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)

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, of ST. 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.

Finally, we take this opportunity to extend our deep appreciation to our family and friends, for all that they meant to us during the crucial times of the completion of our project.

Chapt er 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.7.1 1.7.2 1.7.3 1.8 1.9 2 2.1

Table of Contents Topics Introduction

Abstract Statement of problem Background and rationale of study Purpose of study Contribution of study Research objectives

Page No 6-8 8-9 9-11 11-12 12-13 13 14 14 14

Research Methodology
Research design Data collection Reliability and validity of data Tools, techniques and

technologies Limitation of the study

15-17 18 19-20

Risk

Analysis

Conceptual Framework
Introduction

2.2 Different types of risk 2.3 How Do We Manage Risk? 2.3 Financial risks and their management .1 2.3 .2
Case Study
Political risks and their management

2024 2437 3845

a) b)

Frightened China

Capital?

The

Case

of

3940 41 4647 47 4851

The Case of Slovakia: When Political Environment Sways Investors

2.4 Role of the risk managers in

Multinational Corporations

2.5 Risk management in ASIA 2.5 Types and Level Of Risk In ASIA .1 2.5 .2
Risks management practices of Asiabased MNCs

5153

3 Analysis & Findings 3.1 Introduction 3.2 Types 4

of risk

53-

54 management 5456 and

policies and their objectives 7

Summary,

conclusion

CHAPTER 1
INTRODUCTION
Risk management structure should be well thoughtout, 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 more complex, 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

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).

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 with complex 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

10

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 11

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

12

(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.

13

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 risk management 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 14

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

15

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. 16

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 tools including 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). 17

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

18

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.

19

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.

20

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.

21

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 category comprises 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. 22

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 for long-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).

23

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 24

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 of cash 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

25

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 13suspected 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

26

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 plan and 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 27

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

28

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 of two 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

29

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.

30

Diagram 1: Risk management processes as described by Standards Australia

31

Risk Management Institute of Australia Risk management http://www.rmia.org.au Standards Australia Risk management standard (AS/NZS 4360) http://www.standards.org.au

Factors 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 to maturity, 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:

32

 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 30year 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

33

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 shortterm 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.

34

 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 Exchange Rates

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

35

 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.

36

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:

Selective History

37

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-century Amsterdam 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.

38

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 largescale 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

39

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 valueat-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

40

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.

41

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 converting them 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.

42

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 Environment Sways Investors

Political

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,

43

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 understand the 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:

44

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 45

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 may propel 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 of

on

Market

Misreading

Relative

46

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

47

2.3

Role

of

Risk

Managers

in

Multinational Corporations
An expatriate, on international business travel most of the times, arrives on the British Air Ways 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 CocaCola 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 48

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).

49

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 of Think 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. 50

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 Australia Singapore Japan New Zealand Taiwan Hong Kong South Korea Malaysia China Thailand India 16 17 18 22 25 27 34 47 58 59 61 Total Score (100) 90.39 90.24 88.68 86.69 82.60 81.55 69.46 63.05 56.39 56.28 55.10 Political Risk (25) 23.13 23.25 21.5 22.35 21.14 19.86 18.34 16.72 16.97 14.73 14.79 Economic Performance (25) 18.56 18.84 19.26 15.44 15.31 17.80 12.06 10.23 9.39 8.77 7.68 Debt Indicator (10) 10.0 10.0 10.0 10.0 10.0 10.0 9.41 9.39 9.68 8.91 9.44

51

Countries

Debt Default Rescheduled (10) 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0

in Credit Rating or (10)

Access to Bank Finance (5)

Access to Capital Market (5) 5.0 4.0 4.5 5.0 4.0 3.33 3.50 3.50 2.0 2.0 2.75

Australia Singapore Japan New Zealand Taiwan Hong Kong South Korea Malaysia China Thailand India

8.96 9.79 8.75 8.96 8.13 7.29 6.46 5.21 5.83 4.38 3.13

5.0 5.0 5.0 5.0 5.0 5.0 0.98 1.21 0.01 0.34 0.03

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.

