Chapter 10 FINANCIAL RISK MANAGEMENT

Chapter 10

FINANCIAL RISK MANAGEMENT

FINANCIAL RISK MANAGEMENT

Risk management is a structured approach / methodology in managing the uncertainty associated with the threat. Financial risk management focuses on risks that can be managed using financial instruments. The main objective of financial risk management is to minimize the potential loss arising from unexpected changes in currency rates, credit, commodities, and equities.
Market participants tend not to take risks. Intermediary financial services and a market maker responds by creating a financial product that allows a trader to shift the risk of unexpected price changes to others-the other side.

1.                  Main Components of Foreign Currency Risk

To minimize exposure faced by the volatility of foreign exchange rates, commodity prices, interest rates and securities prices, the financial services industry offers a lot of financial hedging products, such as swaps, interest rate, and also an option. Most financial instruments are treated as items outside the balance sheet by a number of companies that conduct international financial reporting. As a result, the risks associated with using this instrument is often covered up, and until now the world's accounting standard makers to be in discussions on the principles of measurement and reporting are appropriate for these financial products. The material of this discussion is to discuss one of the internal reporting and control issues associated with a very important
There are several key components in the foreign currency risk, namely:

a.   Accounting risk (the risk of accounting): The risk that the preferred accounting treatment of a transaction are not available.

b.   Balance sheet hedge (balance sheet hedging): Reducing foreign exchange exposure faced by differentiating the various assets and liabilities of a company abroad.

c.    Counterparty (the opponent): Individuals / organizations who are affected by a transaction.

d.        Credit risk (credit risk): The risk that the opponent had failed to pay its obligations.

e.   Derivatives: the contractual agreement creating rights or obligations specific to the value derived from other financial instrument or commodity.

f.   Economic exposure (economic exposure): Effect of changes in foreign exchange rates against the cost and revenue in the future.

g.  Exposure management (exposure management): Preparation of strukturdalam companies to minimize impacts kursterhadap changes in earnings.

h.   Foreign currency commitment (commitment to a foreign currency): Commitment to  the sale / purchase of the company denominated in foreign currencies.

i.  Inflation differential (difference of inflation): The difference in the rate of inflation

   between two countries or more.

j.  Liquidity risk (liquidity risk): The inability to trade a financial instrument in a timely

   manner.

k. Market discontinuities (discontinuities market): Changes in market value suddenly and significantly.

l.  Market risk (market risk): risk of losses due to unexpected changes in foreign exchange rates, commodity loans, and equity.

m. Net exposed asset position (the net asset position of the potential risk): Excess assets position of the position of liabilities (also referred to as a positive position).

n.Exposed net liability position (potential risk of the net liability position): Excess liability position to the position of the asset (also referred to as a negative position).

o.Net investment (net investment): An asset or net liability position that happens to a company.

p.National amount (national number): Total principal amount stated in the contract to determine the settlement.

q.Operational hedge (hedging operations): Protection valutaasing risk that focuses on variables that affect a company's expenses pendapatandan in foreign currency.

r.  Option (option): The right (not obligation) to buy or sell a financial contract at a specified price before or during a specific date in the future.

s. Regulatory risk (regulatory risk): The risk that a law limiting the public will mean the use of a financial product.

t.  Risk mapping (risk mapping): Observing the temporal relationship with the market risks of financial reporting variables that affect the value of the company and analyze the possibility of occurrence.

u. Structural hedges (hedge structural): Selection or relocation of operations to reduce the overall foreign exchange exposure of a company.

v.Tax risk (the risk of tax): The risk that the absence of the desired tax treatment.

w. Translation exposure (translation exposure): Measuring the effect in the currency of the parent company of the change in foreign exchange for the assets, liabilities, revenues, and expenses in foreign currencies.

x.Transaction risk potential (the potential risks of the transaction): Advantages ataukerugian foreign exchange arising from the settlement or konversitransaksi in foreign currencies.

y.Value at risk (the value of the risk): Risk of loss on trading portfolio of a company which is caused by changes in market conditions.

z. Value drivers (trigger value): The accounts of the balance sheet and income statement yang mempengaruhi value of the company.

2.               Managing tasks in Foreign Currencies

Risk management can enhance shareholder value by identifying, controlling / managing the financial risks faced by actively. If the value of the company to match the present value of future cash flows, active management of potential risks can be justified by the following reasons:

a.       Exposure management helped in stabilizing the company's cash flow expectations. Flow is more stable cash flows that can minimize the earnings surprise, thereby increasing the present value of expected cash flows. Stable earnings also reduces the likelihood of default and bankruptcy risk, or risk that profits may not be able to cover contractual debt service payments.

b.      Active exposure management allows companies to concentrate on the major business risks. For example in a manufacturing company, he can hedge interest rate risk and currency, so it can concentrate on the production and marketing.

c.       Lenders, employees, and customers also benefit from exposure management. Lenders generally have a lower risk tolerance than the shareholders, thereby limiting the exposure of companies to balance the interests of shareholders and bondholders. Derivative products also allow pension funds managed by the employer obtain a higher return by giving the opportunity to invest in certain instruments without having to buy or sell the related real instrument. Due to losses caused by price and interest rate risk of certain transferred to the customer in the form of higher prices, limiting exposure management of risks faced by consumers.

