Analysing Strategic Risks and How To Measure

Strategic risk, definition:

• an unexpected event or set of conditions that significantly reduces the ability of managers to implement their intended business strategy (Simons, 2000)
• uncertain future events which could influence achievement of the organisation's objectives, including strategic, operational, financial and compliance objectives (PricewaterhouseCoopers)

Operations risk: 

• breakdown in a core operating, manufacturing or processing capability, example: defective products, neglected maintenance leads to breakdowns, lost in customer packages.
• critical product or process failures, example: toxic substance mixed with a product formulation. 
• often triggered by employee error, mostly are unintended and/or accidental.

Competitive risk:

• results from changes in the competitive environment that could impair the business's ability to successfully create value and differentiate its product and services.
• Example: actions of competitors in developing superior products and services, changes in regulation and public policy, shift in customer tastes or desires (such as fashion fads), and changing in supplier pricing and policies.
• Porter five forces.

Asset impairment risk:

• when it loses a significant portion of its current value because of a reduction in the likelihood of receiving those future cash flows.
• 3 potential types:
• Financial impairment: result from a decline in the market value of a significant balance sheet asset held for resale or as collateral. Example: currency devaluation decreased the expected value of future cash flows, a long-term bond portfolio may sink dramatically due to a rise in market interest rates.
• Intellectual property rights impairment: related to intangible resources, example: due to unauthorised use of intellectual property by competitors (patent infringement), unauthorised disclosure of trade secrets to competitor or third party, etc.
• Physical impairment: dur to physical destruction of key processing or production facilities, because of fire, flood, terrorist, or other catastrophe. 

Franchise risk (reputation risk):

• when the value of the entire business erodes due to a loss in confidence by critical constituents.
• occurs when business problems or actions negatively affect customer perceptions of value in using the business's goods or services.
• can negatively influence public perception and drive away customers.

Risk Assessment Template:

• Risk factor, eg. price fluctuation, competitive rivalry
• Description, eg: 
• Oil, natural gas & chemical prices can vary due to changes in supply and demand for products.
• Product innovations, technical advances, intensifications of price competition by competitors, industry consolidation can impact operating results.
• Risk Category: operation risk, competitive risk, asset impairment risk, franchise (reputation) risk.
• Strategic impact: Low, Medium, High.
• Reputation Risk: Low, Medium, High.
• Uncontrollable --> Low, Controllable --> High.

The risk exposure calculators:

Analysis the pressure points inside a business that can cause strategic risks to "blow up" (occur).

If the pressure builds too high, operations risk, asset impairment risk and competitive risk can cause irreparable damage. High score --> high risk (1 = no risk, 2 = medium risk, 3 = high risk).

Three key analysis areas:

• Growth: --> fundamental goals of the business but also bears risk pressure
• Pressure for performance: 
• goals are set at demanding levels with high performance expectations (or else risk punishment or possible replacement).
• Rate of expansion: 
• rapidly expanding scale of operations -- companies grow bigger, but resources, people and system often work beyond their normal capacity. 
• As a result, mistakes and breakdowns may occur, operations error, increase credit risk, downgrade of product and services, etc.
• Inexperience of Key Employees: 
• growth also means hiring large number of new people, sometimes in the rush, background employee check may be waived and minimum performance standard and education qualification may be lowered.

• Culture: --> history and top-management leadership style bears risk pressure
• Reward for entrepreneurial risk taking: 
• individual are motivated to be creative in finding and creating market opportunities, although it's a good thing, but in the risk taking management, such as: investment may be made in risky asset, deals may be struck with counterparts who have limited ability to honor contract, commitment made but difficult to fulfil, or employees may engage in behaviours that damage the reputation of business.
• Executive resistance to bad news: 
• culture also influence the willingness of subordinates to inform superiors about potential risks in the business. 
• Early warning systems? How much employees fear in bearing bad news and communicate to senior management? Fear of sanction or other personal repercussions?
• Level of internal comparison: 
• cultures also foster spirit of internal competition, which bring a unique set of issues. Intense competition among subordinates targeting for bonuses or promotion. 
• To enhance short-term performance and advance own careers, individuals may gambling with business assets, credit exposure, firm reputation. The payoff and costs are asymmetric, the worst situations the employees could lose their job and business fall to financial loss.
• Information Management: -->
• Transaction complexity and velocity:
• high transaction volume and increased processing speed --> increase the possibility of operation risk.
• As transaction become more complex, fewer people may fully understand the nature of transactions and how to control them.
• Example: cross border agreement in international operations, creative financing, consortium agreement.
• Without fully understanding contractual obligations and the nature of cash flows, asset impairment risk will increase substantially.
• Gaps in diagnostic performance measures:
• management may be unaware of potential problems, cannot take remedial action to contain the risk. All type of risk need to diagnostic appropriately to track current risk level and early warning indicators about changes in competitive risk and franchise risk should be in place.
• may require specialised information processing system that can consolidate information across dispersed operations.
• Degree of decentralised decision making:
• In decentralised business, individuals are encouraged to make decisions autonomously and creates opportunities without constant monitoring and oversight by superiors.
• Due to freedom environment, operating rules and constraints may be neglected. Consequently, they may be able to engage in activities that increase risk without requiring approval from corporate level managers.
• Also, by decentralising credit approval, will increase the magnitude of credit risk.

