CHAPTER 17 Advanced Topic in Risk Management SCOPE OF CHAPTER Describes about modern risk management Describes the terminology in financial risk management Helps to understand the Enterprise risk management(ERM) Introduces several innovative financial solutions to evolving the risk management problems. Determine the amount of loss exposure to retain and the amount to transfer Describe the responsibility of risk manger of international firm Describe a risk management information systems(RMISs) TRADITIONAL RISK MANAGEMENT VS. MODERN RISK MANAGEMENT The aims of traditional risk management (chapter 3) is to solve management problems associated with pure risk. Modern risk management considers losses that arise from both pure and speculative risks. In modern risk management approach the logic is that a $1 million loss from currency fluctuations is as destructive to a firm’s value as a $1 million fire loss. FINANCIAL RISK MANAGEMENT VS. ENTERPRISE RISK MANAGEMENT The aim of financial risk management is to describe a program to manage efficiently potential losses arising from things such as interest rate changes, currency fluctuations, credit risks or commodity price changes. Definition: Financial risk management refers to the identification, analysis, and treatment of financial risk which include the following risks: Commodity price risk Interest rate risk Currency exchange rate risk The aim of Enterprise risk management(ERM) is to describe a program that considers all sources of loss at the same time. o Commodity price risk is the risk of losing money if the price of a commodity changes. Producers and users of commodities face commodity price risks. Example: Consider an agricultural operation that will have thousands of bushels of grain at harvest time. At harvest, the price of the commodity may have increased or decreased , depending on the supply and demand for grain. Because little storage is available for the crop, the grain must be sold at the current market price, even if the price is low. In a similar fashion ,users and distributors of commodities face commodity price risks. Interest rate risk Financial instructions face to interest rate risk. Definition: Interest rate risk is the risk of loss caused by adverse interest rate movements. Example: A corporation might issue bonds at a time when interest rates are high. For the bonds to sell at their face value when issued, the coupon interest rate must equal the investor required rate of return. If interest rates later decline , the company must still pay the higher coupon interest rate on the bonds. Currency exchange rate risk The currency exchange risk is the value for which one nation’s currency may be converted to another nation’s currency. Example: One U.S. dollar might be worth the equivalent of 1.80 of one Turkish Lira. At this currency exchange rate, one U.S. dollar may be converted to 1.80 Turkish Lira. Definition : Currency exchange rate risk is the risk of loss of value caused by changes in the rate at which one nation’s currency may be converted to another nation’s currency. Example: A U.S. company faces currency exchange rate risk when it agrees to accept a specified amount of foreign currency in the future as payment for goods sold or work performed. ENTERPRISE RISK MANAGEMENT Definitions: Enterprise risk management is a comprehensive risk management program that address an organization’s pure risks, speculative risks, strategic risks, and operational risks. Pure and speculative risks Strategic risk refers to uncertainty regarding an organization’s strengths , weaknesses, opportunities, and threats. Operational risks develop out of business operations, including the manufacture and distribution of products and providing services to customers. By packaging all of these risks in a single program , the organization offsets one risk against another , and in the process reduces its overall risk . HEDGING Definition: Hedging is a technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling futures contracts on an organized exchange , such as the Chicago Board of Trade or New York Stock Exchange(NYSE). Modern financial arrangements allow risk managers to construct hedges against many different types of losses. Using derivatives securities is a way to reduce or limit risk. EXAMPLE OF HEDGING The portfolio manager of a pension fund may hold a substantial position in long-term U.S. Treasury bonds. If interest rates rise , the value of the Treasury bonds will decline . To hedge that risk, the portfolio manager can sell U.S. Treasury bond futures. Assume that the interest rates rise as expected, and bond prices decline. The value of the futures contract will also decline , which will enable the portfolio manager to make an offsetting purchase at a lower price. “ The profit obtained from closing out the futures option will partly or completely offset the decline in the market value of the Treasury bonds owned”. DERIVATIVES SECURITIES AND OTHER FINANCIAL TRANSACTIONS Derivatives are financial instruments that allow risk managers to construct hedges against many different types of losses. The value of derivative security is based on the value of an underlying financial asset or commodity. There are 4 types of contracts under the derivatives securities: Future contracts Forward contracts Swap contracts Option contracts Future contracts These types of contract are orders placed by traders in advance to buy or sell a commodity or financial asset at a specified price. Risk manager use futures to provide a hedge when an increase or decrease in a commodity ‘s price can reduce profits. Forward contracts These contracts are similar to futures contracts, but forward contracts are not traded on organized exchange, such as the Chicago Board of Trade or New York Stock Exchange(NYSE). Swap contracts A swap is a contract in which both parts of contract settle to make payments to one another on scheduled dates in future. The swap contracts may used by corporations to change foreign debt into domestic debt or domestic debt into foreign debt. Currency swap : two companies or two countries lend each other currency. Interest rate swap : Two companies lend one currency at different interest rate, one fixed ,one floating. Option contracts Options are contracts where two parts of contract have the right to trade the certain quantity of underlying asset at determined price within the specific time period by paying the premium, but they don’t have obligation to trade. Option holder or the party with long position has the right to buy or sell under the agreed terms. Call option is an option to buy an underlying asset. A call option would have value if the holder could buy the asset for below the prevailing market price. Put option is an option to sell an underlying asset. A put option would have value if the holder could sell the stock at above the prevailing market