2 most common financial risks faced by a company
You might visit this site, being a treasury professional with years of experience in the field. However you could also be a student or a businessman wanting to know more details on the subject, or a reader in general, eager to learn something new. The ‘Treasury for non-treasurers’ series is for readers who want to understand what treasury is all about. From our expert Victor Macrae we received another article on risk management, of which we thought that it adds some extra aspects to the earlier article on riskmanagement.
An important task of a treasurer is to fully understand the financial risks that impact the firm. Two risks faced by most companies are interest rate risk and foreign exchange risk. Both risks can negatively impact the firm’s financial statements and can ultimately even lead to bankruptcy!
Interest rate risk
Interest rate risk originates from interest bearing liabilities. Most firms have loans. In the case the interest rate is variable, the interest paid varies according to an agreed market rate, such as Euribor or Libor. The risk is that the market rate will increase to a level where the firm is not able to pay its interest payments any more. In that case the firm is in default and theoretically the loan provider can request full loan redemption. In practice the loan provider is now in charge and will increase the margins on the loan as a result of the higher counterparty risk and also other charges such as fees of lawyers will be due. In order to mitigate interest rate risk a firm can use fixed rate loans or use variable rate loans in combination with interest rate derivatives such as interest rate swaps or options.
Foreign exchange risk
Foreign exchange risk occurs when a firm has subsidiaries abroad or when it transacts in a foreign currency. Suppose a firm with the euro as home currency sells products in Japanese Yen (JPY). Payment is due in three months’ time. If the JPY has weakened against the euro with 20% when the payment is due after three months, the revenues in euro are 20% lower. If the margin on the sales was 15%, then the negative foreign exchange rate change has led to a loss of 5%. Foreign exchange rate risk can be mitigated by various means, such a moving production to countries where the firm sell its products in order to match the currency of cash in- and outflows. Furthermore, derivatives such as forwards or options can be used to mitigate foreign exchange risk.
The first step in managing interest rate risk and foreign exchange risk is to examine how the firm is exposed to these risks. The second step is to measure the impact of the volatility of interest and currency rates to which the firm is exposed on its financial statements. In the third step, if the effects are serious, the treasurer should consider which of the available options for risk mitigation best suits the firm.
Victor Macrae – Owner of Macrae Finance