3.               Risk definition and calculation of Translation

Companies with significant overseas operations prepare consolidated financial statements that allow the readers of financial statements to gain a holistic understanding of the company's operations both domestically and abroad. The financial statements of foreign subsidiaries are denominated in foreign currencies are presented again in the currency of the parent company. The process of re-presentation of financial information from one currency to another currency is called translation. Translation is not equal to the conversion. Conversion is the exchange of one currency to another currency physically. Translation is just a change of monetary units, such as only a balance sheet re-expressed in GBP are presented in U.S. dollar equivalent value. Potential risk of these measuring translational effects of changes in foreign exchange against domestic currency equivalent value of assets and liabilities denominated in foreign currency held by the company. Because the amount of foreign currency is generally translated into domestic currency equivalent value for purposes of monitoring or management of external financial reporting, translational effects that pose an immediate impact on the desired profit.
Translation risks can be calculated in 2 ways, namely:

a.       Said to be positive when the potential risk of exposure to assets is greater than the liabilities (ie items in foreign currencies are translated based on the exchange rate now. Devaluation of foreign currencies relative to the reporting currency (foreign currency exchange rate decreases) causing translational losses. Revaluation of foreign currency (foreign currency exchange rate increases) making a profit translation.

b.      Potential downside risks if the assets exceed the liability exposure to exposure. In this case, the devaluation of foreign currency translation gains cause. Revalusi foreign currency translation losses caused. In addition to the potential risks of translational traditional accounting measurement of the potential foreign exchange risk is also centered on the potential risks of the transaction. Potential risks associated with the transaction gains and losses in foreign exchange rates arising from the settlement of transactions denominated in foreign currencies. Transaction gains and losses have a direct impact on cash flow. Potential risks of the transaction report contains items that generally do not appear in conventional financial statements, but it raises transaction gains and losses as foreign currency forward contracts, purchase commitments and future sales and long-term lease.

4.               Risk differences in Accounting with Economic Risks

Management accounting plays an important role in the process of risk management. They assist in the identification of market exposure, quantify the balance associated with alternative risk response strategy, the company faced a potential measure of risk, noting certain hedging products and evaluate the hedging program.

The basic framework is useful for identifying different types of market risk can potentially be referred to as risk mapping. This framework begins with the observation of the relationship of the various market risks triggering a company's value and its competitors. The trigger value refers to the financial condition and operating performance items that affect the main financial value of a company. Market risks include the risk of foreign exchange rates and interest rates, and commodity and equity price risk. State the source of the purchase currency depreciates in value relative to domestic currency country, then these changes can lead to domestic competitors able to sell at lower prices, is referred to as the risk of facing currency competitive. Management accountants have to enter a function such that the probability associated with a series of output values ​​of each trigger.
Another role played by accountants in the process of risk management involves balancing the quantification process relating to the alternative risk response strategies. Foreign exchange risk is one of the most common form of risk and will be faced by multinational companies. In the world of floating exchange rates, risk management include:

a.       anticipated exchange rate movements,

b.      measurement of exchange rate risk faced by the company,

c.        design of appropriate protection strategies,

d.      manufacture of internal risk management control.

Financial managers must have information about the possible direction, timing, and magnitude of changes in exchange rates and to develop adequate defensive measures more efficiently and effectively.

5.     Protection Strategy Exchange Rate and Accounting Treatment

Necessary After identifying potential risks, the next is designing hedging strategies to minimize or even eliminate the potential risk. This can be done with balance sheet hedging, operational, and contractual.

a.       Balance Sheet Hedging , Protection strategy by adjusting the level and value of monetary assets and liabilities denominated exposed companies, which will reduce the potential risks facing the company. Example of a hedging method subsidiaries located in countries that are vulnerable to devaluation is:

·         Maintain cash balances in local currency at the minimum level needed to support current operations.

·         Restore the earnings above the required amount of capital to the parent company untukekspansi.

·         Speeding (ensure-leading) the receipt of outstanding receivables dagangyang in local currency.

·         Delay (slow-lagging) the payment of debt in local currency

·          Accelerate the payment of debts in foreign currencies.

·         Invest surplus cash into the stock of debt other danaktiva in local currency which was less affected by devaluation losses.

·         Invest in assets outside the country with a strong currency

b.      Operational Hedging Focusing on operational hedging variables affecting revenues and expenses in foreign currencies. More stringent cost control allows a greater margin of safety against potential currency losses. Structural hedging include relocation of manufacturing to reduce the potential risks facing the company or changing the state is the source of raw materials and component manufacturing.

c.        Contractual Hedging One form of hedging with financial instruments, both the derivative instrument and the basic instrument. This instrument products include forward contracts, futures, options, and the mix of all three are developed. To provide greater flexibility for managers to manage the potential risks faced by foreign exchange.

