The Financial Risk Administration
Financial risk management is a specialized branch of corporate finance, dedicated to managing or hedging financial risks
“Uncertainty exists whenever you don't know for sure what will happen in the future. Risk is the uncertainty that “matters” because it affects people's well-being….. All risky situations are uncertain, but there can be uncertainty without risk ”. (Bodie, 1998).
For this reason, a financial risk manager is in charge of advising and managing the exposure to corporate or company risk through the use of financial derivative instruments.
To provide a more specific overview of risk management in Table No. 1, the difference between objectives and functions of financial risk management can be seen.
Table No. 1: Objectives and functions of financial risk management
| OBJECTIVES | FUNCTIONS |
| Identify the different types of risk that may affect the operation and / or expected results of an entity or investment. | Determine the level of risk tolerance or aversion. |
| Measure and control “non-systematic” risk, through the instrumentation of techniques and tools, policies and process implementation. | Determination of capital to cover a risk. |
| Risk monitoring and control. | |
| Guarantee returns on capital to shareholders. | |
| Identify alternatives to reallocate capital and improve returns. |
Source: Fragoso (2002).
It is also extremely important to know the types of risks that every company faces, as well as their definition; See Table No. 2 where all the most general and common types of financial risks are presented.
Table No. 2: Types of financial risks
| TYPE OF RISK | DEFINITION |
| MARKET RISK | It is derived from changes in the prices of financial assets and liabilities (or volatilities) and is measured through changes in the value of open positions. |
| CREDIT RISK | It occurs when the counterparties are unwilling or unable to fulfill their contractual obligations |
| LIQUIDITY RISK | Refers to the inability to obtain necessary cash flow obligations, which can force an early settlement, consequently transforming losses on “paper” into realized losses |
| OPERATIONAL RISK | Refers to potential losses resulting from inadequate systems, administrative failures, faulty controls, fraud, or human error |
| LEGAL RISK | It occurs when a counterparty does not have the legal or regulatory authority to carry out a transaction |
| TRANSACTION RISK | Associated with the individual transaction denominated in foreign currency: imports, exports, foreign capital and loans |
| TRANSLATION RISK | It arises from the translation of financial statements in foreign currency into the currency of the parent company for financial reporting purposes |
| ECONOMIC RISK | Associated with loss of competitive advantage due to exchange rate movements |
Source: Own elaboration based on: Lewent (1990), Fragoso (2002), Jorion (1999), Baca (1997) and, Díaz (1996).
Having explained the fundamentals of risk management objectives and functions, as well as the types of financial risks, it is important to know, in turn, the process of how risk is managed step by step, in a very general way (see table No.3).
Table No. 3: Risk management process
| HE PASSED | DEFINITION |
| RISK IDENTIFICATION | Determine which are the most important exposures to risk in the unit of analysis (family, company or entity). |
| RISK ASSESSMENT | It is the quantification of the costs associated with risks that have already been identified. |
| SELECTION OF RISK MANAGEMENT METHODS | It depends on the position you want to take: risk avoidance (not exposing yourself to a certain risk); loss prevention and control (measures aimed at reducing the probability or severity of loss); risk retention (absorb the risk and cover the losses with own resources) and finally, the transfer of the risk (which consists of transferring the risk to others, either by selling the risky asset or buying an insurance policy). |
| IMPLEMENTATION | Implement the decision made. |
| REVIEW | Decisions should be periodically evaluated and reviewed. |
Source: Own elaboration, based on Bodie (1998).
It is important to emphasize the importance of the risk transfer method, since today it is the most used method in risk management, in turn, it is the method that is used through derivative instruments.
The risk transfer method has three dimensions, that of protection or coverage, that of insurance and that of diversification (see Table No.4).
Table No. 4: Dimensions of risk transfer
| DIMENSION | DEFINITION |
| PROTECTION OR COVERAGE | When action to reduce exposure to a loss also forces you to give up the possibility of a profit. |
| INSURANCE | It means paying a premium (the price of insurance) to avoid losses. |
| DIVERSIFICATION | It means keeping similar amounts of many risky assets rather than concentrating the entire investment on one. |
Source: Own elaboration, based on Bodie (1998).
Emergence, Evolution and Importance of Derivative Instruments
Throughout the history of humanity, the human being has always been exposed to some type of risk, be it economic, political or social.
The origins of derivative instruments go back to the Middle Ages, where they were used to satisfy the demand of farmers and merchants through future contracts.