Example: Case Study - Luvano Wine Group (Australian Wine Company)

• Growth:
•  Pressure for performance: 2 to 3
• intense competition and rivalry in Australia's wine industry.
• Profit and growth target increased.
• lots of competitors and very high competitive landscape.
• Rate of expansion: 2
• no rapidly growing, highly dependen to Australia wine market.
• but, there's an increase of intense to expand to new areas outside Australia, such as Asia, America and European market as they already has good relationship with international distributor and perform an international joint venture
• Inexperience of Key Employees: 1
• strong management teams and only employs 570 people, including highly skilled and experienced vintrepreneurs. 
• Culture:
• Reward for entrepreneurial risk taking: 1
• not enough information from case study
• Executive resistance to bad news: 1
• not enough information from case study
• Level of internal comparison: 1
• not have divisions, 
• not enough information from case study
• Information Management: 
• Transaction complexity and velocity: 2
• Medium, not very highly complex but not to simple, as they develop several international brands
• Gaps in diagnostic performance measures: 1
• Friendly and close related family business, not so hard to disclose bad news.
• Degree of decentralised decision making: 2
• Possessed subsidiary in England and US, not enough information about the constraint of operating rules and freedom of credit approval risks.
• Total score: 13 to 14

Risk Management and Controls (Simon)

• Belief Systems --> Beliefs and core values empower employees to make decisions that align with the company's interests. Help organisation to manage risks (what employee have to do)
• Example in Royal Dutch/Shell Group Statement of General Business --> "Shell companies insist on honesty, integrity and fairness in all aspects of their business and expect the same in the relationships with all those with whom they do business."
• Boundary Systems --> Boundaries for business conduct provide clear, enforceable sanctions.
• Example in Royal Dutch/Shell Group Statement of General Business --> "The direct or indirect offer, payment, soliciting and acceptance of bribes in any form are unacceptable practices". "Employees must avoid conflict of interest between their private financial activities and their part in the conduct of company business" 
• But, we can recommend to Shell to state enforceable sanction, in which not clearly stated in their Group Statement.
• Internal Control Systems --> Internal controls ensure any errors of omission and commission that do occur are detected.

Risk Management in Futures & Options - To Hedge or Not To Hedge??

To hedge or not to hedge?

• Hedging = risk mitigation by using forward contract, futures and option.
• Against Hedging: costly, difficult, not suitable for risk-averse investors, and can create bad incentives (attempt for currency speculations).
• For Hedging: can reduce firm's expected taxes (tax-loss carry forward & convex tax code), lower the costs of financial distress, improve firm's future investment decisions. --> If firm did not hedge and its value fell, (+) NPV projects may be missed. 