Accounting Treatment Before a standard is created, global accounting standards for derivative products is incomplete, inconsistent and developed gradually. Most financial instruments, that are executable, be treated as items outside the balance sheet. Then the FASB issued FAS 133, FAS 149 is clarified through the month of April 2003, to provide a single, comprehensive approach to accounting for derivatives and hedging transactions. No IFRS. 39 (revised) contains guidelines for the first time provide universal guidance on accounting for financial derivatives.

Basic provisions of this standard are:

a.       Derivative instruments are recorded on the balance sheet as assets and liabilities. Derivative instruments are recorded at fair value, including those attached to the main contract is not carried at fair value.

b.      Gains or losses from changes in fair value of derivative instruments, not including the assets or liabilities, but are recognized as income if it is planned as a hedge.

c.       Hedge must be highly effective in order to deserve a special accounting treatment, the gain or loss on the hedging instrument exactly offset the gains or losses should be something that is hedged.

d.      Hedging relationships must be documented in full for the benefit of readers of the report.

e.       Gains / losses from net investment in foreign currency (asset or liability position of the net exposure) were initially recorded in other comprehensive income. Subsequently reclassified into current earnings if the subsidiary is sold or liquidated.

f.       Gains / losses from hedge against future cash flows are uncertain, such estimates of export sales, are initially recognized as part of comprehensive income. Gains / losses recognized in earnings when the transaction is expected to occur that affect earnings.
However, although the rules guiding the FASB and IASB issued has a lot to clarify the recognition and pengukuan derivatives, there are still some problems. The first relates to fair value. The complexity of financial reporting have also increased if the hedge is deemed ineffective to offset foreign exchange risk.

6.    Problems Related to Accounting for and Control of Foreign Exchange Risk Management

Foreign CurrencyExamples of accounting and control issues associated with the risk management of foreign exchange can be seen in the following cases:
These companies continuously create and implement new strategies to improve their cash flow in order to increase shareholder wealth. It does require some expansion strategy in the local market. Other strategies require penetration into foreign markets. Foreign markets can be very different from the local market. Foreign markets creates opportunities increased incidence of corporate cash flow.
The number of barriers to entry into foreign markets that have been revoked or reduced, encouraging companies to expand international trade. Consequently, many national companies become multinational companies (multinational corporation) that are defined as companies engaged in some form of international business.
MNC own purpose generally is to maximize shareholder wealth. Goal setting is very important for an MNC, as all decisions must be made to contribute to the achievement of these goals. Any corporate policy proposals not only need to consider the potential return, but also its risks. An MNC must make decisions based on the same goal with the goal of purely domestic firms. But on the other hand, MNC companies have a much wider opportunity, which makes the decision became more complex.
There are several constraints faced by MNC companies such as, environmental constraints, regulatory constraints, and ethical constraints. Environmental constraints can be seen from the different characteristics of each country. Regulatory constraints of each country regulatory differences that exist such as, taxes, currency conversion rules, as well as other regulations that may affect the cash flows of subsidiaries. Constraint itself is described as an ethical business practices vary in each country.
MNC, in doing international business, in general can use the following methods:

·         International trade

·          Licensing

·          Franchising

·         The joint venture

·         Acquisition of companies

·         Establishment of new subsidiaries abroad International business methods require direct investments in operations abroad, or better known as the Direct Foreign Investment (DFI). International trade and licensing is usually not considered a DFI because they do not involve direct investment in overseas operations. Franchising and joint ventures tend to ask for direct investment, but in relatively small amounts. The acquisition and establishment of new subsidiary is the largest element of DFI.

Various opportunities and advantages of a MNC is not free from risks that would arise. Although international business can reduce the exposure of an MNC to the economic conditions of their home country, international business usually also increase the MNC's exposure to exchange rate movements, economic conditions abroad, and political risk. Most of the international business require the exchange of one currency with another currency to make payments. Because the exchange rate continues to fluctuate, the amount of cash required to make payments is also uncertain. Consequently, the number of currency units of country of origin is required to pay may change even if its suppliers do not change the price. In addition, when multinationals enter foreign markets to sell products, the demand for such products depends on economic conditions in those markets. Thus, the multinational company's cash flow is affected by economic conditions overseas.
Management can use the controls on foreign currency exchange rates by hedging. However, any financial risk management strategy should evaluate the effectiveness of the hedging program. Feedback from the evaluation system that is running will help to develop the institutional experience in the practice of risk menajamen. Performance assessment of risk management program also provides information about when the current strategy is no longer appropriate to use. So basically, effective financial control is a system of performance evaluation.
Performance evaluation system proved useful in various sectors. These sectors include, but are not limited to, the corporate treasury, purchasing and overseas subsidiaries. Control of the company's treasury includes the entire performance measurement prodram exchange risk management, hedging is used to identify, and reporting the results of the hedge. The evaluation system also includes documentation on how and to what extent the company trasuri help other business units within the organization.
In many organizations, foreign exchange risk management is centralized at corporate headquarters. This allows the managers of subsidiaries to concentrate on its core business. However, when comparing the actual and expected results, the evaluation system must have a reference that is used untukmembandingkan success of the company's risk protection.