52

TABLE 2 Business Risks in Asia A US

Perspective

Country China Hong Kong Vietnam Philippines Taiwan South Korea Thailand Indonesia Malaysia US Japan Singapore

Political Risk 68.55 62.32 56.54 56.32 54.20 50.24 48.70 48.41 42.00 32.19 31.79 27.07

Degree of Difficulty of doing business 6.33 3.61 5.75 5.83 4.78 5.62 5.59 6.27 5.35 2.89 4.97 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

53

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 MNCs

As 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 the construction 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 Selfinsured Contingency Fund amounting to S$ 25 million to cover uninsured losses as stated by Howard.

54

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

55

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

56

 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 the ability of the department as a whole, and units and sites as local delivery points, to protect themselves from adversity or to quickly take ameliorative action, put in place improvements in decision making about process and programs and enhance value through flexibly leveraging opportunities and better managing uncertainties 57

Risk

management

and

business

continuity
Risk management is simply a practice of systematically selecting cost effective approaches for minimising the effect of threat realization to the organization. All risks can never be fully avoided or mitigated simply because of financial and practical limitations. Therefore all organizations have to accept some level of residual risks. Whereas risk management tends to be preemptive, business continuity planning (BCP) was invented to deal with the consequences of realised residual risks. The necessity to have BCP in place arises because even very unlikely events will occur if given enough time. Risk management and BCP are often mistakenly seen as rivals or overlapping practices. In fact these processes are so tightly tied together that such separation seems artificial. For example, the risk management process creates important inputs for the BCP (assets, impact assessments, cost estimates etc). Risk management also proposes applicable controls for the observed risks. Therefore, risk management covers several areas that are vital for the BCP process. However, the BCP process goes beyond risk management's preemptive approach and assumes that the disaster will happen at some point.

Seven cardinal rules for the practice of risk communication

(as first expressed by the U.S. Environmental Protection Agency and several of the field's founders)

Accept and involve the public as a legitimate partner.

58

Plan carefully and evaluate your efforts. Listen to the public's specific concerns. Be honest, frank, and open. Coordinate and collaborate with other credible sources. Meet the needs of the media. Speak clearly and with compassion.

Chapter 5 Summary, conclusion and recommendations

5.1 Summary
Financial risk management is not a contemporary issue. Financial risk management has been a challenge for as long as there have been markets and price fluctuations. Financial risks arise from an organizations exposure to financial markets, its transactions with others, and its reliance on processes, systems, and people. To understand financial risks, it is useful to consider the factors that affect financial prices and rates, including interest rates, exchange rates, and commodities prices. Since financial decisions are made by humans, a little financial history is useful in understanding the nature of financial risk.

59

5.2 Conclusion
Enterprise Risk Management forms part of the glue that holds corporate governance together. It also contributes to an organisations long-term profitability and sustainable growth. Effective risk management initiatives need to be both proactive and embedded within the culture of an organisation. ERM frameworks offer a structured approach to risk management, which enable organisations to:

establish sound risk impact/probability assessment processes and develop solutions provide an enterprise-wide view of risk align available resources for managing risks, thus controlling costs and ensuring compliance

take measured risks, manage them effectively, and create a competitive advantage Strengthen corporate governance while increasing stakeholder and regulator confidence.

Risk maps and risk registers are excellent mechanisms for communicating organisational risks throughout an organisation. Risk management capabilities and processes must be shaped to fit each organisations operations, people, and performance. A strong culture and awareness of risk is a powerful defence mechanism against risk. An organisations reputation relates to how it is perceived by its stakeholders, including its customers, partners, employees, and regulators, providing a powerful stimulus for establishing effective reputation risk evaluation programmes. This preliminary attempt to define a standard evaluation framework for the quality of risk management disclosure is based on a functional approach and is grounded on five general propositions. The data requirements are limited to mandatory, widely disseminated and 60

