, and they averaged the responses for each country to arrive at a

composite score or weight.

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TABLE 2

Business Risks in Asia - A US

Perspective

Country Political Risk Degree of Difficulty of doing

business

China 68.55 6.33

Hong Kong 62.32 3.61

Vietnam 56.54 5.75

Philippines 56.32 5.83

Taiwan 54.20 4.78

South Korea 50.24 5.62

Thailand 48.70 5.59

Indonesia 48.41 6.27

Malaysia 42.00 5.35

US 32.19 2.89

Japan 31.79 4.97

Singapore 27.07 3.50

Adapted from a survey from the POLITICAL AND ECONOMIC RISK CONSULTANCY

Co. Ltd.

1. Measured as a percentage of total country risk.

2. Graded on a 0 to 10 scale, with zero being the best possible grade, or an extremely

hospitable business environment, and a 10 the worst grade possible, or a very

difficult business environment.

From the survey, it can be concluded that the executives were most concerned about

political risks in China and Hong Kong, which was understandable at that time, considering

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Hong Kongs transition was less than half a year away and led to the number of questions

in mind of many managers.

From the PERC survey it can be noted that although there is some correlation between the

weight given to political risk and degree of difficulty of doing business, the match is not

exact. This shows the importance of familarity with one environment can surely influence

how business are carried out no matters what are the level of political risk or any other risk.

2.4.2 Risks management practices of

Asia-based MNCsAs with their counterparts in the west, multinational corporations based in Asia have also

employed a wide variety of risks to manage their risks. Howard provided an analysis of the

changes in risk management of a major multinational corporation based in Singapore:

Singapore Airlines. According to Martin De Souza, the risk manager\insurance officer of

the corporation the airline created a risk management program in 1982 to cover the losses

of its global properties and their related ground-based facilities. In order to provide

full coverage, the airline purchased almost 50 insurance policies that increased with theconstruction of new buildings or new projects. Apart from the large number of discrete

policies, this risk management program also led to gaps in coverage and sufficient

limits.

To address this problem, the corporation changed its strategy by creating a combined

program that catered to both property and liability risks with a deductible of one million

Singapore Dollars. Consequently the company was able to reduce administration cost and

premium, as well as eliminate gaps in the coverage. Based on its own calculations,

Singapore concluded that S$ 150 million coverage for liability and S$ 1.5 billion coverage

for property was sufficient to reduce its risks. Finally the company also created a Self-

insured Contingency Fund amounting to S$ 25 million to cover uninsured losses as stated

by Howard.

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Apart from using insurance policies, the airline also protected its computer centre with a

halon fire protection system. Furthermore should the computer centre be affected by

fire, employees are able to move backup building with the same computer systems and

resume their operations as emphasized by Howard.

In the face of continuous threat of global terrorism, Haddock in his 2002 article stated that

some Asia based multinational corporation has continued to maintain a CALM Approach

towards their management of risks. For example, S. Sukumar head of Corporate Planning

at Infosys, an Indian-based company that specializes in global technology, explained that

their strategy for managing political risk is to diversify their sources of revenue. Due to its

dealing with a large number of countries, Infosys can take advantage of natural hedge to

manage its risks. The company imposes a limit on the amount of revenues that come from

one geography,customer,vertical industry or transient service offering as qualified

in Haddock 2002. Essentially the company is not dependent on any specific region for their

sales. This strategy is still effective in the global environment that is affected by the threat

of terrorism.

Chapter 4 Analysis & Findings

4.1 Introduction

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Risk management protects and adds value to the organisation and its stakeholders through

supporting the organisations objectives by:

providing a framework for an organisation that enables future activity to take

place in a consistent and controlled manner

improving decision making, planning and prioritisation by comprehensive and structured

understanding of business activity, volatility and project opportunity/threat

reducing volatility in the non essential areas of the business

protecting and enhancing assets and company image

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contributing to more efficient use/allocation of capital and resources within the

organisation

developing and supporting people and the organisations knowledge base

4.2 Types of risk management policies

and their objectives

The South Australian Government Risk Management Policy Statement,

2003, states that The Government recognises that the management of risk is

an integral part of sound management practice. This policy makes

departmental and agency Chief Executives accountable to their Ministers for

the effective implementation of risk management standards and practices.

A strong enterprise risk management culture and practices will assist

Department of Education and Childrens Services (DECS) to:

efficiently achieve strategic objectives,

improve governance and accountability,

increase th

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