FINANCIAL RISK MANAGEMENT

Financial risk management is the practice of creating economic value in a firm by using financial
instruments to manage exposure to risk, particularly credit risk and market risk. Other types include
Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk
management, financial risk management requires identifying its sources, measuring it, and plans to
address them.
Financial risk management can be qualitative and quantitative. As a specialization of risk management,
financial risk management focuses on when and how to hedge using financial instruments to manage
costly exposures to risk.

Issues in financial risk management

Financial assets represent claims to ownership/cash/income as in the case of share
certificates, or debt instruments like bonds, term finance certificates (TFCs) and government
securities. The evidence of ownership or creditor ship is now increasingly available only as
an electronic entry to an account on a computer system.
People are generally said to be risk averse. But is it possible to find an investment which is
completely free from risk? The answer is a firm no! Why? Because a completely risk free
investment would be one which would repay at a future date, an amount equivalent in
purchasing power to that represented by the amount originally invested. For this to happen,
two necessary conditions should be complied:
(i) The promised amount is actually paid i.e. there is no chance of default; (ii).an additional
amount is also paid, if required, to compensate for decline in purchasing power, measured in
terms of the price index of the consumption basket of the investor.
When the issuer of security is a sovereign government empowered to print currency,
condition No (i) can usually be met but no issuer of a security would perhaps ever be able to
offer anything close to what condition No. (ii) represents. Investment options and risks:
Individual investors have the following investment options available: short to medium-term
and long-term government securities; various short to long-term deposit schemes, COIs etc
offered by commercial banks and non-banking financial institutions (NBFI`s); stock market
shares; long and short-term finance certificates; real estate; gold, silver and precious stones
and foreign currencies.
How can an investor minimise the investment risk? The main option currently appears to be
diversification of investments because hedging devices like derivatives are not available in
our markets. Moreover, derivatives like options and futures are considered to be un-Islamic.
Diversification however, is not very effective in the case of small investors with limited funds.
Thus the need to be satisfied with a relatively low return by investing a certain percentage
(depending on their appetite for risk) of their funds in low risk government securities.

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Institutional investors can do the same and generally their average return on investment
should be higher than that of the individual investors, given their greater ability to take risk.
In the short run, diversification appears to be the main risk minimisation tool, with an
important income smoothening role being played by the government securities. How ever, in
the long run, effective regulatory intervention to minimise the manipulation component of the
risk would be the key, followed by development of debt instruments conforming to the
Shariah. Secondary market for debt instruments:
Presently about 685 companies are listed on the Karachi Stock Exchange. However, the
secondary market for shares is far more developed than the market for debt instruments,
with less than five per cent of listed companies currently having debt securities listed on the
Karachi Stock Exchange. The listed debt securities are term finance certificates (TFCs) and
Sukuks (Islamic bonds), which are equivalent to bonds traded worldwide on security
exchanges.
It is pertinent to examine the inhibiting factors for issuance of debt securities by companies.
After all, there can be no secondary debt market development without the primary market
first being firmly in saddle. The matter can be examined both from the prospective holders
(buyers) of TFCs and from the issuers viewpoint. The two main categories of buyers of TFCs
are individual investors and institutional investors. Individual investors belonging to the
segment of retired salaried employees generally do not have a significant capacity to face the
risk of default. Thus, they have traditionally favoured the National Savings Schemes. The
monthly income scheme and special saving certificates (offering six monthly returns with a
three-year maturity) are popular for providing regular near risk free income. The Defence
Savings
Certificates, with maturities up to ten years give an option for long-term capital appreciation
for people who can afford to set aside some amount for the long term but are not willing to
take the risk of default. The rate of return on these schemes has not been able to keep pace
with the rate of inflation. The government would like to restrict the cost of borrowing.
Realising that the risk taking ability of a majority of individual investor is low, the government
perhaps does not foresee a significant fall in deposits into its saving schemes, despite the
lowering of returns. This has really hit the individual investor hard, particularly the retired
salaried class.
This category of people would be keen to invest at least a portion of their funds in TFCs, if
the promised yield is even 2-3 percentage points more than government schemes. This class
is the least likely to subject, even a part of their life time savings, to the volatility of our stock
exchanges.

