Revista Empresarial Inter Metro / Inter Metro Business Journal Spring 2017 / Vol. 13 No. 1 / p. 23

FINANCIAL EXPOSURE: SOME THOUGHTS

by

Enrique Martinez- Calimano

School of Economics

Ph.D. Program

Metropolitan Campus

Inter American University of Puerto Rico

San Juan, Puerto Rico

Abstract

Financial exposure refers to the amount of resources that can be lost in an investment. Different

risks may be the cause of these loses. This paper discusses some of these as well as some of the

factors affecting them. Derivatives are mentioned as a way to reduce risks.

Keywords: financial risk, hedging, risk factors, risk management, derivatives

Introduction

In times of economic turmoil, when managing hedges, greater care and better tools are

needed (Becker, Mazur, 1995). Efficient risk managing is, knowing among other things, were to

invest, divest, and diversify.

Financial Risk

Financial risk is a term used to evaluate the likeyhood that an investor may lose money as

a result of insolvency of any or all its investments in a business. It also refers to the situation

were governments default bond payments.

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Financial risks include, among other risks impacting investments, default risk, foreign

investment risk, market and country risk, political risk, economic risk, exchange risk, transfer

risk, bankruptcy risk, opportunity risks, and event risk. A brief description of the

aforementioned follows.

Default risk, is the possibility that debtors will not pay all or part of their obligations

when they become due. It also includes foreign investment risk, foreign monetary policies may

hurt the investor’s financial position. Other factors contributing are market and country risk.

Market risk refers to possible losses due to market performance. Country risk refers to how likely

are losses generated due to specific country characteristics. This last risk is impacted by many

different aspects of life in a foreign land, including, among others, political risk, economic risk,

exchange risk, and transfer risk.

There is also bankruptcy risk. Bankruptcy risk refers to the situation were a debtor

becomes insolvent and cannot meet its obligations.

Investors must decide if risk is acceptable or not. Some risk is tolerated because the cost

of eliminating it is high (as compared to the cost). It is important to study and understand the risk

and how will it be impacted by paying to reduce or avoid it.

Investors will also want to consider the always feasible event and opportunity risks.

Event risk is the possibility that a future occurrence may have a negative impact in future

earnings of an investor or a whole industry. Opportunity risk is how likely it is that resources are

committed, to a business alternative and cannot be redirected, and then other finer alternatives

become available (Wagoner, 2002).

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Risk must be assessed in a continuing basis. The more information gathered, will give an

expanded capability to assess prospective future results (Greenspan, 1999). Investors must have

all possible information, to successfully assess risks, the more the better (Cagan, 1999).

Offering a product that is well liked in the foreign market is only a part of the process. A

company must research how the economies of selected countries.

When a multinational company measures financial risk their analysis must include factors

contributing to those risks. These include interest rates, exchange rates, inflation rates, and trade

treaties between the targeted countries. Some of the questions that must be answered are: what

are the prevailing economic conditions? What are the major government policies affecting the

economy in general and international trade in particular?

Foreign Investment

A foreign country's rate of inflation can affect the cost of obtaining the raw materials

and other components necessary for production. Inflation rates will affect the cost of

obtaining financing. Higher inflation will also increase country risk. Foreign inflation will have

an effect on the exchange rate of a country’s currency. Products will appear cheaper to

foreign customers paying with their local currencies. Conversely, if the targeted foreign country's

currency experiments inflation imports paid in its currency will appear more expensive in

that foreign country. This can have an adverse effect on the firm's production costs. If inflation

increases, most exchange accords will be affected. Prospective agreements between the company

and the foreign government or with foreign private enterprises will feel the effect of inflation and

the decreased purchasing power of the local currency. As a result things such as the price paid

for the lease of production facilities can be affected.

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The cost of production of a company's proposed foreign subsidiary could also be affected

by a number of country-related factors. Variations in the salary structure will affect the cost of

products manufactured by the company. In many businesses that are not automated labor is a

major component of the cost of goods manufactured. Changes in the rates paid or in the benefits

earned by employees can cause a major change in the cost of goods manufactured which is a

major component of the overall cost of most operations.

The company must understand that with increased businesses in the foreign country, at

some point sooner or later wage increases will occur as well as increases in the benefits that must

be given to the workers such as sick pay, severance pay vacations, medical and health benefits.

