TOPIC 4

EVALUATION OF
FINANCIAL RISK
GROUP 4
 Our Team

LIM WIN LIANG CHONG YONG QI MANDY OWI MEI CHING

D20201092436 D20201092512 D20201092438

LEONG KA YEE CHENG CHING CHING ENG YU JIA

D20201092491 D20201092453 D20201092481
 WHAT IS
FINANCIAL RISK?
 FINANCIAL RISK

Financial risk is the uncertainty arising due to the use of debt

finance in the capital structure of the company.

Financial risk indicate the ability of the firm to pay off the debt it
has taken from the bank or the financial institution.
 5 types of financial risk…

1 FOREIGN EXCHANGE RISK

2 INTEREST RATE RISK 3 CREDIT RISK

4 GEARING RISK 5 CASH FLOW RISK

 1. Foreign Exchange Risk

The risk of an investment’s value changing due to

changes in currency exchange rates.
 Foreign Exchange Risk

Transaction Economic Translation

Risk Risk Risk
 a. Transaction Risk

The risk of an exchange rate changing between the

transaction date and the subsequent settlement date.

Now 12 months

Agree deal Pay/receive

foreign currency
 Example
Now: 27/3/2022 12 months later: 27/3/2023

Agree deal Pay/receive

foreign currency
A M’sia company agrees to buy some 12 months later, the MYR has
equipment in 12 months for 100,000 SGD. weakened against the SGD.
Current exchange rate is: Exchange rate is now:
1 MYR = 0.3226 SGD 1 MYR = 0.3010 SGD

Cost if settle today: Cost when pay after 1 year:

100,000 SGD/0.3226 = RM 309,981.40 100,000 SGD/0.3010 = RM 332,225.91
 Example
Now: 27/3/2022 12 months later: 27/3/2023

Agree deal Pay/receive

foreign currency
A M’sia company agrees to buy some 12 months later, the MYR has
equipment in 12 months for 100,000 SGD. weakened against the SGD.
Current exchange rate is: Exchange rate is now:
1 MYR = 0.3226 SGD Different: 1 MYR = 0.3010 SGD

Cost if settle today:

Loss of Cost when pay after 1 year:
100,000 SGD/0.3226 = RM 309,981.40 RM 22,244.51 100,000 SGD/0.3010 = RM 332,225.91
 Mitigations for Transaction Risk

Operational Techniques
Invoice in home currency
★ Insist foreign customers pay in our home currency and our
company pays the suppliers in our home currency.
★ It is an unrealistic approach as the risk has just been passed onto
the customer.
★ A risk of loss of customer if they unhappy with our strategy.
 Mitigations for Transaction Risk

Operational Techniques
Leading and Lagging (Speed up/Slow down settlement)
★ Importers may attempt to delay payment if they expect the
currency in which they are due to depreciate.
★ If an exporter expects the currency it owes will weaken in the next
three months, it may try to obtain payment immediately.
★ The problem is that the firm has to guess which way the exchange
rate will move.
 Mitigations for Transaction Risk

Operational Techniques
Matching inflows and outflows in the foreign currency
★ When a company has receipts and payments in the same foreign
currency due at the same time, it can simply match them against
each other.
★ Firm only need to deal on the foreign exchange markets for the
unmatched portion of the total transactions.
 Mitigations for Transaction Risk

Financial Techniques
Forward Contracts
★ A customized contract between two parties to buy or sell asset at
today’s pre-agreed price on a specified future date.
★ Entering forward contract which fix the rate in advance will
eliminates the chances of suffering due to currency fluctuations.
 Mitigations for Transaction Risk

Financial Techniques

Future Contracts
★ A transferable, standardized agreement traded on a regulated
exchange, allows buyers and sellers to buy and sell an underlying
asset at some date in future at a predetermined rate.
 Mitigations for Transaction Risk

Financial Techniques
Options
★ Give the holder a right, no obligation to exercise his right to buy or sell
asset at a specific rate in the future.

Money Market Hedge

★ The basic idea is to avoid future exchange rate uncertainty by making
the exchange at today’s spot rate instead.
★ This is achieved by depositing/borrowing the foreign currency until the
actual commercial transaction cash flows occur.
 b. Economic Risk

The risk which is caused by the effect of unexpected

currency fluctuations on a company’s future cash flow
and market value and is long-term in nature.