Futures Contract

• Allow individuals and firms to buy and sell specific amounts of foreign currency at an agreed-upon price determined on a given future day.
• Differences between forward contract and futures contract:
• Futures: traded on an exchange (NYSE, Tokyo Financial Exchange), forward: made by bank and their clients.
• Futures: standardised smaller amounts of currencies, forward: larger.
• Futures: have only a few maturity dates, fixed and generally 6 month. Forward: a client can request any future maturity date with maturities of 30, 60, 90, 180 or 360 days.
• Credit risk --> 
• Forward contract: Bank willingly trade it with large corporations, hedge funds, and institutional investors. But not trade with individual investors or small firm with bad credit risk.
• Futures: all contracts are between a member of the exchange and the exchange itself. Retail clients buy it from futures brokerage which must be registered with CFTC (Commodity Futures Trading Commissions) as FCM (Futures Commissions Merchant). Clearing member/clearinghouse.
• Margins
• Credit risk is handled by setting up an account called a margin account --> deposit an asset to act as collateral.
• 1st asset --> initial margin
• Asset can be cash, US government obligation, securities, gold or letter of credit.
• Marking to market --> deposit of daily losses/profits
• Maintenance margin --> minimum amount that must be kept to guard against severe fluctuations in the futures price.
• Margin Call --> when the value of the margin account reaches the maintenance margin. --> the account must be brought up to its initial value.
• Pricing:
• Payoff on forward contract --> S(t) - F(t) ; S(t): future spot rate, F(t): forward price
• Payoff on futures contract  -->  f(T) - f(t) ; f(T): futures price at maturity time, f(t): futures price 
• Potential problems with Futures Contract:
• Futures contracts are sold only in standardised sizes (ex: $125,000). Problem: if you need to hedge an amount that is not a multiple of the standard size.
• Relative low number of delivery date, which sometimes the maturity date of futures contract not match with a settlement date of the company's asset and liabilities.
• Basis risk: if the price of futures contract does not move one-for-one with the spot exchange rate (not perfectly hedge). The basis is the differences between the spot price at time t, S(t), and the futures price at time t, f(t,T), for maturity date at time T.

Foreign Currency Option Contract

• Gives the buyer the right, but not the obligation to buy (call) or sell (put) a specific amount of foreign currency for domestic currency at a specific forex rate.
• Price is called premium.
• Traded by money centre banks and exchanges (e.g. NASDAX OMX PHLX)
• European vs American option: European --> exercise only at maturity date; American --> exercise any time.
• Strike/exercise price --> forex rate in the contract, compare with the current spot exchange rate. 
• Intrinsic value --> revenue from exercising an option
• in the money: if some revenue could be earned by exercising the option immediately.
• out of the money: no revenue
• at the money: option has a strike price equal to the current spot rate.
• at the money forward: option has a strike price equal to the forward rate for that maturity.

Exchange-listed currency warrants

• Longer maturity foreign currency options (> 1 year)
• Issued by major corporations.
• Actively traded on exchanges such as the American Stock Exchange, London Stock Exchange, or ASX.
• American-style option contracts
• Allow retail investors and small corporations which is too small to participate in OTC market to purchase L/T currency options.

Synthetic forward contract: Using put and call options (same K) simultaneously --> Ex: purchase a $ put option and write a $ call option for revenue. Both are at strike price K.

Combination of Options and Exotic option:

• Exotic options: options with different pay-off patterns than the basic options.
• Range forward contract:  allows a company to specify a range of future spot rates over which the firm can sell or buy forex at the future spot rate --> no money up front.
• Cylinder options: allow buyers to specify a desired trading range and either pay money or potentially receive money up front for entering into the contract.
• Both can be synthesized: buying a call and selling a put (at a lower K) and for range forward.
• Average-rate option: where S defined as the average forex rate between the initiation of the contract and the expiration date.
• Barrier options: regular options with additional requirement that either activates or extinguishes the option if a barrier forex is exchange.
• Lookback option: option that allows you to buy/sell at least/most expensive prices over a year (more expensive than regular options).
• Digital options ("binary" options): pays off principal if K is reached and 0 otherwise (think lottery). 

International Capital Market Equilibrium

Two risks of investing abroad:

• Return of the international asset in its local currency.
• Variations in the value of the foreign currency relative to investor's currency.
• Return of investment = return of asset + return of currency

Sharpe ratios:

• measured as the average excess return relative to the volatility of the return.
• Risk adjusted excess return.

Nonsystematic variance = idiosyncratic variance (changes over time --> implication on how many firms it takes to diversify)
Systematic variance = Beta.
p < 1; the lower the better, firms more diversify.

What drive correlation of returns?

• Trade
• Geographic proximity
• Industrial structure: firms in the same industry --> buffeted by the same shocks, their systematic risk also move together.
• Irrational investors : contagion phenomenon.

Investment hurdle rates --> lowest possible expected return that allows for an improvement in the Sharpe ratio when they invest in that foreign market.

Risk premium of the market --> how much the market compensates investors for systematic risk.

Home bias --> local investors hold a disproportionately large share of local assets compared to global assets.

• Issues: Investors should not hold foreign equities because they are more volatile and have been yielding lower return than US stocks. --> False. 
• You should add foreign equities as soon as the foreign sharpe ratio exceeds the American sharpe ratio times the correlation between US portfolio and foreign security retun.
• Issues: Home bias arises because investors face an additional risk when investing internationally - currency risk. Because currency risk makes return more volatile but does not lead to a higher expected return, investing more in domestic assets is rational.
• Issues: Home bias arises because investors have a non-traded domestic assets that they care about as well - namely human capital. The returns to this asset can be thought of as labor income.