The more money is invested in a specific stock, the larger the risk. That is due to the

volatility of individual stocks. With three general types of risk described by some

economists, individual stocks are subject to market volatility, industry risk , and individual

company risk. Market volatility describes the way a stock will rise or fall because of overall

moves in the market. Industry risk is the degree to which a stock is affected by events related

to its sector. Then there is the individual company risk, that is how a stock moves based on

its own particular events (Wang, 2002).

Risk Factors increasing exposure

Financial factors must be considered along with political and country risk factors

when developing a model to reduce exposure. In general, situations that increase country risk

discourage foreign investment. For entities already doing business in foreign countries regular

assessments of country risk is also important. If country risk starts to increase the parent

company may consider divesting.

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Multinational corporations are usually unable to detect and predict big problems in

the foreign countries were they intend to invest. Reliance on statistical methods may be the

cause. These methods cannot evaluate subjective data that cannot be quantified. Furthermore,

historical trends cannot always detect or anticipate crises in their gestation stages.

Other factors that must be considered when assessing country risk include government

subsidies given by the targeted country's government to local industries. Also when acquiring

goods, a question arises, will this foreign government favor domestic producers and severely

restrict purchases of imported goods by its government agencies? Other considerations also

include customs laws and administrative procedures regarding the country's imports and exports.

These encompass a large variety of government policies and procedures that either discriminate

against imports or favor exports.

It is also important to evaluate the political environment in the foreign country. An

extreme case is the possibility of expropriation, by a foreign government, of some or all the

operations established there. If it happens, what compensation, if any, would be received?

Further analysis should determine if such events would take place peacefully or by force.

The income taxation issue is important. Will the corporation receive the same tax

treatment as other local businesses in the foreign country? It is important to know what the

tax rate will be and what rate will be charged on earned profits. The company must also

determine if the foreign country imposes a tax on the repatriation of profits.

Risk is inherent in all business and financial activities. Companies are not sure that

specific non-financial assets will be profitable. They are also uncertain about the flow of

returns that the asset might generate. In general, uncertainty perceptions influence the

discount factors in a way making the expectations of future earnings congruent with current

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present values, or wealth (Greenspan, 1999).

The key to managing an information strategy without feeling like the sky is falling in

is anticipation. It is imperative that the company anticipates the needs of its users, and take an

active role in the filtering of information (Cagan 1999).

In an economy were supply and demand determine the prices of goods and services, risks

evolve from holding assets or, claims to assets that are not hedged. Financial intermediation can

redistribute and lower financial risk. This occurs because financial intermediation, eases

diversification of risk and it’s redirecting (Greenspan, 1999).

Risk Exposure Management

The key to the search for better risk management lay in the development of

derivatives (Economist, 1993). When working with derivatives, however, investors

should use only those that they understand and are in accordance with their risk management

strategies. Derivatives are used to hedge or to speculate by trying to anticipate how market will

behave. (Siems, 1998). This, always looking to make a profit.

Financial risk, such as exposure to interest rates, commodity or currency prices. The

sharpest tools for managing these risks are derivatives (Economist, 1993.) A derivative is defined

as an instrument used to hedge against price fluctuations of goods and /or services. It is a

financial contract whose value depends on the values of one or more underlying assets or indices

of asset values. This definition would include such instruments as mortgage-backed securities

and collateralized mortgage obligations. However, generally refer more narrowly to contracts

such as forwards, futures, swaps and options whose primary purpose is not to borrow and lend

funds but rather to transfer price risks associated with fluctuations in asset values. Most contracts

fall into one of four classes: foreign exchange, interest rate, commodity and equity. Very

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recently, the first property and tax derivatives have been appearing (Economist, 1993). They are

independent of operations such as acquiring currencies, goods, or to cover credit risks.

Derivatives include options, swaps, futures and forward contracts. (Siems, 1998).

In recent years there increased interest in risk management by insurance companies.

Like other types of multinational they are also exposed to financial risk because of their

operating and investing activities. Insurance companies collect premiums in advance for a

promise to pay covered losses at an unknown time in the future. Premium volume and equity

are invested in a variety of assets. Insurance companies invest mainly in fixed-income

securities. To the extent these adverse effects can be associated with specific sources, they

can be hedged with financial derivatives.

Managers are faced with the prospect of deciding what the financial risks are. It is

important to decide what risks will be hedge and what instruments will be used. These risks

present potential real problems that can lead to cash flow or insolvency problems. (Siems,

1998). Fine instruments used to guard against different financial risks exposures are derivatives.

Before using derivatives, however, managers must understand what their purpose is.

