A SEMINAR PAPER ON FINANCIAL RISK MANAGEMENT CHAPTER ONE Introduction Risk means the possibility of loss due to exposure to certain circumstances. In any financial investment, there is a chance that the actual return will be much lesser than expected. This chance is referred to as Financial Risk. Managing this risk to minimize financial losses is the best practice known as Financial Risk Management. Managers with a finance responsibility are expected to have a working knowledge of the principles and practices of financial risk management.
Whereas in the past such managers devoted their time to financial reporting, this is now seen as less important than skill in financial decision making. The rationale financial risk management is straightforward: In today’s environment the observed volatility in financial and commodity markets is testimony to the inherent risks firms face. Financial risk management is the discipline that aims to analyse, control, and if necessary reduce those risks to an acceptable level.
Therefore, 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. The optimal level of ex-post investment risk, from the shareholders’ perspective, is determined by a trade-off between the costs of financial distress and value associated with the limited liability of the firm’s equity. Unlike the risk-shifting models such as Jensen and Meckling (1976), equity-value is not always an increasing function of firm risk in my model.
While a high risk project increases the value of equity’s limited liability, it also imposes a cost on the shareholders by increasing the expected cost of financial distress. Due to these losses, the shareholders find it optimal to implement a risk-management strategy ex-post even in the absence of an explicit pre-commitment to do so. The optimal investment risk in the model depends on firm leverage, the financial distress boundary, the time horizon of the project and the costs of financial distress.
As in the extant models (Smith and Stulz (1985), a firm with high leverage (financial distress) has a higher incentive to engage in hedging activities. However, by explicitly modelling the shareholders’ risk-shifting incentives, my model shows that risk-management incentives disappear for firms with extremely high leverage. The model predicts stronger hedging incentive for highly leveraged firms in industries with higher incidence of predatory behavior by the competitors such as high concentration industries as shown by the empirical results of Opler and Titman (1994).
The model shows that hedging incentives increase with project maturity. Financial risk management motivation in the model arises from costs incurred by the firm in states where it hits the financial distress barrier but remains solvent on the maturity date. If there are no financial distress costs, risk-management incentives disappear. On the other hand, when these costs are very high, the distinction between financial distress and insolvency diminishes along with any ex-post risk-management motivations.
Intermediate levels of deadweight losses create financial risk-management incentives within the firm. Historical Developments Financial risks the risks to a corporation which emerge from the price fluctuations directly or indirectly influence the value of a company. A combination of greater deregulation, international competition, interest rates and foreign exchange rate volatility,
Whether it is a multinational company and its exposure to exchange rate changes, a transportation company and the price of fuel, or a highly leveraged company and its interest rate exposure, the manner and extent of managing such risks has often played a major role in the success or failure of a business. Therefore, it could be argued that financial risk management is one of the most important corporate functions as it contributes to the realization of the company’s primary goal stockholder wealth maximization. Financial risk management can be conducted in two rather distinct ways.
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The first approach is to employ a diversification strategy in the portfolio of businesses operated by the firm, while the second strategy is the firm’s engagement in financial transactions. In the case of diversification, which was once a popular risk management strategy, firms that are concerned about the volatility of their earnings have turned to the financial markets. This is because the financial markets have developed more direct approaches to risk management that transcend the need to directly invest in activities that reduce volatility.
The task of financial risk management has been facilitated by the increasing availability of a variety of derivative instruments to transfer financial price risks to other parties. Before derivatives markets were truly developed, the means for dealing with financial risks were few and financial risks were largely outside managerial control. Few exchange-traded derivatives did exist, but they allowed corporate users to hedge only against certain financial risks, in limited ways and over short time horizons.
Companies were often forced to resort to operational alternatives like establishing plants abroad, in order to minimize exchange-rate risks, or to the natural hedging by trying to match currency structures of their assets and liabilities (Santomero, 1995). Allen and Santomero (1998) wrote that, during the 1980s and 1990s, commercial and investment banks introduced a broad selection of new products designed to help corporate managers in handling financial risks.
