Risk Management Analysis Essential Tools Research Paper

  • Length: 10 pages
  • Sources: 8
  • Subject: Economics
  • Type: Research Paper
  • Paper: #3095048

Excerpt from Research Paper :

Most developed economies, however, allow the market to set exchange rates, only influencing currency values through indirect means such as the increased or reduced sale of bonds to foreign entities and individuals, or through other means of international wealth exchange. Essentially, all manipulations of exchange rates and actions based on predictions of exchange rates are focused on the forward exchange rate, or the predicted rate of exchange between two currencies at a future point in time.

The spot exchange rate, on the other hand, is the rate of exchange at the current moment in time. It is through a comparison of the spot rate and the forward rate of exchange -- inasmuch as it can be predicted with any accuracy -- that companies and businesses make decisions that affect either the exchange rate itself (in the case of some governments, notably China in the modern period), or more often make decisions that limit their exposure to foreign exchange rate volatilities and risks.

In the context of treasury management, stabilization of the domestic currency value is also of importance in maintaining investor confidence both in domestic and international investors, and although direct currency manipulations are generally frowned upon efforts are taken to maintain a positive and relatively stable line of change between spot rates and forward exchange rates.

Currency markets are incredibly volatile, and there is not a great deal that a government can do to change this short of taking direct control of the currency, which comes with its own host of problems.

Without taking any measures to stabilize exchange rates or currency value or to limit exposure to the volatilities of these exchange rates, however, businesses face a great loss of valuation and governments runs the risk of racking up huge deficits (or, conversely, rather worthless trade surpluses).

Through management of foreign direct investment in the government and government investment in both domestic and foreign programs, forward exchange rates can be somewhat managed and risks mitigated.

Interest Rates

The manipulation of interest rates by treasury departments and central banks is a complex task, and one that has an effect on these entities even as they have a direct effect on the interest rates themselves. Interest rate risk exposure exists for governments as well as for businesses, especially private banking institutions, all of which have complex balance sheets with many long- and short-term assets and liabilities, the combination of which could prove hugely detrimental to the organization due to interest rate fluctuations.

If, for instance, an organizations liabilities carried a significantly higher average interest rate than their assets (and if the asset principals did not significantly outweigh the liability principals) that organization would end up losing significant amounts of capital to interest payments, with possibilities for reversing this trend dependent on interest rate changes.

The manipulation of interest rates, then, becomes an increasingly important aspect of government intervention in the money supply as a method for risk management. Private companies and institutions can also try to manage their risks through limiting their exposure to interest rate changes and capitalizing on positive changes when they occur, but treasury management allows for more direct influence. Such influence is not without its drawbacks, however, and though central banks have been very active of late in dropping interest rates to increase the flow of capital, the ease of borrowing has separate dangers.

The dangers of not affecting interest rates at all, however, and letting them instead regulate and manipulate capital availabilities, leaves the market much more at the mercy of the vagaries of human impulses and motives that essentially make up any economy -- especially one based on the principles of a free (er) market. Failing to limit the economy's exposure to market fluctuations in the interest rate can allow these rates to skyrocket, even -- and perhaps especially -- in times of economic fear and hesitancy, which would create far worse recessive tendencies in the economy. Managing the risks involved with interest rate volatility creates a more stable and more productive economy -- and a more profitable private enterprise, as the case may be -- and is seen as an entirely necessary and well-founded activity of almost all central banks and/or treasury departments.

Currency Swaps

One last method of managing risk exposure for both large governments and private companies is through the relatively straightforward activity of currency swaps, which has the potential for very complex effects. Simply put, currency swaps are long-term derivatives exchanges where a debt or asset in one currency is traded for repayment in a different currency at a later date at an agreed-upon rate of exchange, typically the spot rate at the time the deal is struck.

While they can be simply defined, however, currency swaps and their effects cannot be simply explained by any stretch of the imagination.

Currency swaps can in many instances amount to what are basically loans, even though they often aren't recorded this way in a business's or government's balance sheets.

Essentially, currency swaps can become a way of hiding debt, and this will eventually become hugely detrimental to an entity -- public or private -- that is unable to efficiently discharge its debts. Utilizing currency swaps responsibly, however, is a way of mitigating risks in the foreign exchange rate by essentially setting an artificial and per-contract exchange rate for some future date (as determined in the contract), allowing for a more accurate and certain assessment of liabilities an d assets that are held in foreign currencies. By limiting volatility, or at least the effects of market volatility on the single deal represented by any individual currency swap, currency swaps also help to mitigate risks and thus serve as an effective means for managing capital flow and balance sheets in a treasury context.

Conclusion

The tools of risk management and hedging are highly complex, and many are not fully understood even by those who utilize and analyze them.

The brief overview here of several risk management tools is by no means exhaustive either in the number or examination of these tools, upon which volumes of information, scholarship, and debate have been written. As the tools of risk management improve, increased stability in national economies might be an expected result, but risk itself will never be eliminated -- it makes life (and finance) far too interesting.

References

Christofferson, Peter F. Elements of Financial Risk Management. San Diego: Elsevier Sciences, 2003.

Comptroller of the Currency Administrator of National Banks. Interest Rate Risks. 1997. Accessed 19 March 2010. http://www.occ.treas.gov/handbook/irr.pdf

Cusatis, Patrick and Martin R. Thomas. Hedging Instruments and Risk Management. New York: McGraw Hill, 2005.

Dun & Bradstreet. Financial Risk Management. New Delhi: McGraw Hill, 2008.

Giddy, Ian H. And Gunter Dufey. "The Management of Foreign Exchange Risk." NYU Stern School of Business. Accessed 19 March 2010. http://pages.stern.nyu.edu/~igiddy/fxrisk.htm

Horcher, Karen a. Essentials of Financial Risk Management. Hoboken, NJ: Wiley & Sons, 2005.

Organisation for Economic Co-operation and Development. Advances in Risk Management of Government Debt. OECD Publishing, 2005. pp. 29.

Phillips, Matt. "Goldman and Greece: What the Heck are Currency Swaps?" The Wall Street Journal. Accessed 19 March 2010. http://blogs.wsj.com/marketbeat/2010/02/17/goldman-and-greece-what-the-heck-are-currency-swaps/tab/article/

Dun & Bradstreet. Financial Risk Management. New Delhi: McGraw Hill, 2008.

Ibid, pp. 1.

Karen a. Horcher. Essentials of Financial Risk Management. Hoboken, NJ: Wiley & Sons, 2005.

Peter F. Christofferson. Elements of Financial Risk Management. San Diego: Elsevier Sciences, 2003.

Organisation for Economic Co-operation and Development. Advances in Risk Management of Government Debt. OECD Publishing, 2005. pp. 29.

Patrick Cusatis and Martin R. Thomas. Hedging Instruments and Risk Management. New York: McGraw Hill, 2005.

Ibid.

Ibid.

Ian H. Giddy and Gunter Dufey. "The Management of Foreign Exchange Risk." NYU Stern School of Business. Accessed 19 March 2010. http://pages.stern.nyu.edu/~igiddy/fxrisk.htm

Ibid.

Ibid.

Comptroller of the Currency Administrator of National Banks. Interest Rate Risks. 1997. Accessed 19 March 2010. http://www.occ.treas.gov/handbook/irr.pdf

Ibid.

Ibid.

Matt Phillips. "Goldman and Greece: What the Heck are Currency Swaps?" The Wall Street Journal. Accessed 19 March 2010. http://blogs.wsj.com/marketbeat/2010/02/17/goldman-and-greece-what-the-heck-are-currency-swaps/tab/article/

Ibid.

Ibid.

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