Pros and Cons of Risk Management
1.0 The pros of risk management
Maintaining competitiveness
Adverse changes in interest and exchange rates may reduce the competitive position of a company against those with lower levels of gearing or smaller exchange rate exposures, or compared with companies that have taken the precaution of hedging against rate changes.
Reduction of bankruptcy risk
Adverse movements in interest and exchange rates may jeopardize the continued operation of a company. A classic example is that of a highly geared company with a large proportion of floating rate debt being forced into bankruptcy due to an increase in interest rate.
Restructuring of capital obligations
Interest rate hedging instruments can be used to restructure a company’s capital profile by altering the nature of its interest obligations, thereby avoiding the repayment of existing debt or the issuing of new securities. In consequence, considerable savings can be made in respect of call fees and issue costs. At the same time, a wider range of financial sources becomes available to the company.
Reducing in the volatility of corporate cash flows
Reducing the volatility of net cash flows may increase the market rating of the company and will facilitate the process of forward planning.
2.0 The cons of risk management
The complicated nature of hedging instruments
A combination of unfamiliarity with the range of hedging methods available and a belief by potential users that such methods are complex may result in treasurers choosing not to hedge exchange and interest rate exposures.
The risks associated with using external hedging instruments
The perceived risk associated with in using hedging instruments can sometimes dissuade potential users. Instead of providing protection from steeply increasing interest rates, the transactions turned out to be highly speculative bets.
The complicated tax and financial reporting treatments of derivatives
The accounting and tax
Maintaining competitiveness
Adverse changes in interest and exchange rates may reduce the competitive position of a company against those with lower levels of gearing or smaller exchange rate exposures, or compared with companies that have taken the precaution of hedging against rate changes.
Reduction of bankruptcy risk
Adverse movements in interest and exchange rates may jeopardize the continued operation of a company. A classic example is that of a highly geared company with a large proportion of floating rate debt being forced into bankruptcy due to an increase in interest rate.
Restructuring of capital obligations
Interest rate hedging instruments can be used to restructure a company’s capital profile by altering the nature of its interest obligations, thereby avoiding the repayment of existing debt or the issuing of new securities. In consequence, considerable savings can be made in respect of call fees and issue costs. At the same time, a wider range of financial sources becomes available to the company.
Reducing in the volatility of corporate cash flows
Reducing the volatility of net cash flows may increase the market rating of the company and will facilitate the process of forward planning.
2.0 The cons of risk management
The complicated nature of hedging instruments
A combination of unfamiliarity with the range of hedging methods available and a belief by potential users that such methods are complex may result in treasurers choosing not to hedge exchange and interest rate exposures.
The risks associated with using external hedging instruments
The perceived risk associated with in using hedging instruments can sometimes dissuade potential users. Instead of providing protection from steeply increasing interest rates, the transactions turned out to be highly speculative bets.
The complicated tax and financial reporting treatments of derivatives
The accounting and tax
References: Daniel A. Nuxoll. Internal Risk-Management Models as a Basis Capital Requirements. Denzil Watson and Antony Head. Corporate Finance Principles & Practice. Third edition. UK:Prentice Hall,2004. Exchange Rates and Interest Rate Differentials: Recent Developments Since The Introduction of The Euro. Monthly Report July 2005. Deutsche Bundersbank. Hedging Foreign Exchange Risk with Forwards, Futures, Options and the Gold Dinar: A Comparison Note. The Theft of Nations- Returning to Gold. Interest Rate Risk Management. Examination Manual April 2007. FHFB Office of Supervision. Michael G. Papaioannou, Ph.D. (2006). Exchange Rate Risk Measurement And Management: Issues And Approaches For Firms .International Monetary Fund.South-Eastem Europe Journal of Economics 2, 129-146. Michael Papaioannou. (2006, Nov). Exchange Rate Risk Measurement and Management: Issues and Approaches for Firms. Principles for the Management and Supervision of Interest Rate Risk. (2001, January. Basel Committee on Banking Supervision. Consultative Document. Supporting Document to the New Based Capital Accord Issued for comment by 31 May 2001.