Transcript
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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)
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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, ofST. 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.
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Finally, we take this opportunity to extend our deep appreciation to ourfamily and friends,
for all that they meant to us during the crucial times of the completion of our project.
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Table of Contents
Chapt
er
Topics Page
No1 Introduction1.1 Abstract 6-81.2 Statement of problem 8-91.3 Background and rationale
of study 9-111.4 Purpose of study 11-121.5 Contribution of study 12-131.6 Research objectives 13
1.7 Research Methodology1.7.1 Research design 14
1.7.2 Data collection 141.7.3 Reliability and validity of
data
14
1.8 Tools, techniques and
technologies 15-17
1.9 Limitation of the study 182 Risk Analysis -
Conceptual Framework2.1 Introduction 19-20
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2.2 Different types of risk 20-
242.3 How Do We Manage Risk?
2.3
.1
Financial risks and their management 24-
37
2.3
.2
Political risks and their management 38-
45Case Study
a) Frightened Capital? The Case of
China
39-
40
b)The Case of Slovakia: When Political
Environment Sways Investors41
2.4 Role of the risk managers in
Multinational Corporations 46-
47
2.5 Risk management in ASIA 472.5
.1
Types and Level Of Risk In ASIA 48-
512.5
.2
Risks management practices of Asia-
based MNCs51-
533 Analysis & Findings3.1 Introduction 53-
543.2 Types of risk management
policies and their objectives
54-
56
4 Summary, conclusion and
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CHAPTER 1CHAPTER 1
INTRODUCTION
Risk management structure should be well thought-
out, 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 morecomplex, 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
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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).
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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 withcomplex 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
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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
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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
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(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.
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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 riskmanagement 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
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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
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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.
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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 toolsincluding 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).
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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
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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.
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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.
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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.
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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 categorycomprises 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.
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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 forlong-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).
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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
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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 ofcash 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
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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 13-
suspected 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
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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 planand 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
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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
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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 oftwo 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
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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.
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Diagram 1: Risk management processes
as described by Standards Australia
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Risk ManagementInstitute of AustraliaRisk management http://www.rmia.org.auStandards Australia Risk management standard (AS/NZS 4360)
http://www.standards.org.auFactors 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 tomaturity, 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:
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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 30-year 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
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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 short-
term 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.
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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 ExchangeRates
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
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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.
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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: A
Selective History
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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-centuryAmsterdam 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.
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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 large-
scale 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
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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 value-
at-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
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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.
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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 convertingthem 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.
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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 PoliticalEnvironment Sways Investors
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,
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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 understandthe 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:
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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
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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 maypropel 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 on
Market Misreading of Relative
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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
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2.3 Role of Risk Managers in
Multinational Corporations
An expatriate, on international business travel most of the times, arrives on the British AirWays 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 Coca-
Cola 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
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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).
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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 ofThink 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.
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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
Total
Score
(100)
Political
Risk
(25)
Economic
Performance
(25)
Debt
Indicator
(10)
Australia 16 90.39 23.13 18.56 10.0
Singapore 17 90.24 23.25 18.84 10.0
Japan 18 88.68 21.5 19.26 10.0
New Zealand 22 86.69 22.35 15.44 10.0
Taiwan 25 82.60 21.14 15.31 10.0
Hong Kong 27 81.55 19.86 17.80 10.0South Korea 34 69.46 18.34 12.06 9.41
Malaysia 47 63.05 16.72 10.23 9.39
China 58 56.39 16.97 9.39 9.68
Thailand 59 56.28 14.73 8.77 8.91
India 61 55.10 14.79 7.68 9.44
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Countries Debt in
Default or
Rescheduled
(10)
Credit Rating
(10)
Access to Bank
Finance
(5)
Access to
Capital Market
(5)
Australia 10.0 8.96 5.0 5.0
Singapore 10.0 9.79 5.0 4.0
Japan 10.0 8.75 5.0 4.5
New Zealand 10.0 8.96 5.0 5.0
Taiwan 10.0 8.13 5.0 4.0
Hong Kong 10.0 7.29 5.0 3.33
South Korea 10.0 6.46 0.98 3.50
Malaysia 10.0 5.21 1.21 3.50
China 10.0 5.83 0.01 2.0
Thailand 10.0 4.38 0.34 2.0
India 10.0 3.13 0.03 2.75
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.
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TABLE 2
Business Risks in Asia - A US
Perspective
Country Political Risk Degree of Difficulty of doing
business
China 68.55 6.33
Hong Kong 62.32 3.61
Vietnam 56.54 5.75
Philippines 56.32 5.83
Taiwan 54.20 4.78
South Korea 50.24 5.62
Thailand 48.70 5.59
Indonesia 48.41 6.27
Malaysia 42.00 5.35
US 32.19 2.89
Japan 31.79 4.97
Singapore 27.07 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
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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 MNCsAs 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 theconstruction 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 Self-
insured Contingency Fund amounting to S$ 25 million to cover uninsured losses as stated
by Howard.
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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
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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
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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 th
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