At the same time, the derivatives exchanges, which successfully introduced interest rate and currency derivatives in the 1970s, have become vigorous innovators, continually adding new products, refining the existing ones, and finding new ways to increase their liquidity. Since than, markets for derivative instruments such as forwards and futures, swaps and options, and innovative combinations of these basic financial instruments, have been developing and growing at a breathtaking pace.
The range and quality of both exchange traded and OTC derivatives, together with the depth of the market for such instruments, have expanded intensively. Consequently, the corporate use of derivatives in hedging interest rate, currency, and commodity price risks is widespread and growing. It could be said that the derivatives revolution has begun. The emergence of the modern and innovative derivative markets allows corporations to insulate themselves from financial risks, or to modify them (Hu, 1995; 1996).
Therefore, under these new conditions, shareholders and stakeholders increasingly expect company’s management to be able to identify and manage exposures to financial risks. It was long believed that corporate risk management was irrelevant to the value of the firm and the arguments in favour of the irrelevance were based on the Capital Asset Pricing Model (Sharpe, 1964; Lintner, 1965; Mossin, 1966) and the Modigliani-Miller theorem (Modigliani and Miller, 1958). One of the most important implications of CAPM is thatdiversified shareholders should care only about the systematic component of total risk.
On the surface this may imply that managers of firms who are acting in the best interests of shareholders should be indifferent about the hedging of risks that are non-systematic. Miller and Modigliani’s proposition supports the CAPM findings. The conditions underlying MM propositions also imply that decisions to hedge corporate exposures to interest rate, exchange rate and commodity price risks are completely irrelevant because stockholders already protect themselves against such risks by holding well-diversified portfolios.
However, it is apparent that managers are constantly engaged in hedging activities that are directed towards reduction of non-systematic risk. As an explanation for this clash between theory and practice, imperfections in the capital market are used to argue for the relevance of corporate risk management function. Studies that test the relevance of derivatives as risk management instruments generally support the expected relationships between the risks and firm’s characteristics. Stulz (1984), Smith and Stulz (1985) and Froot, Scharfstein and Stein (1993) constructed the models of financial risk management.
These models predicted that firms attempted to reduce the risks arising from large costs of potential bankruptcy, or had funding needs for future investment projects in the face of strongly asymmetric information. In many instances, such risk reduction can be achieved by the use of derivative instruments. Campbell and Kracaw (1987), Bessembinder (1991), Nance, Smith and Smithson (1993), Dolde (1995), Mian (1996), as well as Getzy, Minton and Schrand (1997) and Haushalter (2000) found empirical evidence that firms with highly leveraged capital structures are more inclined to hedging by using derivatives.
The probability of a firm to encounter financial distress is directly related to the size of the firm’s fixed claims relative to the value of its assets. Hence, hedging will be more valuable the more indebted the firm, because financial distress can lead to bankruptcy and restructuring or liquidation situations in which the firm faces direct costs of financial distress. By reducing the variance of a firm’s cash flows or accounting profits, hedging decreases the likelihood, and thus the expected costs, of financial distress (Mayers and Smith, 1982; Myers, 1984; Stulz, 1984; Smith and Stulz, 1985; Shapiro and Titman, 1998).
The argument of reducing the expected costs of financial distress implies that the benefits of risk management should be greater the larger the fraction of fixed claims in the firm’s capital structure. The results of the empirical studies suggest that the use of derivatives and risk management practices are broadly consistent with the predictions from the theoretical literature, which is based upon value-maximizing behaviour. By hedging financial risks such as currency, interest rate and commodity risk, firms can decrease cash flow volatility.
By reducing the cash flow volatility, firms can decrease the expected financial distress and agency costs, thereby enhancing the present value of expected future cash flows. Theories and Previous Research Financial Economics Approach Financial economics approach to corporate financial risk management has so far been the most prolific in terms of both theoretical model extensions and empirical research. This approach builds upon classic Modigliani-Miller paradigm (Miller and Modigliani, 1958) which states conditions for irrelevance of financial structure for corporate value.