★ Risk that a company’s cash flow, foreign investments, and earnings may
suffer as a result of fluctuating foreign currency exchange rates.
★ Even if the company does not operate overseas or export goods, the
impact of this risk is inevitable.
 Example
Now: 27/3/2022 12 months later: 27/3/2023

A M’sia company acquires inventories from a
US supplier for $ 1,300 per unit. These are
then to be sold in M’sia for an agreed price of
RM 7,500 per unit.
Current exchange rate is: $1 USD = RM4.2107
A M’sia company acquires inventories from a
US supplier for $ 1,300 per unit. These are
then to be sold in M’sia for an agreed price of
RM 7,500 per unit.
Current exchange rate is: $1 USD = RM4.4219

Cost of goods is $ 1,300 x 4.2107 = RM 5,473.91 Cost of goods is $ 1,300 x 4.4219 = RM 5,748.47

Profit is RM 7,500 - RM 5,473.91 = RM 2,026.09 Profit is RM 7,500 - RM 5,748.47 = RM 1,751.53

 Example
Now: 27/3/2022
A M’sia company acquires inventories from a
US supplier for $ 1,300 per unit. These are
then to be sold in M’sia for an agreed price of
RM 7,500 per unit.
Current exchange rate is: $1 USD = RM4.2107
Cost of goods is $ 1,300 x 4.2107 = RM 5,473.91
Profit is RM 7,500 - RM 5,473.91 = RM 2,026.09
Different: 12 months later: 27/3/2023
Loss of
RM 274.56
A M’sia company acquires inventories from a
US supplier for $ 1,300 per unit. These are
then to be sold in M’sia for an agreed price of
RM 7,500 per unit.
Current exchange rate is: $1 USD = RM4.4219
Cost of goods is $ 1,300 x 4.4219 = RM 5,748.47
Profit is RM 7,500 - RM 5,748.47 = RM 1,751.53
 Mitigations for Economic Risk

- Unlikely to be able to use traditional hedging techniques

- Companies could diversify the currencies in which they
trade
- Diversification reduces the risks inherent in concentrating
on one or two markets.
 c. Translation Risk

The risk of changes in value of a overseas subsidiary due to

changes in exchange rates.

★ Arise when a company has assets & liabilities, which are denominated
in foreign currencies.
★ Fluctuations in foreign currencies will alter (+/- tive) balance sheet of
company between two reporting periods.
★ Consolidation of group accounts involving foreign subsidiaries and
associations will result in ‘losses’ due to negative currency movements.
 Example
This Y/E : 31/12/2020 Y/E in 1 year: 31/12/2021

A Singapore Subsidiary of M’sia company is A Singapore Subsidiary of M’sia company is

worth 100,000 SGD. still worth 100,000 SGD.

Current exchange rate is: 1 MYR = 0.3050 SGD Current exchange rate is: 1 MYR = 0.3241 SGD

Value of the Singapore subsidiary is Value of the Singapore subsidiary is

RM 327,868.85 RM 308,546.74
 Example
This Y/E : 31/12/2020 Y/E in 1 year: 31/12/2021

A Singapore Subsidiary of M’sia company is A Singapore Subsidiary of M’sia company is

worth 100,000 SGD. still worth 100,000 SGD.

Current exchange rate is: 1 MYR = 0.3050 SGD Current exchange rate is: 1 MYR = 0.3241 SGD

Value of the Singapore subsidiary is Different: Value of the Singapore subsidiary is

RM 327,868.85 RM 308,546.74
RM 19,322.11
 Mitigations for Translation Risk

- This is an accounting risk rather than a cash-based one.

- Therefore, most companies would not look to hedge
translation risk.
- Balance sheet hedging creates an offsetting exposure with a
balance sheet hedge account to mitigate currency gains and
losses generated from a foreign currency exposure.
 2. Interest Rate Risk (IRR)

- The risk that an investment will lose value based on a charge

in interest rate.
- Interest rate and value of an investment are in negative
relationship.
- IRR come from repricing risk, yield curve risk, basis risk and
optionality.
 2. Interest Rate Risk (IRR)
Method to measure IRR (1)
★ Gap Analysis
This is a tool used by credit unions to analyse the
match between rate sensitive assets (RSA) and the
rate sensitive liabilities (RSL)
★ Duration Model
This model is used to measure the percentage
changes in the economic value of a position that
occurs when the interest rate level
changes slightly.
For example, Bank ABC has $150
million in interest rate sensitive
assets (such as loans) and $100
million in interest-rate sensitive
liabilities (such as savings accounts
and certificates of deposit). The
gap ratio is 1.5, or $150 million
divided by $100 million.
For example, if a bond has a
duration of 5 years, and interest
rates increase by 1%, the bond's
price will decline by
approximately 5%. Conversely, if a
bond has a duration of 5 years
and interest rates fall by 1%, the
bond's price will increase by
approximately 5%.
 2. Interest Rate Risk (IRR)
★
Method
Rate Shift Scenarios
to measure IRR (2)
This analysis is used to show the changes in earnings and value expected under different
rate scenarios.
As an example, let us consider a bank with $90 million in savings accounts and $100 million in fixed-rate mortgages.
# Assume that the current interbank rate is 5%, the savings accounts pay 2%, and the mortgages pay 10%.
# The expected net income over the next year is $8.2 million:
# Interest Income = 10% x $100M - 2% x $90M = $8.2M

