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Risk Management Essay

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Strategic Management Financial & Political Risk David Warnock-Smith Strategic Management Programme • • • • Introduction to “risk” and “risk management” Sources of risk Risk classification Overview and management of: – Financial risk – Political risk – (Business / operational risk) Strategic Management Risk – Definition “The fact that the results of any action are not certain, but may take more than one value.

Risk is usually used to describe the form of uncertainty where, while the actual outcome of an action is not known, it is expected that it will be determined as the result of a random drawing from a set of possible outcomes whose distribution is known…. ” “risk” A Dictionary of Economics. John Black. Oxford University Press, 2002 Strategic Management Risk Examples • “You can make a million in the airline business ………. ……… but only if you start with a billion! ” • Identify examples of risks faced by an airline Strategic Management

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Risk Parameters Probability of Occurrence Susceptibility to Change Risk Severity of Impact Risk interdependence Risk parameters (Allen 1995) Strategic Management Sources of Risk (Examples) • • • • Political Environmental Market Financial • • • • Project Criminal Safety Legal General increase in risk levels Many examples of companies that have failed to manage risk Merna & Al-Thani, 2005 p15 Strategic Management Risk Classification • Business / Operational • Focuses on the risks a business takes to maximise shareholder wealth Financial • “Unexpected changes in the value of the portfolio of assets / liabilities as a result of activities in financial markets or the value of financial instruments” • Concerns the fundamental changes in a country’s social, political or macroeconomic environment • Political / Country Strategic Management Risk Management • “a formal process that enables the identification, assessment, planning and management of risks” • Aim – Identify risk – Undertake an objective ssessment of risks specific to the organisation – Respond to risks in an appropriate and effective manner • Should apply at all levels of an organisation (corporate, strategic business, project) Merna & Al-Thani, 2005 p2 Strategic Management Risk Management Approaches • • • • • • • Process controls / Operating procedures Portfolio approach Hedging Guarantees Insurance Company structure & joint ventures Contractual arrangements • Key element of Corporate Governance “The board’s role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed. The Combined Code, 2003 Strategic Management Financial Risk: Examples

• Impact on the value of an organisation as a result of changes in: – Equity Prices – Exchange rates – Interest rates – Commodity prices Strategic Management Equity Market Volatility • 1700’s – South Sea Bubble • 1929 – Stock Market Crash – DJ 400 to 145 in 3 days • 1987 – “Black Monday” – DJIA – 22. 6% – HSI – 45. 8% – FTSE – 26. 4% • 1997 Far East Stock Market Crash – South Korea – 60% in 3 months FTSE 100 -2008 2008 Market Falls • Shanghai – down 65. 2% • Hong Kong – down 48. 3% • Paris – down 42. 7% • Frankfurt – down 40. 4% • New York – down 33. 4% • London – down 31. 3% Dow Jones I A – 2008 Strategic Management FTSE 100 past12 months Exchange Rate Volatility • Increasingly volatile since collapse of Bretton Woods fixed exchange rate system in 1970’s • Dramatic currency movements during the financial crisis 2008 ? /US$ ?/ US$ 2010 Strategic Management 2009 Exchange Rate Risk Sterling challenge for UK shops (2009) • Next warned that a coming headache would be a massive increase in costs caused by the sharp devaluation of sterling. • In Next’s case this didn’t bite until the autumn and winter of 2009, because it hedged its currency exposure until then.

For most big retailers, including Marks ; Spencer, the big impact of the weakened pound would come in the middle of 2009. • Should they absorb an estimated 20% currency-related increase in the cost of clothing and other goods manufactured for them in China, India, Hungary and so on? • That, of course, would mean that their profits – which were already on a crash diet – would be squeezed further. • Or, in a period of feeble consumer demand, is there any chance they’ll be able to pass on the cost increases to cash-strapped consumers? Source: BBC News 06/01/09 (http://news. bbc. co. k/1/hi/business/7813142. stm) Strategic Management Exchange Risk Management Examples • Borrow in one currency, move money into required currency and place on deposit until needed – locks in at current exchange rate, however, there may be a cost in terms of differential interest rates • Take out a “forward” deal to be exercised at an agreed rate / time • Borrow / raise equity for a foreign subsidiary in the local currency • Net off trading currency exchanges across subsidiaries through a central clearing function – lower exposure and reduced transaction costs Strategic Management Interest Rate Volatility Interest rates greatly affect cash flows, funding costs, asset values and investment levels • In 1992 UK interest rates peaked at 15% • Reduced UK volatility since 1997 – rates set by BoE