This paradigm was later extended to the field of risk management. This approach stipulates also that hedging leads to lower volatility of cash flow and therefore lower volatility of firm value. Rationales for corporate risk management were deduced from the irrelevance conditions and included: higher debt capacity (Miller and Modigliani, 1963), progressive tax rates, lower expected costs of bankruptcy (Smith and Stulz, 1985), securing internal financing (Froot et al. , 1993), information asymmetries (Geczy et al. 1997) and comparative advantage in information (Stulz, 1996). The ultimate result of hedging, if it indeed is beneficial to the firm, should be higher value a hedging premium. Evidence to support the predictions of financial economics theory approach to risk management is poor. Although risk management does lead to lower variability of corporate value (e. g. Jin and Jorion, 2006), which is the main prerequisite for all other effects, there seems to be little proof of this being linked with benefits specified by the theory.
One of the most widely cited papers by Tufano (1996) finds no evidence to support financial hypotheses, and concentrates on the influence of managerial preferences instead. On the other hand, the higher debt capacity hypothesis seems to be verified positively, as shown by Faff and Nguyen (2002), Graham and Rogers (2002) and Guay (1999). Internal financing hypothesis was positively verified by Guay (1999) and Geczy et al. (1997), while it was rejected by Faff and Guyen (2002) and Mian (1996). Judge (2006) found evidence in support of financial distress hypothesis.
Tax hypothesis was verified positively by Nance, Smith and Smithson (1993), while other studies verified it negatively (Mian, 1996 ; Graham and Rogers, 2002). More recently Jin and Jorion (2006) provide strong evidence of lack of value relevance of hedging, although some previous studies have identified a hedging premium (Allayannis and Weston,2001, Carter et al. , 2006). The hypotheses tested include all of the above rationales, except for information asymmetries and comparative information advantage.
The first two hypothesis test the underlying assumption, that hedging leads to lower volatility of company value. Hypothesis 1a: There is a negative relationship between hedging and stock price volatility. Hypothesis 1b: There is a negative relationship between hedging a particular risk and stock price exposure to that risk factor. The next hypothesis tests for a hedging premium by looking at companies that start hedging, rather than a cross-section of hedgers vs. non-hedgers, following the approach of Guay (1999). Hypothesis 1c: Firms that begin hedging experience a rise in market value of equity.
According to debt capacity and tax incentive rationales, firms should be interested in raising their gearing ratios, using the tax shield to the full extent, and lowering their tax charges. Hedging facilitates this by lowering risk of default and allowing higher debt capacity. Lower volatility of earnings may also result in lower average tax charges if the tax curve is concave, however in Poland corporate income tax is flat-rate so this effect is not important. Hypothesis 1d: There is a positive relationship between hedging and debt/equity ratio.
Hypothesis 1e: Firms that begin hedging, raise their debt equity ratio subsequently. Hypothesis 1f: Firms with low times interest earned ratio (EBIT/interest paid), but above one, hedge more often than either firms with high ratio or lower than one. Hypothesis 1g: Firms that hedge are able to pay their interest charges (times interest earned ratio > 1). Hypothesis 2h: There is a negative relationship between hedging and income tax paid (relative to sales). Hypothesis 2i: Average tax charge falls after firms start to hedge.
The final hypothesis of financial economics is linked to securing internal financing for important strategic projects and lowering costs of financial distress. These incentives should be more important to companies with high development expenditure or other growth options. Hypothesis 2j: There is a positive relationship between hedging and growth options, represented by high R&D expenditure or high market-to-book value ratio. Agency Theory Agency theory extends the analysis of the firm to include separation of ownership and control, and managerial motivation.
In the field of corporate risk management agency issues have been shown to influence managerial attitudes toward risk taking and hedging (Smith and Stulz, 1985). Theory also explains a possible mismatch of interest between shareholders,management and debt holders due to asymmetries in earning distribution, which can result in the firm taking too much risk or not engaging in positive net value projects (Mayers and Smith, 1987). Consequently, agency theory implies that defined hedging policies can have important influence on firm value (Fite and Pfleiderer, 1995). The latter ypotheses are associated with financing structure, and give predictions similar to financial theory. Managerial motivation factors in implementation of corporate risk management have been empirically investigated in a few studies with a negative effect (Faff and Nguyen, 2002; MacCrimmon and Wehrung, 1990; Geczy et al. , 1997). Notably, positive evidence was found however by Tufano (1996) in his analysis of the gold mining industry in the US. Financial policy hypotheses were tested in studies of the financial theory, since both theories give similar predictions in this respect.
