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1、Identifying, measuring and managing financial riskBy Tom Chan, HK2015.06.15Identifying, measuring and managing financial risk Corporate FinanceLiquidity risk: risk of having insufficient cash resources to meet day-to-day obligations.Interest rate risk: adverse movement in interest rates will affect
2、profit by increasing interest expense or reduce interest income.Foreign exchange risk: risk that the rate of exchange used to convert foreign currency revenues, expenses, cash flows, assets or liabilities to the home currency moves adversely resulting in reduced profitability and/or shareholder weal
3、th. Economic risk arises when a company is exposed to the effect of exchange rate movements on its international competitiveness.Translation risk arises from the conversion of long-term foreign currency assets and liabilities into the home currency at regular intervals for statutory reasons.Transact
4、ion risk arises from normal operational business activities of converting foreign currency receipts or payments into the home currency.Commodity pricing: risk that a price change in a key commodity input or output adversely affects the financial performance. Other commodity prices have a foreign cur
5、rency element to their pricing and this heightens the risk. Managing commodity price risk is similar to managing foreign exchange risk.Financial risks*Treasury operational risk: the risk associated at financial loss arising from the operational activities of the treasury function. This is the inhere
6、nt risk arising from operating a treasury function.Business operating risk: the risk associated with reliance on internal and external systems relevant to the monitoring, negotiating and delivery of financial transactions.Credit risk: the risk that the other party to a financial transaction complete
7、ly defaults and does not meet its financial obligations or fails to meet its financial obligation on time.Counterparty risk arises when the other party to a financial transaction will not meet its obligations as to timing or amount of settlement.Country risk could be sub-divided into three types of
8、risk: Political risk: Government directives and policies that may affect the financial contractual performance of either party to the transaction or create continuing uncertainty about what the government might do next. Regulatory risk: Introduction of regulations affecting financial conditions or e
9、xisting regulations will be enforced more severely. In other words, it is the risk associated with the timing and amount of foreign exchange conversion that may require regulatory approval. * In emerging markets with capital and currency control, there is the additional risk relating to regulatory c
10、ontrol of foreign exchange conversion. For example, in Mainland China foreign exchange transactions are regulated by the State Administration of Foreign Exchange. Economic risk: Economic conditions within a country have adverse financial impacts such as inflation, interest rates and foreign exchange
11、 rates.Interest rate parity (IRPT)The IRPT is a method of predicting foreign exchange rates based on the hypothesis that the difference between the interest rates in the two countries should offset the difference between the spot rates and forward foreign exchange rates over the same period.IRPT for
12、mula applied to HK$/ forward rate:(1 + HK interest ) / (1+ interest ) x current exchange rate Example: HK interest = 3%, interest = 7%, current HK$/=10.0000IRPT implies that HK$/ forward rate will appreciate (forward premium) against euro as it has a lower interest rate compare to Europe.HK$/ forwar
13、d rate(1 + 3%) / (1 + 7%) X 10.0000 = 9.6262 HK$ appreciatesCentral to IRPT is the concept of interest arbitrage, namely short-term capital movements to optimise interest discrepancies in international money markets.Arbitrageurs ensure that, in the absence of market imperfections, funds are attracte
14、d to where they will be most profitable.Their borrowing in low-cost centres and investing in high-cost ones, helps eliminate these differentials as interest rates are raised in the low-cost centres and lowered in high-cost ones. Interest parity is achieved when the positive interest differential equ
15、als the forward discount on the foreign currency expressed annually.In effect, high interest rates on a currency are offset by forward discounts and low interest rates by forward premiums. When this holds, there is no advantage to borrowing or investing in specific markets or from covered interest a
16、rbitrage.*Sample questionTwo currencies: HKD & THBSpot rates: 4.725THB/HKD or 0.21164 HKD/THBMoney market interest rate for 90-day deposit in THB is 7.5% annualised. (Assume 365-day) 90-day forward rate: THB4.75069/HKD or HKD0.2105/THBWhat is implied interest rates for HKD?Solution:As HKD1 could buy THB4.725, which co