The first known case of an organized futures market was in Japan around 1600, presented as a "mismatch problem" of assets and liabilities between the incomes and expenses of the Japanese feudal lords. " (Rodríguez, 1997).
Towards 1730, a Dojima rice market officially designated as “cho-ai-mai”, or “forward rice market” was officially created, “already presenting the characteristics of an authentic modern futures market”. (Ibid.).
In 1848, the “Chicago Board of Trade” was founded and served to standardize the quantities and qualities of cereals that were sold.
For the year 1874, the Chicago Mercantile Exchange was founded, providing a central market for perishable agricultural products.
Derivative instruments became more important towards risk exposure after 1971, with the change from the gold standard to the dollar (Bretton Woods).
"Since that date, the behavior of the currency market has undergone movements that affect the development of interest rates, while the general instability of the markets has been reinforced by the inflationary phenomenon that modern economies have had to face". (Baca, 1997).
The international monetary system is historically made up of three periods: "the gold standard era (from 1870 to 1914), the period between wars (from 1918 to 1939) and the period after World War II during which the types of The changes were set according to the Bretton Woods agreement (1945-1973) ”(Krugman, 1995).
The gold standard (1870-1914), was established as a legal institution as an international standard where each country ties its currency to gold and this allowed it without restrictions, the import or export of gold. The essence of this type of pattern was that the exchange rates were fixed.
The central country within this pattern was England since it was the world leader in commercial and financial affairs. And actually in this period, the gold standard did not cover the whole world, only a group of the main European countries.
Period between the two world wars (1918-1939), this period is also known as the “dark era of the international financial system”, since it was characterized by a strong excess of money supply and inflation.
With the outbreak of the First World War, the nations in conflict suspended the convertibility of their currencies to gold by enacting an embargo on gold exports, in order to protect their gold reserves. Later, most nations adopted the same policy.
Therefore, the financing of military expenditures was through the printing of money in a massive and excessive way.
In 1922, at the Geneva Conference, the adoption of a gold exchange standard was recommended, for this "it was necessary for countries with deficits to allow the influence of said deficits on their gold reserves to decrease monetary growth.
Surplus countries also needed to allow their growing gold reserves to liberalize their monetary policies. ” (Levi, 1997).
The problem was that many countries began to manipulate exchange rates according to their national objectives. In 1931 England suspended its convertibility (sterling-gold), due to the shortage of its reserves.
From that moment on, the world was divided into three economic blocks: the Pound Sterling block, the Dollar block and the Gold block. "In 1934 only the US dollar could be exchanged for gold." (Ibid.).
For this period it was characterized by a phenomenon known as “policies to impoverish the neighbor”, which are made up of competitive devaluations and increases in the protection of tariffs, such an environment ended up hindering global economic growth.
In July 1944, world powers met at the Mount Washington Hotel in Bretton Woods, New Hampshire, to design a new international financial order.
The main characteristics of the Bretton Woods System are shown in Table No. 5.
Table No. 5: Main characteristics of the Bretton Woods System
| FEATURES | WHAT DOES IT CONSIST OF? |
| INTERNATIONAL INSTITUTIONS | The creation of an international agency with defined powers and functions. |
| EXCHANGE RATE REGIME | Exchange rates should be fixed in the short term but adjustable from time to time in the presence of "fundamental imbalances". |
| INTERNATIONAL MONETARY RESERVES | Increase in gold and reserve currencies. |
| CURRENCY CONVERTIBILITY | All countries must adhere to an unrestricted and convertible multilateral trading system. |
Source: Own elaboration, based on Chacholiades (1995).
From the Bretton Woods derives the creation of the IMF (International Monetary Fund). Agency in charge of the administration of the new international financial system. Since he is in charge of gathering and distributing the reserves, as implanter of the Bretton Woods system.
Reserves are contributed by member countries according to a quota system based on national income and the importance of trade in different countries. "Of the original contribution, 25% was in gold… and 75% was in the country's own currency." (Levi, 1997).
Until 1994 there were 178 countries affiliated with the IMF.
"All countries pegged their currencies to the dollar, and the US pegged the dollar to gold, agreeing to exchange gold for dollars with foreign central banks at the price of $ 35 an ounce." (Krugman, 1995).
Beginning in 1958, where the reinstatement of the convertibility of European currencies and the financial markets of the countries becoming more integrated, monetary policy became less effective and movements in international reserves became more volatile, thus revealing that the system suffered from a certain weakness, and part of the fact that the US faced a serious confidence problem, due to the demand for dollars based on the US reserves.