All in all, the bulk of empirical evidence seems to be against agency theory hypotheses however. Agency theory provides strong support for hedging as a response to mismatch between menagerial incentives and shareholder interests. The following hypotheses are designed to test the basic implications of this theory. The first hypothesis tests if firms hedge in order to decrease risk to block shareholders. The next three hypotheses address the question of hedging as a tool to safeguard debtholder interest and thus increase debt capacity. Hypothesis 2a: There is a positive relationship between hedging and individual block ownership.
Hypothesis 2b: Hedging is used most often by companies with high debt/equity ratios. Hypothesis 2c: Firms start hedging more often if they have low equity/assets ratios and wish to issue debt or take out a bank loan. Hypothesis 2d: Firms start hedging more often if they have high debt/equity ratios and wish to issue debt or take out a bank loan. New Institutional Economics A different perspective on financial risk management is offered by new institutional economics. The focus is shifted here to governance processes and socio-economic institutions that guide these processes, as explained by Williamson (1998).
Although no empirical studies of new institutional economics approach to risk management have been carried out so far, the theory offers an alternative explanation of corporate behavior. Namely, it predicts that risk management practices may be determined by institutions or accepted practice within a market or industry. Moreover, the theory links security with specific assets purchase (Williamson,1987), which implies that risk management can be important in contracts which bind two sides without allowing diversification, such as large financing contract or close cooperation within a supply chain.
If institutional factors do play an important role in hedging, this should be observable in the data. First of all, there may be a difference between sectors. Secondly, hedging may be more popular in certain periods in Poland one might venture a guess, that hedging should become more popular with years. A more concrete implication of this theory, is that shareholders may be interested in attracting block ownership by reducing company risk. Here NIE is similar in its predictions to agency theory. However this theory also suggest that firm practices may be influenced by the ownership structure in general.
These implications are tested with the following hypotheses. Hypothesis 3a. There are differences in popularity of hedging between industries. Hypothesis 3b: The frequency of hedging changes with time. Hypothesis 3c: Hedging is positively related to individual block onwership. Hypothesis 3d: Hedging behaviour is influenced by the ownership structure: the government, institutional investors, foreign investors. Stakeholder Theory Stakeholder theory, developed originally by Freeman (1984) as a managerial instrument, has since evolved into a theory of the firm with high explanatory potential.
Stakeholder theory focuses explicitly on an equilibrium of stakeholder interests as the main determinant of corporate policy. The most promising contribution to financial risk management is the extension of implicit contracts theory from employment to other contracts, including sales and financing (Cornell and Shapiro, 1987). In certain industries, particularly high-tech and services, consumer trust in the company being able to continue offering its services in the future can substantially contribute to company value.
However, the value of these implicit claims is highly sensitive to expected costs of financial distress and bankruptcy. Since corporate risk management practices lead to a decrease in these expected costs, company value rises (Klimczak, 2005). Therefore stakeholder theory provides a new insight into possible rationale for financial risk management. However, it has not yet been tested directly. Investigations of financial distress hypothesis (Smith and Stulz, 1995) provide only indirect evidence (Judge, 2006). Finance Theory
According to Charles (2004) Finance theory prescribes that a firm should take on a project when it increases shareholder value. Finance theory also shows that firm managers cannot create value for shareholders, also called its investors, by taking on projects that shareholders could do for themselves at the same cost. When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. This notion was captured by the hedging irrelevance proposition. In a perfect marktet, the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm. In practice, financial markets are not likely to be perfect markets. This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is that market risks that result in unique risks for the firm are the best candidates for financial risk management.
The concepts of financial risk management change dramatically in the international realm. Multinational corporations are faced with many different obstacles in overcoming these challenges. There has been some research on the risks firms must consider when operating in many countries, such as the three kinds of foreign exchange exposure for various future time horizons: transactions exposure, accounting exposure, and economic exposure (Conti & Mauri, 2008). CHAPTER TWO Empirical Evidence Financial risk management is a crucial issue for both managers and researchers.
