23: Introduction to Financial Risk Managementmanagers engaged in risk management, with 71% of respondents indicating that their company faces
significant risks related to interest rate movements.
Interest rate risk is of particular concern to financial companies such as banks that derive their
earnings from the spread between the interest rates they pay to depositors and the interest rates they earn
on loans and investments. In the survey of risk managers, more than 90% of respondents who worked
for financial companies said that interest rate risk represented a material risk for their companies. Even
non-financial companies are exposed to this type of risk. For example, a retailing company that funds
its seasonal build-up of inventories with floating-rate debt will face higher interest expenses if market
rates of interest increase. This is an example of transactions exposure, the risk that a change in prices will
negatively affect the value of a specific transaction or series of transactions.
Interest rate fluctuations can also affect a company’s cash flows in indirect ways. For example,
some companies have revenue streams that are sensitive to changes in interest rates. For example, a
building products manufacturer may experience lower demand when interest rates increase. Even if the
manufacturer has no outstanding debt, and thus does not face higher interest expenses when rates rise,
the increase in rates lowers the company’s cash flows through its effects on the company’s customers.
This is an example of economic exposure, the risk that a change in interest rates (or more broadly, a change
in exchange rates or commodity prices) will have a negative impact on the future cash flows generated by
the company. As we will see later in this chapter, corporations can minimise both their transactions and
their economic exposures to interest rate risk in several ways.
At the same time that currency exchange rates were becoming more volatile, world economies were
becoming more integrated. In recent years, currency exchange rates have remained volatile, and the
pace of global integration has continued to accelerate. This means ever-increasing exposure to foreign
exchange risk, as discussed in Chapter 17. Consider another example of a transactions exposure. A
US-based company with manufacturing operations in Canada denominates the products it sells in
international markets in the buyer’s home currency. Suppose that it books a sale, denominated in euros,
to a buyer in Germany, requiring delivery and payment in three months. If the euro depreciates in value
relative to the Canadian dollar (C$) over the next three months, this company will receive fewer C$
than expected when it converts the euros received in payment into C$ to cover its own production costs.
As another example of economic exposure, if this US manufacturing company faces stiff competition
from a Japanese manufacturer and the value of the yen declines, the Japanese company may be able to
reduce the prices it charges in European markets, thereby hurting demand for the products manufactured
by the US company. Again, the decline in the value of the yen reduces the value of the US company even
though that company has neither expenses nor revenues denominated in yen. Its exposure is not through
a specific transaction, but rather through the broader economic effects of the falling yen.
Commodity price risk is also very important for many companies. Any company that uses a commodity
as a production input is potentially exposed to losses if the price of the commodity increases. Likewise,
the commodity producers are also exposed to the risk that the price of the commodity could decline.
transactions exposure
The risk that a change in
prices will negatively affect
the value of a specific
transaction or series of
transactions
economic exposure
The risk that a change in
interest rates (or more broadly,
a change in exchange rates or
commodity prices) will have a
negative impact on the future
cash flows generated by the
companyDavid Childress, Asset
Liability Manager, Ford
Motor Co.
‘Interest rate risk really
comes down to how
assets and liabilities
on the balance sheet
reprice.’
See the entire interview on
the CourseMate website.Source: Cengage LearningCOURSEMATE
SMART VIDEOA significant source of risk for Hershey Foods
Corporation is the price of cocoa. Cocoa is an
important commodity input for Hershey. If the price
of cocoa increases, Hershey may be able to pass the
increase to consumers by charging higher prices for
Kisses and other confections. However, an increase
in the price of Kisses is bound to hurt the demand
for them. Consider the consequences of not hedging
this risk exposure, especially if competitors such as
Nestlé and Mars do hedge their exposure by lockingexample