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Business Risk

What is risk management? Identify at least 10 business risks facing shang TIF and the business objective.
 

Business risk is probability of earning lower than expected profits. The business risk is influenced by the several factors such as overall economic climate, per unit prices, sales prices, and competition and input prices.

The risks are prioritized as follows:

Table 1: Prioritization of risk

Risks

Ranking

o   Political risk

2

o   Risk related to government regulations

4

o   Risk of technology

3

o   Risk of not offering better services

5

o   Not earning higher profits

7

o   Not Meeting the expectation of passengers

6

o   Risk of charging high prices

10

o   Risk of natural calamity

9

o   Imbalance in supply and demand

8

o   Not having sufficient resources

1

The risks are prioritizing on the basis of controllability of risk factors and the loss done by the risk to the business. As per the risk table given above the most urgent risk for the company will be to not have the sufficient resources. This kind of risk will be impacting the business and profits negatively. This is followed by political risk and government regulations, which will impact the business. Risk of charging high prices is given least weigh as it might be possible that passengers would be ready to pay higher prices to get the better experience.

The risk Reponses strategy is made by keeping in mind the business of the company. The business of company is highly seasonal. First half of the year is low and second half is quite higher. The company needs to take the approval from the government for operating in particular route.  It has to comply with the safety regulations of safety maritime. Keeping in mind all the factors, the risk responses strategy is framed.

Control activities taken to mitigate the impact of the risk can to have the abundant of resources. The company can reduce the risk by making contingency plan to combat the effect of natural calamity and political risks. Technology related risks and other risks can be encountered by infusing more capital.

Organization risk environment

The risk environment of the organization can be understood as the environment of uncertainty. Environments of the organization are complex set of relationship which is not easy to understand.

The management of the company can be advised to make the contingency plan for combating with the risks. There are so many kinds of risks which cannot be controlled but the impact of which can be alleviated by the help of contingency plan.

The most urgent risk is risk of not having sufficient resources. The company should make sure that it possesses all the resources required for business.

The company is dealing in the diverse culture. Company has to make changes to the cultural environment of the company. The culture of the company should be flexible and should have diverse workforce. The management of the company should try to improve the operations of company.

Prioritizing the Risks

This report is a case analysis report of a Regional Bank Manager making a proposal for the committee for approval based on a solution provided to hedge the perceived interest risks of two corporations. The two parties involved in this case are:

  • Diamond Corporation Ltd. which is a diamond mining company and is an existing client of this Regional Bank
  • Random Trading Pty Ltd. which is a Trading company and is not a client of this bank.

The perceived interest risks of both the companies are opposite in nature with James Lincoln, Chief Executive of Diamond Corporation Ltd. having a view that the interest rates would fall in future while Luke Washington, Chief Executive of Random Trading Pty Ltd is worried about exposure to potential increase in interest rates (Alexander, 2008 ).

The summary of both the companies is as below:

Company

Diamond Corporation Ltd

Random Trading Pty Ltd

Loan Amount

$ 5,000,000

$ 5,000,000

Loan Status

Debentures Issued

Loan Required

Interest Rate

Fixed at 7%

Looking for a fixed interest rate below 10%

Interest Rate Risk Perception

Rates will fall

Rates will increase

Looking for

Variable interest rate loan

Fixed interest rate below 10%

Credit Rating

AAA

ABB

As a Bank Manager, if I assess the perceived interest risk may be hedged as below:

  • Diamond company is looking for a variable interest rate that my regional bank can offer at BBSW (bank bill swap rate) + 1% against the debentures of the company fixed at 7% fixed rate
  • Random Trading Pty Ltd can be provided with the loan at the fixed rate of above 7% and below 10% which the Chief Executive will happily accept.
  • This way, if the interest rates fall, the loss against the fixed 7% from the Diamond Company is mitigated from the profit of having fixed rate from Random Trading Pty Ltd. Similarly if the interest rates are increased, the loss against the fixed rate loan to Random Trading Pty Ltd may be obtained from profit from Diamond Corporation having variable rate. This way the interest rate risk at both the companies is hedged for the bank.
  • Also, this would increase the business of the bank by adding a new client Random Trading Pty Ltd to its clientele list.
  • Though the credit risk rating of Random Trading Pty Ltd is ABB but as trading company being into services, the credit risk for a loan amount of $ 5 million should be acceptable and is recommended to the committee for approval.