Managers have to control financial risk for long-term development of companies, and researchers are also interested in the theoretical and practical issue. In the past decades, numerous scholars devoted themselves to researching the enterprise financial risks from different angles. Barbro and Bagajewicz(2004) put forward a new twostage random management pattern based on the angle of management to decrease financial risk. For the study on financial risk of small and medium-sized enterprises. And Hu (2005), by survey, analyzed the small and medium-sized enterprises in central Taiwan with multivariable analysis and Logit regression.
A financial preparing model has been built and four conclusions were drawn to decrease financial risk: the company leaders should own multiple professional knowledge; the company must focus on significant environmental change, which may cause poor management of small and medium-sized enterprise (such as the change of government policy); the sound financial system is needed; and the company would perfect the good monitoring system. If the company has done the four aspects well, the probability of company financial crisis would be reduced largely.
Cao and Zeng(2005) used financial leverage as dependent variable to study empirically financial risk management of large enterprises. They asserted that financial risk of enterproses have a positive correlation with liabilities scale and liabilities structure, a negative correlation with profitability and operation ability, and no obvious linear correlation with interest rate and solvency. From prior studies, we find that the majority of researchers mainly focus on the concept of financial risk for SMEs, early warning models, strategies, management of financial risk.
The minority of scholars have done the empirical studies on financial risk management at present especially on financial risk for SMEs. The global financial crisis occurred since 2008, and numerous enterprises, including large enterprises and SMEs, have been influenced by the continuing crisis. Zhou and Zhao (2006) researched the financial risks of listed private enterprise with Z value by an empirical method, and found that average level of private listed companies’ financial risk are significantly higher than that of state-owned listed companies.
Liao (2006) used the small and medium-sized enterprise material offered by a financial institution to study the characteristics of this kind of enterprises, with the Logistic regression and factor analysis, in which the variable contains financial variables and the non-financial variables. The conclusions are as follows: when the model considers the financial and non-financial variables, the predictive ability of model is superior to the odel that only uses financial variables; it is more difficult to predict financial risk of young small and medium-sized companies (less than 7 years) than that of the older companies. Wang and Chen (2010) investigated financial risk under financing restricted condition with the unbalanced panel data and found that financial risk of constrained companies are higher than those of unconstrained companies CHAPTER THREE Summary of Research Methodology Data Analysis will be conducted on a panel of Kenyan non-financial companies, listed at the Nairobi Securities Exchange.
The panel will include data of some 150 companies (numbers for particular years variying slightly) for the period from 2006 to 20011. The last two years of the series will be used for verification of results and data for this period will be gathered from 30 companies selected randomly. The choice of Kenyan listed companies for theory verification will require a comment, since there may be concerns about possible idiosyncratic factors influencing financial risk management in Kenya. All companies included in the study will be based in Kenya, their ownership structure notwithstanding.
The position taken in this case is that verifying financial risk management theory on data from a country which is still developing can yield results as reliable as studies based on richest country data. Firstly, kenyan companies have for the past 17 years been rapidly learning new business models and techniques, including financial risk management. Secondly, due to ongoing economic transition there are fewer historical and institutional determinants of the current state of financial risk management in Kenya than there might be in the USA, UK, or Germany.
Thirdly, sufficient financial market infrastructure does exist in Kenyans for companies to engage in risk management. Consequently, kenyan companies can implement financial risk management processes provided they find them useful. The sample will further limited to include only non-financial corporations, that is companies from sectors other than financial services. This approach, adopted by Nance et al. (1993), Faff and Nguyen (2002) and Berkman and Bradbury (1996) is based on the premise that banks, insurance companies and other financial sector nterprises purchase and issue derivative instruments not only for hedging but also for trading purposes. Data will be collected from two sources: annual reports and notes to the financial statements for the fiscal year 2006, and through the survey. A questionnaire will be mailed to Kenyan managers of the selected companies involved in making decisions on financial risk management. The survey data will be statistically analyzed by using both univariate and multivariate analysis. Descriptive statistics has been presented giving an insight into risk management practices of firms in both samples.
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