Understanding corporate finance: derivative contracts: using derivatives to manage risk
Ways in which companies manage risk
Companies face many types of risk, such as the possibility of being sued by customers, or the threat of disasters such as fire, earthquake or terrorist action. Some risks are specific to particular businesses. For example, animal diseases such as foot and mouth represent a particular risk to livestock producers and to industries which process animal products.
Businesses will normally take steps to minimise such risks by good legal and commercial practices, having clear disaster recovery plans, and taking out insurance. Many will have defined strategies for evaluating and reducing risk across the whole range of their activities, including production, sales, administration, capital expenditure and investment.
All businesses face financial risk - the possibility that a business may be exposed to monetary loss. The most common types of financial risk include:
- Interest rate risk (CFM13280) - the risk (for a borrower) that market interest rates may rise or (for a lender or investor) that they may fall.
- Credit risk (CFM13360) - the risk that a customer may default, or that the business will be adversely affected by, for example, the bankruptcy of a supplier.
- Foreign exchange risk (CFM13390) - any business which buys or sells in one or more foreign currencies, or has foreign currency denominated investments, is potentially vulnerable to adverse exchange movements.
Particular types of business may also be exposed to:
- Commodity risk (CFM13440); A manufacturer will be adversely affected by a rise in the price of raw materials. Prevailing commodity prices may also affect how much he can charge for the finished product. Conversely, a primary producer such as a farming, forestry or mining company will be hit if the market price of its product falls. Similarly, enterprises which produce oil products, gas or electricity will be adversely affected if energy costs fall, while major consumers are at risk from rises in energy costs.
- Investment risk (CFM13450); A business with surplus capital is likely to secure a higher return by setting up a managed investment portfolio than by simply depositing the money in a bank account, but it also runs a higher risk of financial loss. And, of course, a company or fund whose major activity is the making of investments, such as an insurance company or pension fund, may suffer serious losses if the stock market falls.