It has been a great pleasure dealing business with you as a client and this is in reference to our recent discussion regarding your Fixed Interest Rate Debenture Loan of $ 5,000,000.

Considering your concerns about the interest rate risk involved, we hereby propose you with a variable interest rate on the debenture loan issued to you at a cost of BBSW (Bank Bill Swap Rate) + 2%. This proposal has been considered keeping in view of our long term relationship and effective business dealings with you.

We request you to kindly revert with your acceptance and acknowledge.

We look forward for a long term relationship and take customer satisfaction as our priority.

In reference to our discussion about your company’s growth strategies and fund raising aspects, we are glad to propose you a loan of $ 5,000,000 at a fixed interest rate of 8% per year. A detailed sanction approval along with terms and conditions shall be provided subject to approval from the concerned authority.

In view of the same, we request you to kindly submit a detailed note on your growth strategies and business profile along with a request proposal for the loan requirement so that appropriate decision may be recommended to the concerned authorities for approval.

We would also like to inform you that 0.5% of the loan amount would be charged as a one-time payment as the fund arrangement and processing charges.

Request you to kindly provide with us with the details required as stated above at the earliest.

We look forward for a long term relationship and take customer satisfaction as our priority.

This is to bring to your kind notice about the proposals I had assessed recently related to an existing client, Diamond Corporation and a new envisaged client, Random Trading Pty Ltd.

Justification of Ranking

Diamond Corporation has been an existing client to our Bank since many years and has a Debenture loan sanctioned from us at a fixed interest rate of 7% per annum. The loan raised is to the tune of $ 5 million. The company is an AAA credit rated company having good standard diamond mining operations.

In my recent client interaction with the Chief Executive of the company, it is understood that they are looking for variable interest rate availability against the fixed interest rate that they are currently charged as they perceive decrease in interest rates. He has even mentioned about the company being exploring options to mitigate this risk perceived by them.

The client being a good credit rated company and with the possible solution as to be discussed below, I recommend to sanction the client with a variable interest rate of BBSW + 2% to continue the client over longer run.

The solution I have for mitigating or hedging the risk involved with Diamond Corporation is to start a business with Random Trading Pty Ltd.

Random Trading Pty Ltd is a trading company doing its business from past few years and the credit rating of the company if at ABB. Though credit rating is having higher risk as compared to Diamond Corporation, the company being into services and ding good has a positive recommendation.

In my recent meeting with the Chief Executive of Random Trading Pty Ltd, they are looking for a loan of $ 5 million for their business expansion and growth. They are keen towards a fixed interest rate. A detailed profile of the company and their growth strategy is attached for your reference.

I recommend this proposal at a fixed interest rate of 8% may be taken up which will hedge the variable interest rate recommended for Diamond Corporation. Though credit rating risk is different for both the companies, the positive review and business of Random Trading Pty Ltd adds on business to us and also provides a long term relationship with existing clients.

With these observations, I recommend both the proposals for your perusal and approval.

The foreign currency forward exchange is (FEC) is an agreement between the two parties for the purpose of exchange of one currency with the other currency on agreed date at an agreed prices and it is applicable for more than 2 business days post the agreement date. While arranging for the foreign exchange contract one has to quote a foreign exchange rate. Foreign exchange rate is rate at which one currency for another currency is exchanged at the future date. The rate is computed by adjusting the current spot rate by the forward margin (PDS, 2014).

