Week 9 Learning Objectives • Explain the concept of financial risk • Discuss the scope of financial risk • Discuss the benefits and implementation of financial risk management • Explain four important components of financial risk, including their definitions, measurements and mitigation strategies: Liquidity Risk Credit Risk Market Risk Funding Risk 92
93 Financial risk defined • Financial risk is the exposure to adverse financial events that erode profitability and in extreme circumstances bring about business collapse. • It can include the failure of financial systems, limited access to funding (debt and/or equity), poor management of liquidity needs, non-payment from customers, unexpected adverse changes in traded market prices, poor hedging decisions, unexpected adverse changes in tax laws or accounting treatments, and excessive financial leverage (too much debt).
Scope of financial risk Liquidity Risk Credit Risk Market Risk Interest rate risk FX risk Equity price risk Commodity price risk Funding Risk Financial Risk 94
95 Definition of liquidity • Liquidity is the availability of cash or cash equivalent resources to allow expected and unexpected obligations to be met when needed so that business affairs can proceed uninterrupted. Ø Cash is short dated assets, receivables from sales, deposits in a bank etc. Ø A cash equivalent is something that can be converted quickly into cash e.g. a line of credit from a bank. • In the absence of sufficient cash resources, business activities may be jeopardized, and reputational damage result in relationships with suppliers, employees, customers, lenders, etc. The probability of encountering severe financial distress increases with poor liquidity management due to the risk of your organization defaulting on its obligations as they fall due. • Diligent and prudent management of liquidity is therefore a vital part of corporate financial risk management.
96 Factors impacting funding liquidity risk in banks • Two main type of events impacting bank funding liquidity 1. Bank specific events • events that distress the confidence of third parties • rating downgrades (especially relevant when covenants or triggers minimum rating required) 2. Systemic events • e.g. market disruption, liquidity dry up (e.g. Global Financial Crisis) • Contractual mismatch between maturity of assets and liabilities • Uncertainty embedded in some bank products (demand deposits can be called at depositor’s option) • Off-balance sheet liquidity risks
97 Sources of Corporate Liquidity risk Unpredictable cash flow Unfavourable legal or regulatory judgements Mismanagement Negative perceptions or market actions Limited access to working capital and CAPEX funding Fully drawn borrowing facilities and overdrafts
98 Cash conversion cycle Source: Lorenzo Preve and Virginia Sarria-Allende (2010) “Working Capital Management” Oxford Scholarship, Chapter 5 Cash Management
99 Managing the Cash Conversion Cycle to reduce liquidity risk • Collect receivables in the shortest time possible. This may include offering
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- Spring '18
- risk principles