Real Exchange Risk

Definition: the phenomenon whereby the profitability of a firm can change because of fluctuations in the real exchange rate. (= operating exposure or economic exposure)

Value of a firm is represented by the present value of its expected future profitability, thus could affect a firm's cash flows, either through changes in demand or costs.

Pricing to market: producer charges different prices for the same good in different markets.

Depreciation of local currency: hurts net importer but benefits net exporter.

Strategies for managing real exchange risk: 

• Production scheduling: use changes in inventory to meet firm's transitory fluctuations in demand.
• Input sourcing: when domestic currency is strong, domestic firms should use foreign inputs.
• Plant locations: shifting production among existing locations (firm should increase production in countries whose depreciated in currency)
• Pricing policies: when a currency depreciates, exporter to that country face a trade off (profits vs market share). If firm increase price -- they will lose market share, but if the product is inelastic, the exporter could increase its prices by a greater amount.
• The frequency of price adjustment: consumer hates it, thus company should build boundaries that will not trigger a change in price.
• Market entry decision: introducing new product in foreign markets when the foreign currencies are strong -- set up a comparatively low price for product.
• Brand loyalty -- consumer hardly to switch to other competitor's product.

The fisher hypothesis: nominal interest rates should reflect expectations of the rate of inflation. Real rates of return - measures how much your purchasing power has increased over time.

Fundamental exchange rate forecasting: econometric models (money supply, inflation, productivity, growth rates); judgment of future macroeconomic relationships; concerned with multiyear forecasts.

Technical analysis: short term forecasts; using historical data to find pattern; information about the future exchange rate is assumed to be present in past trading behaviour.

The asset market approach: the exchange rate as an asset price, just like stocks -- based on current and future cash flows; fluctuate randomly by people's willingness to hold this particular currencies; the exchange rate as a weighted average of current fundamental and its expected future values; changes as news come out or good/bad expectations.

The monetary approach: real money balance; concerned with the real value of the nominal money; function of money supplies and income levels in two countries; supply money in domestic currency increases--weaken in domestic currency; supply money in foreign currency increases--domestic strengthen; if domestic real income falls--the foreign income rises; or news expected lower domestic growth or faster foreign growth--domestic currency weakens.

Balance of Payments (BOP) = Current Account (export and import) + Capital Account (foreign investment inflows and outflows) + central bank's reserve account = 0
Ex: strong domestic currencies -- foreign goods cheaper -- increase of imports relative to exports -- current account deficit.
Higher interest rates -- increase savings and decrease real investment -- capital account deficit (losing net foreign investment).
Equilibrium: supply and demand force an equilibrium price and quantity of the real exchange rate on the current account through a "goods" channel and a "savings and investment" channel.

Potential spurious pattern: chartist rely on graphs to detect trends rather than on statistics.

Filter rules: provide signals on investors as to when to buy and sell currencies.
x% rules -- buy the currencies if it appreciates by x% above its support level and sell the currencies when it falls x% below its resistance level.
moving average cross-over rules: the average value of an exchange rate over a set of period. Buy (go long)-- short term (y days) moving average crosses the long-term (z days) moving average from below. Sell (go short) if it crosses from above. But, simple moving average rules works better.

Ex-post: correct the nominal interest rate with the realised or ex post rate of inflation; Ex-ante: correct the nominal interest rate with expected inflation.

Higher nominal interest rate -- higher expected rate of inflation -- country's currency expected to depreciate relative to dollar -- trade in forward discount relative to dollar.

Large increase in domestic money supply -- a depreciation of the currency. But it could be offset the money supply effect, if an increase in real income that increase the demand for money.

An increase in government spending or a decrease in taxes that causes a budget deficit should increase the real exchange rate -- increase aggregate demand which causes the real interest rates to rise.

Forward Markets and Transaction Exchange Risk

Transaction exchange risk -- possibility of taking a loss in foreign exchange transactions. Normal distribution for major currencies, but skewed distribution for emerging markets.

Forward contracts -- forward rate (specified in a forward contract); eliminates risk/uncertainty; usually a large sum of money; with bank. Costs: ex ante (before), ex post (after).

Swap: simultaneously purchase and sale of a certain amount of foreign currency for two different dates in the future.

Volatility clustering: when standard deviations (volatility) in forex rate demonstrate a pattern. -- GARCH model.

