Financial Education

Financial risk exposures include market risk, credit risk and liquidity risk.

Market risk relates to interest rates, exchange rates, stock prices and commodity prices. How will changes in these factor affect the portfolio, particularly in the context of asset/liability management?

Credit risk is the loss caused when a debtor or the counterparty in an agreement fails to make a payment. It can be managed using credit derivatives, or simply by using traditional credit analysis techniques in order to screen counterparties.

Liquidity risk is an inability to efficiently buy or sell an asset. It is important to realize that a security’s liquidity can change during the investor’s time horizon. Changes in asset liquidity, particularly when liquidity declines, have an important impact on the overall ability of a portfolio to meet client objectives.

In the Fall/Winter 2006 Journal of Applied Finance, Jiraporn and Ning investigate the relationship between shareholder rights and dividend policy to determine the role of agency costs in dividend policy.

Under the free cash flow theory, higher dividends reduce the cash available to management. This theory suggests that companies with weak shareholder protection will offer lower payouts in order to provide more perks to management. This management opportunism hypothesis suggests a direct relationship between dividends and shareholder rights.

The substitution hypothesis says dividends are a substitute for shareholder rights, and that an inverse relationship exists.

Using the Governance Index as a proxy for shareholder rights, the authors find an inverse relationship between dividends and shareholder rights, supporting the substitution hypothesis that high dividend payments are a method companies use to compensate for having weak shareholder rights.

Enterprise Risk Management is a term used to describe a centralized risk governance process that takes place at the level of senior management. It takes a firm-wide perspective, considering individual risk factors both in isolation and in terms of their interplay with other risk exposures.

An effective risk management system seeks to control exposure to:

• stock market fluctuations, interest rates, exchange rates and commodity prices
• credit and default risk, asset/liability management, operational systems, fraud and other factors

The steps to effective Enterprise Risk Management are to:

1. Identify each risk factor to which the company is exposed
2. Quantify the size of each exposure in money terms
3. Map the inputs into a risk estimation calculation
4. Identify the overall risk exposures and the contribution to overall risk derived from each factor
5. Set up a process for periodic reports to management, who will determine capital allocations, risk limits and risk management policies
6. Monitor compliance with the policies and risk limits

Risk governance is a term for specific processes put in place for the purpose of risk management. Risk governance requires senior management to make choices regarding the governance structure, infrastructure needs, reporting requirements and methodology.

A centralized governance structure has the advantage of economies of scale and allows management to consider whether the risks of various business units offset (diversify) each other.

A decentralized governance structure, by contrast, puts risk management in the hands of those most familiar with the specific risks.

Many firms are now adopting more centralized approaches due to the advantages noted above, and also to have more oversight of the risk management process.

Investment portfolios are subject to a wide range of risks at all time. A significant part of the portfolio management process is a strong risk management process, which should entail the following steps:

1. Identifying the risk exposures faced
2. Establishing appropriate ranges for such exposures
3. Continually measuring each exposure
4. Executing appropriate adjustments whenever a given exposure falls outside the target range

Over time, as more is learned about the various risks it may be necessary to alter the procedures to reflect new policies, preferences and information.

Cheng, Collins and Huang published an article in the September 2006 Review of Quanititative Finance and Accounting that considered the effects of shareholder rights and financial disclosure on the cost of equity capital.

Prior research has shown that the cost of capital is reduced when shareholders have strong rights and the company operates in a transparent manner with full financial disclosure. This article studies interactions between rights and transparency, as well as the resulting impact on cost of capital.

Consistent with prior research, both shareholder rights and transparency individually serve to increase value by reducing the cost of equity capital. Furthermore, the authors find that poor scores on either measure can offset strong scores in the other, and that the greatest benefit is accrued by companies that offer both strong shareholder rights and high financial transparency.