#If interbank rates move up by 1 %, assume that savings customers will expect to be paid an extra 25 basis points, and 10% of
them will move from savings accounts to money-market accounts paying 5%.
# Nothing will happen to the mortgages.
# In this case the expected income falls slightly to $7.5 million:
# Interest Income = 10% x $100M - 2.25% x $81M - 5% x $9M = $7.5M

#Now assume that interbank rates fall by 1%.

# Savings customers are expected to be satisfied with 25 basis points less, but 10% of the mortgages are expected to prepay
and refinance at 9%.
# The expected income in these circumstances is $8.3 million:
# Interest Income = 10% x $90M + 9% x $10M - 1.75% x $90M = $8.3M
 2. Interest Rate Risk (IRR)
Method to measure IRR (3)
★ Simulation Methods
This is to test the non-linear effect with many complex rate scenarios and obtain
a probabilistic measure of the economic capital to be held against asset and
liability management (ALM) interest-rate risk.
 2. Interest Rate Risk (IRR)
Derivatives to manage IRR (1)
★ Financial Futures Contract
A commitment between a buyer and a seller on the quantity of standardized
financial asset or index.

★ Forward Rate Agreements

A forward contract based on interest rates depend on notional principal amount
at a specified future date.
 2. Interest Rate Risk (IRR)
Derivatives to manage IRR (2)
★ Interest Rate Swaps
Agreement between two parties to exchange a series of cash flows based on a
specified notional principal amount.

★ Options Contract
Give the holder a right, no obligation to exercise his right to buy or sell asset at
a specific rate in the future.
 3. Credit Risk

1 What Is Credit Risk?

★ Also known as default risk.
★ Possibility that a contractual party will fail to meet its obligations under
the agreed terms.
★ Refers to the probability of a loss resulting from a borrower’s failure to
repay a loan or meet contractual obligations.
★ Higher credit risk reflect higher interest rate and borrowing costs.
 3. Credit Risk

2 Evaluation of Credit Risk

1. FICO Credit Score (credit rating)
★ A number from 300 to 850 that rates a consumer’s
credit-worthiness
★ Based on credit history (number of open accounts, total levels of
debt, repayment history)
★ The higher the credit score, the less risky of the borrower
 3. Credit Risk

2 Evaluation of Credit Risk

Exceptional: 800 - 850
Very Good: 740 - 799
Good: 670 - 739
Fair: 580 - 669
Poor: 300 - 579
 3. Credit Risk

2 Evaluation of Credit Risk

2. Credit Risk Analysis
★ A form of analysis performed by a credit analyst on potential
borrowers to determine their ability to meet debt obligations.
★ Purpose: to determine the creditworthiness of potential borrowers
and their ability to honour their debt obligations
★ Function: helps the lender determine the borrower’s ability to
meet debt obligations in order to cushion itself from loss of cash
flows and reduce the severity of losses
 3. Credit Risk

2 Evaluation of Credit Risk

Documents that reveal

financial position of the
borrower:
● Borrower’s income
statements
● Balance sheet
● Credit reports
 3. Credit Risk

3 How to Mitigate Credit Risk

★ Self-Insurance
- Companies will create a bad-debt reserve that they tap into if a
customer is unable to make payment.
★ Letter of credit (documentary credits)
- Customer will approach their bank and ask for an agreement which
guarantees the creditor (the company) will receive payment in full by
the due date.
 3. Credit Risk

3 How to Mitigate Credit Risk

★ Trade credit insurance
- If a customer will not pay, the policyholder can submit a claim and be
reimbursed by the trade credit insurer.
★ Account receivables factoring
- Sells account receivable to a factoring company at a discounted rate to
receives immediate cash.
 4. Gearing Risk

1 What Is Gearing?
★ Also known as company’s financial leverage
★ It refers to the proportion of a company's operations that are funded by
its creditors rather than its shareholders.
★ It is the total amount of debt used to fund operations by a corporation
in relation to its equity capital.
★ When a company has a high ratio of debt to equity, people can refer to
such company as being highly geared, which is highly leveraged that
might indicate the risk of financial failure.
 4. Gearing Risk