These instruments are intended to hedge against the decrease in fixed-income assets, to better

match asset/liability duration, to look in the current yield.

The financial risk management industry is a very specialized, information-intensive

sector, with heavy demands for robust data (Cagan, 1999). If corporate officials decide to use

derivatives, they should consider several facts. It is important to understand that the use of

derivatives to mitigate financial risks can include resistance from policy decision makers to

use that hedging approach. Then there is also the possible lack of qualified personnel with

knowledge of derivatives. In addition, an internal control and review plan must be

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established to monitor the use of derivatives. Finally, managers and employees must de

trained in using derivatives. They must acquire the knowledge needed to deal with

derivative's contracts, laws and regulations, and accounting procedures.

In order to better select the best way to reduce or eliminate financial risk managers

must have up to date information about economic conditions in targeted areas and in the

world in general. It is important to know levels of inflation, interest and, exchange rates, and

other related factors that may influence the latter.

To be able to establish a long term strategy to guard their company against financial

risks managers must consider a lot of varied, technical information. What is happening in

prospective countries were investments are being considered? Information that must be evaluated

includes unemployment and interest rates and long term risk rating. Evaluating the later will hint

how good its finances are (Roa, Garcia, et. al., 2009).

As an example of countries’ varying conditions and how complex is the investment

analysis, data from the United States, Germany, Spain, Sweden and, Switzerland, New Zealand

Australia and Canada is presented.

This past august America's unemployment rate was 4.9 % the same number for 3 months.

This statistic embodies 7.8 million workers. Men and women fare the same with 4.5 %

unemployment. That’s not the case with ethnicity. Whites experimented a 4.4 % unemployment

rate while Asians had 4.2%, Hispanics 5.6% and African Americans 8.1%. People unemployed

for more than two years are 2 million. This represents 26.1% of all unemployed. (U.S. Bureau of

Labor Statistics Division of Labor Force Statistics, September 2, 2016)

Additional variables that may contribute to risk, are the specific economic conditions in

different countries were a business venture might operate. Business confidence in the Euro area

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improved has improved since 2001. Unemployment in Germany held steady at 6.4% in July 2016,

compared with 4.7 a year ago. Germany's imports are €949bn and exports €1,196bn, with a surplus

of € 248bn. (Official Labour Market Statistics, August 2016). Other parts of Europe have differing

economic situations and unemployment rates (Statista, 2016). Spain, for example, has 20%

unemployment rate (Instiuto Nacional de Estadistica) Sweden and, Switzerland, 3.2%. (Trading

Economics, 2016).

In other locations around the world, New Zealand has 5.1% unemployment rate in July

2016 down from 5.7% by that date in 2013. Australia and Canada 5.7% and 7% respectively, for

august 2016 Canada was 7% (Trading Economics, 2016).

All the latter are destinations were the level of social or political upheaval is not a threat

to foreign investments. Depending on investor’s goals, needs, and level of risk acceptable, some

of these countries will appear inviting while others will not.

Derivatives

By 1998, the 10 largest derivative players among U.S. banks holding companies,

derivative credit exposure averages 15% of total assets. The average exposure is 49% of assets

for those bank’s loan portfolios. In other words, if those 10 banks lost 100% of their loans, the

impact would be more than three times greater than if they had to replace all of their derivative

contracts (Simens. 1998).

At the present time national derivatives amount to $ 197.9 trillion, American banks hold a

considerable amount of derivatives instruments. Credit exposure in the second quarter of 2015

was $ 405.6 bn. (Office of the Comptroller of the Currency, Second Quarter, 2015).

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Derivatives have a place in hedging investment risks. However they pose problems for

those managers that do not know them. Interesting positions presented in literature tend to

suggest that large numbers of derivatives increase risk. Li and Shaofang (2003) found that

systemic risk increase with the use of derivatives. Similarly, Li and YU (September, 2010) found

that derivatives increased risk. However they also found that increase numbers of these

instruments could contribute to exceeding results. There are other authors (Mayordomo &

Rodriguez-Moreno, August 2014) that affirming that some classes of derivatives do not

contribute much to the systemic risk while others do.

Conclusion

In working to reduce financial exposure risk, a well-planned long term investing strategy

is paramount. Managers must understand the different factors contributing to these risks.

Targeted markets must be studied with care, using available historical data. When and if

investing conditions are no longer attractive, an exit strategy must be planned beforehand. To

reduce financial risk, instruments like derivatives should be considered along with geographical

and industry diversification.

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