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Private limited and public limited companies would also be interested to varying degrees in
picking up TFCs. This is the type of investment, which can serve to smoothen the
fluctuations in a company`s earnings. The extent of interest of any company in such
investments would of course depend upon its cash flow pattern, liquidity and reserves
position, its stage of development i.e. whether it has vertical or horizontal growth
opportunities still available or its products or services are at the maturity stage, the tax
implications of its earnings on TFCs etc.
Apparently, the companies generally would be interested in investing some portion of their
earnings in debt instruments like TFCs and with a higher capacity to take risks as compared
to individual investors. However, they have to be reasonably sure that the secondary market
is sufficiently developed to give them comfort on the liquidity aspect of the investments. This
is important because while the individual investor would also be interested in assured return
and liquidity, the corporate investor would place a much higher premium on liquidity.
For instance, no company having a seasonal requirement of funds, say for purchase of raw
material, would like to be in a situation where it has investments in hand which it cannot
quickly convert into cash at the time of need.
From the TFC issuing company`s viewpoint, the following matters need to be considered:
* Will it be easier to get a loan from the banking system or to issue a TFC?
* Would the effective cost of funds be lower if TFC financing is resorted to rather than going
for a loan from a bank or a consortium of banks?
* Should the company go for rating of their TFC issue? What if it gets a poor rating?
* If the TFC issue is under-subscribed, what implications will it hold for continuance of the
company as a going concern?
* Is the government supportive in promoting the growth of TFCs or is it applying brakes to
restrict their issuance?
During the first six months of 1998, a number TFC issues were under active processing and
the chances of development of secondary markets appeared bright, with the major brokerage
houses gearing themselves to play the role of market makers and reputed foreign banks as
well local DFIs teaming up to underwrite their public issues.
However, the feverish activity going on at that time suddenly came to a grinding halt when
the government decided to withdraw the tax exemption facility on income from TFCs,
previously applicable to corporate TFC investors. Another limiting factor was that for
companies with good standing, who had the opportunity to raise funds through the banking

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system, the TFC option did not entail a significant advantage in terms of the effective
borrowing cost after accounting for the public floatation costs, rating cost, private placement
and underwriting commissions etc. The same would more or less hold true today.
What prompted government`s action which virtually killed the TFCs market? Perhaps the
government apprehended that if the TFCs market developed too fast, the individual investor
might tilt towards it and thereby the government may lose a substantial part of its major
source of public debt i.e. investment in its national savings schemes.
It also appears that the underwriting institutions were unable to generate sufficient public
interest in the TFCs. Perhaps the public also perceived the default risk to be high, given the
history of bank loan defaults. Foreign investment in the TFCs has been virtually absent.
Apparently due to a high degree of perceived sovereign risk of Pakistan, high default risk, as
well as foreign exchange risk of rupee denominated TFCs.
Presently, it seems that the debt securities market would not pick up much until the Sukuk
market picks up momentum. However, an enabling regulatory framework, though necessary,
will not be sufficient to provide a fillip to the debt market. It is also essential that the economy
should pick up and generate requirement for long term debt funds. Risk management
practices
: In order to have an idea about how the brokerage houses play their risk management role,
relative to their own risk and that of their clients, a questionnaire was circulated amongst 26
registered corporate members of the Karachi Stock Exchange. Only nine responses were
received but still they have been helpful in understanding, how the brokerage houses view
risk, the risks they handle and what technologies they employ.
The main operating income of brokerage houses is through commission they earn on
buying/selling on behalf of their clients. Usually they do not buy/sell on their own account but
whenever they do, the earnings or losses would be classified as `other income / (loss)`. In
other words, exposing their own funds to stock market risk is not the usual operating activity
of the brokerage houses
Risk management by brokerage houses can be divided into the following main parts:
* Default risk i.e. the risk that a client fails to settle payment against a transaction undertaken
by the brokerage house on its behalf, on the backing of a margin account
* Investment risk of clients
Discussions with brokerage house executives reveal that brokerage houses do not generally
ask for margin deposits from institutional clients, as chances of default are not considered

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significant. However, in the case of small clients or individuals, brokerage houses do operate
on margins.
Based on the judgment of risk involved, such clients are required to maintain a minimum
margin, with the brokerage house. This normally ranges between 2530 per cent of the
amount of total exposure taken by the brokerage house, on behalf of a client. In effect the
margin percentage reflects the brokerage houses` assessment of the maximum price erosion
during the normal settlement period of one week. Should default occur, the brokerage house
has the option to sell the shares at the reduced market price and use the margin to cover its
loss.
In the case of investment risk of its client, the risk has to be borne entirely by the clients
because it is their funds which have been invested. However, as investment advisors, it is the
moral and professional obligation of brokerage houses to give the best possible advice and
help manage the clients` risk. Thus, although the brokerage house is not directly exposed to
investment risk, it faces the risk of losing reputation and clients, should its advice turn out to
be wrong too often. From the responses received to the questionnaire circulated amongst
brokerage houses, it is gathered that a majority of them are using sophisticated customised
computer software. Only one out of nine respondents has indicated that they do not use any
computer software for risk management purposes. Computer software is used both for
monitoring the margin maintenance of clients and for undertaking technical/fundamental
analyses of specific companies and sectors.
As for risk minimisation options used by the brokerage houses, it was not at all surprising
that all the respondents believe in diversification and advise their clients to diversify their
investments across companies, as well as across industrial sectors. However, it was
surprising that only one of the respondents has indicated hedging as a tool being used for
minimizing investment risk.
Apparently most of the brokerage houses believe that there are no hedging instruments
currently available in the financial system. Six out of nine respondents say that no hedging
instruments exist. However, three of the respondents regard TFCs as a hedging instrument
from the point of view of capital preservation and providing a minimum stable income
component to a balanced portfolio. These respondents have mentioned one or more out of
following as hedging instruments, besides TFCs: (the use of these instruments remains very
limited, however).
National Saving Certificates, high return deposit accounts, Certificates of Investments (COIs),
foreign currency accounts, treasury bills and Pakistan Investment Bonds (PIBs).

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