Risk Responses Strategy

The risk is managed in such case by locking the exchange rate at the specified rate. The rate applicable on the trading is that which has been decided earlier, not the prices prevalent on the same day. This way risk of exchange rate volatility is divided among the parties associated with the contract (Standard Bank, 2016).

For instance if an ABC firm is importing an irrigator in the United States due for the delivery after 4 months and full payment due after 3 months. The firm is having credit facility and they have contacted their treasury representative quoting the following prices:

Current spot rate                    = 1.0004

Forward margin of 3 months = -0.00078

Then FEC rate is = 1.0004 – 0.00078 = .9926

They have agreed to buy irrigator after three months at AUD 151118.28 i.e. USD 150000/0.9926. The rate three months later is 0.9600. The company has saved the following amount on irrigator:

150000*0.9926 = 151118.28

150000*0.9600 = 156250.00

Markets of interest rates are among the most liquid and largest markets of the world today. The options are available both for speculation as well heading of the interest rates (Gupta & Subrahmanyam, 2004). Interest rate options are suitable for hedging the risk against the movements of interest rates without forgoing the profits of the market trends. There are two terms cap and floor used for    higher rates and lower rates respectively. A collar is encompassing both cap and floor. After determination of the strike price cap and floor i.e. upper limit and lower limits are decided. Post that calculations related to premium is done (Credit Suisse, 2016).

This way the upper limit and lower limit of the interest rates are set by the parties in a bid to hedge against the prevalent risk. The trading takes place on the predetermined upper limit or lower limit of the interest rate. On each interest date current interest rate is compared with the strike price. When strike price is more than the interest rate, the trading does not take place.  If interest rate is lower than the strike price there is occurrence of insured event. The bank can play the role of writer to pay the differences (CBOE, 2016).

For instance, financial risk of the company can be mitigated by offering protection against the falling interest rates. Investor operating in money market can be profitable from rising interest rates by paying premium on the floor (Credit Suisse, 2016).

Currency swap can understood to be a best way to hedge the transactions of loan. There is flexibility in currency swap that a fixed rate loan can be fully hedged with combination of currency and interest rate hedge with the help of fixed floating cross currency swaps. Swaps are way of managing the requirements of funding and debt rather than a method of borrowing money. It hedges the risk by making available cheaper funds by reducing cost of borrowing. It improves the income from investment. It hedges the exposure of lone term currency and reduces the financial risk of organization (MFX, 2016).

For instance following are the rates quoted for cross currency interest rate swap for three year against the dollar.

Sterling 7.74 -7.94 percent (Dealing spread of 20 basis points)

Canadian dollars 6.50 – 6.75 percent (dealing spread of 25 basis points)

The quoted rates are fixed rates that a bank is either required to receive (higher rate) or pay (Lower rate) in the cross currency interest rate swap. In this case, the counterpart will pay or receive the interest at LIBOR for 6month dollar (UST, 2016). 

References

Alexander, C., 2008. Market Risk Analysis, Pricing, Hedging and Trading Financial Instruments. John Wiley & Sons.

CBOE, 2016. Interest rate options. CBOE.

Credit Suisse, 2016. Interest-Rate Options. Credit Suisse.

Duffie, D. & Singleton, K.J., 2012. Darrell Duffie, Kenneth J. Singleton. Princeton University Press.

Epstein, B.J., Nach, R. & Bragg, S.M., 2009. Wiley GAAP Codification Enhanced. John Wiley & Sons.

Gupta, A. & Subrahmanyam, M.G., 2004. Pricing and hedging interest rate options: Evidence from cap–floor markets. Journal of Banking & Finance, 29(1), pp.701–33.

MFX, 2016. Cross Currency Swaps. MFX.

PDS, 2014. Forward Exchange Contract. Product Disclosure Statement.

Standard Bank, 2016. Forward exchange contracts (FEC). Standard Bank.

UST, 2016. Currency swaps. UST.

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