2 Function of Gearing
★ Uses of gearing
a) The Creditor/Lenders
- To determine whether to extend credit or not and the creditor’s
ability to repay a loan.
b) The Investor
- To determine whether a business is a viable investment.
- Companies with a strong balance sheet and low gearing ratios
more easily attract investors.
 4. Gearing Risk

3 Degree of Gearing
★ The degree of gearing is divided into:
a) Highly geared
- The company unable to pay off debts quickly and investors
consider it a high-risk company.
b) Lowly geared
- The company able to pay off debts more quickly and investors
consider it a low-risk company.
 4. Gearing Risk

4 Evaluation of Gearing

● A gearing ratio higher than 50% is typically considered highly levered

or geared.
● A gearing ratio lower than 25% is typically considered low-risk by both
investors and creditors.
● A gearing ratio between 25% and 50% is typically considered optimal
or normal for well-established companies.
 4. Gearing Risk

4 Evaluation of Gearing Risk

★ Example:
A company wants to find out if they’re highly geared or not. They

have RM300 million of debt and have just over RM5 million in

shareholder equity. Ultimately, this would mean that they have a

gearing ratio of 60%,.

 4. Gearing Risk

5 How to Mitigate Gearing Risk

★ Issue Shares
- The Board of Directors could authorize the sale of shares in the
company, which could be used to pay down debt.
★ Convert loans
- Negotiate with lenders to swap existing debt for shares in the
company.
 4. Gearing Risk

5 How to Mitigate Gearing Risk

★ Reduce working capital
- Increase the speed of account receivables collections, reduce inventory
levels, increasing the days required to pay account payable or any of which
produces cash that can be used to pay down debt.
★ Increase Profits
- This can be achieved by raising prices, increasing sales, or reducing costs.
The extra cash generated can then be used to pay off existing debts.
 Cash Flow Risk

- Potential danger of falling short in cash due to cash flow

management practices.
- Hence, the lower the cash flow risk indicating that the company is
optimizing its working capital
 Definition of Cash Flow

Cash Flow is a report on a Financial Reporting Standard 107

business entity’s major requires a business entity to
cash inflows and outflows prepare on its cash generation
for a period. and absorption.
 Purpose of Cash Flow

Show your liquidity Changes in assets, Predict future

liabilities and equity cash flows
 Components of Cash Flow

❖ Operating ❖ Financial
activities 1 2 activities
Cash activities related Cash activities related to
to net income. non-current liabilities and
owners’ equity.
3
❖ Investing
Activities
Cash spend or received from
investments.
 Common Cash Metric

Net Present Value (NPV) Internal Rate of Return (IRR)

A tool of capital budgeting to analyze the It is the discount rate that makes
profitability of a project or investment. the net present value of all cash
It is calculated by taking the difference flows (both positive and negative)
between the present value of cash inflows equal to zero for a specific project
and present value of cash outflows over a or investment.
period of time. NPV a
IRR = a + X(b-a)
cash flow NPV a - NPV b
NPV= - initial investment
t
(1+i) Where:
Where:
a = lower cost of capital percentage
i=Required rate of return or discount rate
b=higher cost of capital percentage
t=Number of time periods
 Effective Cash Flow Risk Management
★ Cash Flow at Risk (CFaR)
To measure of how changes in
market variables can cause
future cash flows to fall short of
expectations.
★ Liquidity Risk
To measure how well an
organization can cover its
short-term financial
obligations.
★ Value at Risk (VaR)
To measure in the reporting of
information on the risks of the
company, risk-adjusted returns
that permit the use of resources
within the company to determine
the position and performance
measurement.
 Improving Cash Flow Risk Management
➢ Planning
- Make a list of all potential risks your business may face and create recovery plans.
- Implement Miller-Orr Model (set lower and upper limits of cash balance)

1
➢ Invest in Automation
➢ Cash Flow Forecast
and AI
Reduce all your financial risks, 4 2 Being organized and knowing who you
including cash flow risk, begins with have to pay and when will mitigate the
total transparency into, and control over, cash flow risk.
your company financial activity. 3
➢ Conduct Market Research
Determining the target audience’s characteristics
help reduce the cash flow risk.
 Conclusion
Financial risk indicates the ability of the firm to pay off the debt it has taken from
the bank or the financial institution.

5 Types of Financial Risk

❏ Foreign Exchange Risk
❏ Interest Rate Risk
❏ Credit Risk
❏ Gearing Risk
❏ Cash Flow Risk

Financial risk management has to be conducted in order to mitigate the financial

risk and ensure the company is able to fulfill its obligations by paying off the debt.
THANK YOU