• Current UK rate 0. 5% – Unchanged since March 2009 • Manage exposure through mix of short term / long term, variable and fixed rate arrangements Strategic Management Commodity Price Volatility • Increasing oil price volatility following oil price shocks of the 1970’s (1974, 1980) • 2001 – $20 / barrel • 2008 peak – $140 / barrel 2008 Brent Crude (Barrel) US$ 2010 Strategic Management Hedging: Side bet to neutralise risk per barrel $70 $60 Fuel Price Hedge Example $70- Future rate $9 – Delta $61- End Spot rate -3m Today +3m Future transaction settled such that the “Writer” of the future receives $9 net and buyer of the future can purchase fuel at $61- net cost $70 Strategic Management Financial Risk BA profits dive 92% but shares take off (2008 example) “BA said its fuel bill was expected to rise by about ? 1bn, or 50 per cent, to ? 3bn this year. The weakness of the pound against the dollar and existing hedging contracts taken at higher prices than current levels had offset lower fuel prices. • Profits dive – bad hedging and weakness of pound • Shares take off – on expected gains from lower fuel prices than expected Yahoo Finance 07/11/08 Strategic Management Political Risk “Probability that political forces will negatively affect an organisations profit or impede the attainment of business critical objectives” (Rugman & Hodgetts 2003) • Impact of political change on business climate • Difficult to predict • Example: election of government committed to – nationalisation – reduction of foreign investment / control • Cultural barriers to trade – supported by government

Strategic Management Political Risk • Macro risks – affect all foreign firms in same way – expropriation of assets – indigenisation laws – political boycotts – restrictions on profit repatriation • Micro risks – affect segment of economy or specific foreign enterprises – industry regulations – taxes on specific activity – local content laws Strategic Management Political Risk Assessment • Forecasting political risk • Evaluating products and operations • Political risk evaluation criteria – Political economic environment – Domestic economic conditions – External economic relations Scoring and weighting applied • Allows comparisons between countries Strategic Management Political Risk Management Strategies • Integrative Techniques – – – – – – – – Blend in Local name Develop good relations with government Promote local personnel remote R&D Non – local management Raise capital from country & domestic banks Diversify across a number of countries • Protective / defensive techniques Strategic Management Combination strategies High Low tech manf firm Oil Producing / refining co

Use of integrative techniques Air carrier Low Low High tech R&D firm High Use of protective / defensive techniques Strategic Management JV to reduce Political Risk • Strategic use of joint ventures / partnerships – compatibility of firm specific advantages – Safeguards of unethical behaviour • Risk of R&D / IP theft in the event of relationship breakdown • Joint Venture may be a requirement specified by the host Government to allow market entry – e. g. DHL in Vietnam, Air Arabia in Morocco Strategic Management

Business / Operational Risks Focuses on the risks a business takes to maximise shareholder wealth Sources of Risk • People / Safety • Asset loss • Liability • Cost risks • Volume risks • Customer dependency • Supplier • Competitors • Economic • Obsolesence • Environmental Strategic Management Risk management • Risk assessment / training • Business controls • Contract • Insurance • Portfolio approach – products – markets – customers • Fixed / variable cost structures • Resourcing • Inventory

Summary • Financial and political risks are inherent to international business operations • Risks have generally increased over time as business becomes more complex and more international • Effective risk management can reduce (but generally not eliminate) risks faced by a business • Risk management is fundamental to corporate governance Strategic Management Further Reading • Tayeb M. , (2000). International Business: Theories, Policies and Practice. (Chapter 9 & 10) • Rugman A. Hodgetts R. (2003). International Business (3rd Ed). (Chapter 7 & 13) • Merna, T. & Al-Thani, F. (2008). Corporate Risk Management – an Organisational Perspective, Chichester Strategic Management Tutorial 17th December • One hour session on risk @11:15 • In advance access the 2010 Annual report & accounts for DHL – look at the “Risk section” • Come to the tutorial prepared to discuss risk management within DHL • (separate arrangements for “Air” people) Strategic Management