Exchange Rate System

• Floating currencies: determined by the market forces of supply and demand; 
• managed floating: central banks intervene enough with the country's currencies; 
• fixed/pegged currencies: "pegging" (fix at particular level) a currency to another or a basket of currencies, often used a currency board (domestic currency 100% backed by assets payable in reserve currency; 
• target zone: forex rate is kept within band, the currency is allowed to fluctuate in a percentage band around a "central value".
• crawling pegs: changes are kept lower than preset limits that are adjusted regularly (w/ inflation), adjust for inflation differential between domestic inflation vs inflation of the pegged's currency so the domestic firm's don't lose competitiveness. Latent volatility: the true currency risk does not show up in day-to-day fluctuations, in a long time, historical volatility appears to be zero or very limited.
• special arrangements: where a regional central bank controls the forex rate system for several countries.

Central Banks: Liabilities -- monetary base or base money: deposits of financial institutions (bank reserves) and currency in circulations; Assets: official international reserves ( T-Bills of other countries, gold reserves, IMF-related reserve assets) and domestic credit (government bonds and loans to domestic financial institutions). Seigniorage: the value of the real resources that the central bank obtains through the creation of base money.

The imposible trinity (only two out of three are possible): perfect capital mobility (no capital control), fixed exchange rates, domestic monetary autonomy.

Central Bank interventions: money supply/interest rates, attempts to restrict capital movements, tax/subsidise international trade to influence demand for foreign currencies.

Foreign exchange interventions: Non-sterilised and sterilised (off-setting the effect of money supply by performing an open market operation that counteracts the effect: portfolio shifting on private investors--replace foreign bonds with domestic bonds; squeezing foreign inventories at dealer banks and generate pricing effects). Direct channel: small size - short term effect to sterilised interventions; Indirect channel: interventions can alter people expectations and affect their investments - push to the desire direction.

Defending the target zone: intervene through open market operations, raise interest rates, limits foreign exchange transactions through capital controls.

Lag operations: postpone capital inflow: receivable - exporter (especially when domestic currency devalued)

Lead operations: domestic importer prepay for goods in devaluations effect.

Dollarisation: foreign currency has exclusive or predominant status as full legal tender in a particular country (Ecuador: Dollar).

Globalisation and the Multinational Corporation

Globalisation -- increasing connectivity and integration of countries and corporations and the people within them in term of economic, political, and social activities.

Multinational corporation -- produces and sells good or services in more than one nation.

Securitisation -- repackaging of "pools" of loans or other to create receivables to create a new financial instrument. Pros: banks and companies could hedge against risk. Cons: smart financiers could exploit differences in country-specific regulations and complexity of instruments created opaqueness (not transparant, hard to understand) in the financial system --  lead to financial crisis 2008 - 2010.

Transnational corporations: a parent company in the firm's originating country and operating subsidiaries, branches and affiliates abroad. How they enter the market? Exporting/importing, licensing, franchising, joint venture, greenfield (starting company from scratch).

Important International Players: International banks; international institutions (IMF, the World Bank); multilateral development banks (regional development banks: provide financing and grants); WTO (mediates trade disputes); OECD (Organisation for Economic Cooperation and Development: examines, devised and coordinates policies across 34 countries to foster sustainable economic growth and employment, rising standards of living and financial stability); Bank for International Settlements (BIS) -- fosters international monetary and financial cooperation -- central banks to central bank; European Union (EU), governments, individual investors, institutional investors (superfund, mutual fund, insurance company); sovereign wealth funds (government-run investment pools); hedge funds; private equity funds.

Globalisation and the MNC: Benefactor or Menace? -- global crisis lead to protectionism, slowing trade liberalisation, trade openness and economic risk. Countries who had opened their markets to foreigners subsequently fell into crisis.
Benefits of openness: channels savings to most productive uses, sharing of risk beyond what is possible domestically, domestic recessions can be buffered through borrowing, cost of capital decreases.
Costs of openness: sometimes capital is not used wisely, foreign capital can leave quickly causing financial volatility, difficult in taxing profits -- MNC shift to avoid, capital control effectiveness decreases.

Interbank Market -- Communication System: SWIFT (Society of Worldwide Interbank Financial Telecommunications): links different banks and in different countries; CHIPS (Clearing House Interbank Payments System): clearing house in US for dollars; Fedwire: links computers that deposits within the US Federal Reserve; TARGET (Trans-European Automated Real-time Gross Settlement Express): euro counterpart to Fedwire.
Cross country settlement (or Herstatt) risk: the risk that a financial institutional may not deliver the currency on one side of a completed transaction -- lead to foster netting arrangements.