standardised data, i.e. the risk management information found in the annual report. Obviously, this information does not satisfy the timeliness principle. Yet, we are willing to compromise on timeliness since the framework's main objective is to provide a comparison, both across firms and over time, of the quality of public risk management disclosure. This standard evaluation framework for risk management disclosure is flexible. It can be implemented despite differences in valuation methods, in holding periods and in mandatory trading and non-trading information. To allow comparability across firms and to limit our attention to well-defined and measurable risk factors, the current framework considers the quality of disclosure only for market and credit risk factors. This choice is motivated by the need for comparability of qualitative and quantitative information, since most firms have a well-defined policy for the management of those two risk exposures. The central conclusion of the project is therefore that any system of regulation that is designed to protect against systemic risk in international markets needs to provide a high level of confidence that the firms which are supervised are able to survive any reasonable combination of stress shocks to their earnings with their capital sufficiently intact to ensure that they can continue in business long enough to allow appropriate remedial action to be taken either by the firm itself or by the regulator. Moreover, the approach has to provide a similar level of confidence at all systemically significant firms whatever risks they face and whatever business mix they may have. Finally, risk management is still a new and evolving field that is far from offering structured and unified solutions to problems such as financial and non-financial risks monitoring, risk aggregation, and risk-based capital allocation. The professional community is still struggling with the definition of a sound 'global' risk management policy, including its underlying principles, its evaluation and its value-added to market participants.

5.3 Recommendations

61

 In order to better foster adoptability of the control frameworks (ISO 27xxx, NIST, etc) they need to be optimized to define control requirement requisite to the risks of the assets or organization. The risk assessment methodology output needs to be directly tied to the application of control requirement statements. The expectation would be that greater/stronger controls are mandated for items with higher risk and lesser controls for items with lower risk. Additionally, the output of the risk assessment also needs to offer implementation guidance for how different models address the selection of appropriate controls for High Impact, Low Probability events. This was noted as the area that most significantly impacts the adoptability of the frameworks. To a limited extent, this expectation is addressed by some of the frameworks, but it is believed that this area needs to be greatly enhanced. The risk management plan is implemented to ensure daily consistency and conduct among employees. This plan (the manual in which you devise), and its legal importance, must be part of employee education and initial training practices. The global business integrity capacity model (GBICM), is a good alternative model that inclusively balances types of capitalist, moral accountability, and human nature theories and provides a framework for selected reforms at the macro-, meso-, and microlevels, which are designed to prevent a recurrence of the current financial meltdown, to re-create systemic financial institution integrity, and to promote sustainable prosperity for current and future generations. The areas of concern tend to focus on ensuring smooth conversion and transfer of currency and having confidence that government payment and performance obligations will be honored. As in every other part of the world, these will be concerns regardless of what the political climate may look like at any given point in time. Political risk is rising, and will continue to rise, throughout the course of this severe global recession. The risks of operating a business anywhere in the world is similarly

62

risingincluding in North America and Europe. The unpredictability associated with this economic dislocation naturally affects the political realm. Business owners must take a defensive posture in such an environment, review their risk management contingency plans, and update them on an ongoing basis.

Chapter 6 - Bibliographies
I have collected the data from various sources. They are:

1.

From different books like:

The Social Contours of Risk (Volume 1): Publics, Risk Communication, and the Social Amplification of Risk (Risk, Society and Policy Series) by Jeanne X. Kasperson and Roger E. Kasperson The Social Contours of Risk (Volume 2): Publics, Risk Communication, and the Social Amplification of Risk (Risk, Society and Policy Series) by Roger E. Kasperson Advanced Credit Risk Analysis: Financial Mathematical Models to Assess by Didier Cossin Approaches and

Risk Analysis in Theory and Practice by Jean-Paul Chavas. Theory of Financial Management By I.M.Pandey.

2. From different websites like:

www.google.com

63

 www.riskworld.com www.rmia.org.au www.amazon.com www.yahoo.com www.ask.com

3. Lessons from change - Findings from the market by ERNST & YOUNG

64