price. CATASTROPHE RISK TRANSFER Catastrophic loss because they are relatively large compared to the size of insurance pool are not ideally insurable loss exposure(Chapter 2). In spite of insuring catastrophic losses in not ideal , financiers have provided three financial arrangements to insurance companies faced with catastrophic exposure: Contingent surplus notes Catastrophe bonds Exchange traded options Contingent surplus notes This financial arrangement allow an insurance company to protect itself from paying a“ catastrophic amount” when its own finances may be weakened. Catastrophe bonds This financial arrangement allows an insurance company actually to transfer some or all its catastrophe exposure to a trust account. Exchange traded options If the insurer purchases this type of arrangement to hedge catastrophic losses ,the insurance company gives the seller this right to undertake cash payment. The exchange where these options are traded guarantees the performance of the seller (speculator), and the exchange requires the sellers of these contracts to meet financial responsibility requirements. DEDUCTIBLES AND POLICY LIMITS One common problem in risk management is to determine how much loss exposure to retain and how much to transfer. Deductibles or retention is the proportion of claim payment that insured bear. “ The first dollar of a loss insured bears” Policy limit is the proportion that insurance covers from a loss. “Maximum insurance recovery that is paid by insurer” If a loss is equal to or less than the deductible, the insured bears the cost. If a loss is greater than the policy limits, the insured bears the cost of any deductibles plus the amount of loss above the policy limit. when choosing a deductible and policy limit, there is a trade-off between premium payment and deductibles(uninsured losses). Lower premium-higher retention trade-off Increasing the deductibles reduce the amount of policy limit and as a result the premium also decreases. Policy limit + Deductibles = Total coverage Example in fire insurance Coverage Policy limit $100,000 $95,000 $100,000 $90,000 Deductible $5,000 $10,000 Premium $1,000 $990 In general, increasing policy limits increases premium costs, but the increase is not proportional. DIFFERENT TYPE OF RETENTIONS (DEDUCTIBLES) These following deductibles are commonly found in property insurance contracts: Straight Deductible( Each Occurrence Retention) The retention ( or deductible ) applies to each loss and there is no annual limit on the number of times the deductibles applies. Example: Assume that Ashley has auto collision insurance on her new Toyota, with a $500 deductible. If a collision loss is $7,000, she would receive only $6500 and would have to pay the remaining $500 herself. Aggregate Deductible( Aggregate Retention) An aggregate deductible means that all losses that occur during a specified time period(usually a year)are accumulated to satisfy the deductible amount. Once the deductible is satisfied , the insurer pays all future losses in full. Example : Assume that a policy contains an aggregate deductible of $10,000. Also assume that losses of $1000 and $2000 occur, respectively, during, the policy year. The insurer pays nothing because the deductible is not met. If the third loss of $8000 occurs during the same time period , the insurer would pay $1000( $11,000 losses – $10,000 deductible) Any other losses occurring during the policy year would be paid in full. Example: A manufacturing firm incurred the following insured losses, in the order given, during the current policy year. Loss A B C Amount of Loss $2,500 $3,500 $10,000 How much would the company’s insurer pay for each loss if the policy contained the following type of deductible? 1- $1,000 straight deductible 2- $15,000 annual aggregate deductible FINANCIAL AND OTHER CONSIDERATION In order to solve the lower-premium-higher retention trade-off , the risk manager should consider the following factors: - Tax Implications - Ability to pay for losses - Psychological Factors - Social and Ethical Concern Tax Implications In general, commercial insurance premiums are a tax-deductible expense, as are uninsured losses. The main difference between the two is the timing of the expense. Insurance premiums are deductible when paid; losses are deductible when incurred. Ability to pay for losses To set an efficient retention limit, the firm must consider the liquidity of assets, the stability of net income , and the amount of net worth. Psychological Factors People make decision based on their experience , attitudes toward risk , ability to explain and sell their ideas to other managers, habits, and intuition Social and Ethical Concerns In the absence of adequate funding, uninsured losses could bankrupt organizations and produce socially or ethically undesirable consequences , including undercompensated, dead, or injured employees, a polluted environment, or unemployed workers. INTERNATIONAL RISK MANAGEMENT Multinational Companies(MNCs) are firms that have headquarters maybe in the United States , Europe, or Japan , but they have branches, subsidiaries , employees , and business dealings in dozens of different countries. Many U.S. firms in manufacturing industry have foreign subsidiaries and they engage in importing and exporting activities. RISK MANAGEMENT FOR MNCS International firms must apply all the rules for managing domestic loss exposures(chapter 3): 1- Identify and measure all exposures to loss 2- Evaluate risk control and financing alternatives 3- Implement a cost-effective program 4- Regulatory reevaluate the program to see if objectives are being met. However, managing the domestic loss exposure is not sufficient for international firms because they face the international loss exposure as well. ADDITIONAL CONCERNS RELATED TO RISK MANAGEMENT OF MNCS Although the risk management process remain the same for domestic and international loss exposures, the additional concerns distinguish the domestic risk management and international risk management. Foreign currency fluctuations enter into measurement and financing problems. Political risks arise from unexpected interventions by foreign governments. Risk financing arrangements and practices, including insurance, vary widely throughout the world. RISK MANAGEMENT INFORMATION SYSTEMS (RMISS) Many risk managers use RMISs to record, track, and analyze losses. RMISs also are used to maintain records of plant, property, and equipment and record how they are protected from loss. Some firms also use RMISs to perform statistical analysis of past losses and to forecast losses. RMISs must be tailored to the needs of individual organizations because each organization faces different physical hazards, liability exposures, and property value fluctuations. As a system no standard RMISs can be designed to solve a particular organization’s specific problems.