Understanding Risk Analysis and Management

Understanding Risk Analysis and Management Share

This topic can often cause palpitations in a classroom.  A question may mention some risk management tool, a future, an option, a money market hedge.  This is what draws the focus of the candidate, to their ultimate downfall, as too much time is spent attempting the numbers and not enough time on the written analysis.

Initially, risk analysis.  A candidate should take time to understand the risks that the business is exposed to in the particular transaction in the scenario.

Lets take a business, XYZ plc, that is selling a large bespoke, specialised component  (design and build time 5 months) to an American customer for the first time.  They have offered 3 months credit to the customer. The MD is concerned about risk and is considering a forex futures contract and wants our advice.

The question begins by asking candidates to show the impact on the accounts for the year of entering into the futures contract (cue panic amongst candidates)  but the MD also wants to know:

  1. What are the risks on the contract and to what extent the future will eliminate the risks on the contract and…
  2. What considerations should the company make regarding risk management before entering into such a hedging transaction

It is easy to get dragged into just thinking about foreign exchange.  This will temper a candidates mark potential.  Risk analysis does not have to be so complicated.

Answer i:

This is a transaction that has many potential risks:

  1. forex transaction risk is one (which the future will provide some comfort – to what extent depends upon the numbers given in the scenario)

The remaining risks are in no way covered by the forex futures contract…

  1. Credit risk – the customer is taking 3 months credit – brand new customer, how much due diligence has been done?
  2. Liquidity risk – the design and build time, followed by the credit period suggests a considerable investment in working capital by XYZ
  3. Risk the customer will not accept delivery of the component and XYZ gets dragged into an expensive legal case with a customers under a different legal jurisdiction. XYZ is then unable to sell the component to another customer as it was so specialised.
  4. Candidates can also consider risk of damage in storage, in transit etc

Answer ii:

  1. What is the value of the contract and what is the potential exposure? Futures cost money and time in set up etc; XYZ should consider whether the potential loss on the contract is worth the cost of administering the future.
  2. Equally, consider the currency of the customer and how stable is that currency with sterling. The predicted numbers provided may suggest huge potential losses on the contract but ,in reality, is it likely that £ will move by (say) 20% against the $ over a 3 month period?
  3. XYZ is a plc and bound by corporate governance rules. Any risk management approach has to be consistent with their published risk management policy (as per the Turnbull Report) and consequently the attitude to risk of investors.
  4. Consequently, investor exposure to risk has to be considered. Being a plc investors are likely to be diversified and therefore the transaction risk exposure from this contract with America maybe marginal.

There are others but ultimately I want to finish the question in the time available, get the marks on offer and pass the exam!

In summary, numbers are only part of the solution.  A good accountant has to appreciate the context in which the numbers exist to be able to offer useful advice to individual clients.  Perhaps more importantly in the short term , a successful candidate leaves time for the written stuff as well as the numbers!

Matt Holden

Reed Business School

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