"The macroeconomic policies of the United States in the late 1960s helped bring about the collapse of the Bretton Woods system in early 1973. The super-expansive fiscal policy of the United States contributed to the need to devalue the dollar in the early 1990s. Seventy-one and fears of this happening triggered speculative capital flows, fleeing the dollar, which inflated the monetary offers of foreign countries.
Higher monetary growth in the United States fueled domestic and foreign inflation, making countries increasingly reluctant to continue importing US inflation through fixed exchange rates. A series of international crises, which began in the spring of 1971, led, in stages, to the abandonment of the dollar's ties to gold and of the fixed exchange rates with the dollar by the industrialized countries. ” (Ob. Cit.).
As a result of this fact, it gave rise to the creation of the “International Monetary Market” that was founded in 1972 as a division of the “Chicago Mercantile Exchange”, to process foreign currency futures contracts.
Currently the most relevant futures (or derivative) markets in the world are those of Chicago and New York, covering all areas such as: raw materials (commodities), bonds, interest rates, stock indices, and currencies.
In 1973, a theory was developed that explained how to calculate the value of an option known as the "Black-Scholes" model and its improved version of Merton.
For 1994, JP Morgan proposes "Riskmetrics", as a model to quantify risks through the concept of "Value at Risk".
From the 90`s, it is said that we live "in a riskier world", since with the globalization process that we are living today, the impacts produced by a country spread to the rest of the world through interrelation of economies.
As clear examples of the effects of globalization we have that in:
- 1995, devaluation of the Mexican peso (tequila effect). 1997, Asian crisis (dragon effect). 1998, Russian crisis, where the ruble collapses and its moratorium on its public debt resulting in great uncertainty to international markets. 1999, Samba effect, the real (Brazil).2000 is devalued, the Nasdaq. 2001 has fallen, the US economic slowdown and the general increase in energy sources. 2002, the Argentine economy has collapsed (tango effect).
With all of the above, it can be seen that “the financial markets have been facing increasing price uncertainty. The world has become, from a financial point of view, a riskier place. ” (Pascale, 1999).
This uncertainty is related to three basic financial prices, which are: exchange rates, interest rates and commodities.
The volatility of exchange rates originated from the breakdown of the Bretton Woods system (1971), and a system of floating between currencies was introduced, resulting in the appearance of exchange rate risk.
By 1979, the US Federal Reserve abandoned the practice of setting the interest rate and began to set the practice of growth in the money supply, and thus the interest rate risk appeared.
The instability of oil in the 70's caused instability in other commodities, with the risk of commodity prices appearing.
For all the aforementioned, it can be affirmed that derivative instruments are financial tools of great relevance in the world, since they reduce companies' exposure to risk, avoiding negative economic and financial impacts.
Bibliography:
1.- BODIE, Zwi and Robert C. Merton (1999). Finance. Editorial Pretince Hall, Mexico.
2.- FRAGOSO, JC (2002). "Analysis and Administration of Financial Risks". Exposure of the subject of Risk Analysis, of the specialty in Financial Economics of the Veracruzana University, Chapter 13: Derivatives Market, Xalapa, Ver.
3. - LEWENT, Judy C., and A. John Kearney (1990). "Identifying, Measuring, and Hedging Currency Risk at Merck". Continental Bank Journal of Applied Corporate Finance 2, pp. 19-28; USA
4.- JORION, Philippe (1999). Value at risk. Edita Limusa, Mexico.
5.- BACA, Gómez Antonio (1997). "The Financial Risk Administration". Article taken from the magazine Ejecutivos de Finanzas, monthly publication, Year XXVI, No. 11, November, Mexico.
6.- DÍAZ, Tinoco Jaime and Fausto Hernández Trillo (1996). Financial futures and options. Edita Limusa, Mexico.
7.- RODRÍGUEZ, by Castro J. (1997). Introduction to Analysis of Financial Derivative Products. 2nd Edition, Editorial Limusa, México.
8.- KRUGMAN, R. Paul and Maurice Obstfeld (1995). International economy. 3rd Edition, McGraw-Hill Editorial, Spain.
9.- LEVI, D. Maurice (1997). International finances. 3rd Edition. McGraw-Hill Publishing. Mexico.
10.- PASCALE, Ricardo (1999). Financial decisions. 3rd Edition, Ediciones Machi, Argentina.
