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Risk Management Experiences in UK Non-financial Firms

(LLCT) - Throughout the development of UK financial market, a variety of measure have been used by UK firms to identify, control and manage financial risks. Using derivatives in risk management has proved its effectiveness thus has long and widely applied. This article attempts to demonstrate the influence of corporate size, industry sector and leverage ratio on using derivatives to limit the exposures in interest rate, foreign exchange rate and commodity price.

Research has found significant roles of firm size and industry sector, and less important impact of leverage ratio in the likelihood to manage risk, the choice of derivative instrument and the number of different commodity derivatives. Larger companies have more likelihood to sustain foreign exchange rate and commodity price risk, to enter interest rate and commodity derivatives, to hold more various commodity derivative instruments, and enhance the use of some specific derivative contracts. Using derivatives to limit risks is only common in some industries, Real Estate companies in general and for interest rate derivatives, Consumer Goods derivatives for currency risk and Consumer Services firms for commodity derivatives.  Energy industry uses all types of financial derivatives to limit volatilities in interest rate, foreign exchange rate, and commodity price. Leverage ratio encourages nonfinancial firms to enter interest rate hedging instrument and encourages the use of foreign exchange derivatives and cross currency swap contracts but only until leverage ratio is 75%.

1. Types of market risks

In nonfinancial firms, market risks usually are made up of unpredictable volatilities in foreign exchange rate, interest rate, and commodity price. 

Foreign exchange risk

Foreign exchange risk or currency risk means the unexpected volatility in exchange rate between two different currencies. It usually occurs in foreign trade deals or transactions related to foreign factors. The more foreign transactions rises, the more currency risks appear. In accordance with quarterly reports of the Bank of England, UK always stands as the largest foreign exchange market in the world with 31% global returns in 2001, 31.3% in 2004, and 34.1% in 2007. There also exists an obvious tendency that foreign exchange risk attacks an increasing number of non-financial companies in the UK. Hence, it is predictable that UK companies must face a large amount of currency risks. Among main types of market risk, the volatility in foreign exchange rate is the most widely hedged with derivatives.

Interest rate risk

Interest rate risk is defined as volatilities in interest rate of one currency. It can contribute reasonably on changing income or expense of the company. Interest rate risk, hence, rises when companies enter to loans or debt requiring interest rate. In comparison with different interest rate risk management techniques, hedging with derivatives can create more value to firms.

Overall, currency risk and interest rate risk lie in the heart of corporate risk management. For that reason, companies enter derivatives contracts mostly to manage these two types of risk, however, there are little more currency derivatives than interest rate derivatives in non-financial firms. These types of derivatives are getting more and more common in the UK with a high speed. For six years from 2001 to 2007, the daily revenue of UK over-the-counter currency and interest rate derivatives grew nearly four times ($1081 billion in 2007 and $275 billion in 2001). Contributing to this growth must include the use of derivatives in corporate risk management.

Commodity price risk

Commodities are composed of wheat, oil, diesel, metals, cocoa, coffee, cotton, etc.. Commodity price risks include unexpected fluctuations in commodity prices. Therefore, only companies which use or produce commodities have demand for commodity hedging instruments. Depending on nature of business, some companies expose to commodity price risk, the others do not. In practice, commodity prices are more unstable than interest rate and foreign exchange rate; however, commodity price exposure is less significant than interest rate exposure and currency exposure. Therefore, very few companies enter commodity derivatives contracts. In spite of limited hedges, there is an upward tendency to use commodity derivatives in UK corporations.

Managing risk with derivatives is very common all over the world. In accordance with the most recent survey of the world’s 500 largest companies in 2008, the International Swaps Dealers Association (ISDA) found that 94.2% of the firms reported making some use of derivatives. Of the users of derivatives, 88% reported using derivatives to manage foreign exchange risk, 83% reported using derivatives to manage interest rate risk, and 49% reported using derivatives to manage commodity price risk.(ISDA, 2009)

2. Possible reasons for managing risk with derivatives

A large number of previous studies pointed out that the decision to enter derivatives contract is characterized by several possible factors characterizing of firms, three most common of them are size, industry sector, and leverage ratio.   Firm size

The firm size is a widely expected reason for exposures and using derivatives in risk management. By regression analysis, (Azlan Amranet al., 2009), proved that risk disclosure increased with size of company.  However, the influence of firm size on hedging risks with derivatives, in the same or opposite direction, has not yet been settled.

Employing a comparative analysis between two surveys in the US and Germany, discovered a positive relationship between the size of company and its use of derivatives for reducing risks. Conducting some econometrics tests of the UK companies, also confirms that the firm’s probability of hedging with derivatives increases with its size. This positive influence of company size is also concluded in many other studies. Going more detailed, Adedeji and Baker, 2002determined that company size also encourage UK non-financial firms to use interest rate derivatives and currency derivatives. Furthermore, the larger the firm, the more complex derivatives are used. A possible reason for this positive relationship is that larger companies have more significant information and transaction cost. (Nanceet al., 1993)

On the other hand, using Wilcoxon rank sum test found that smaller firms have more motivations to hedge risk than larger ones. This outcome supports the suggestion that small firms must hedge a lot because of their greater information asymmetric issue. A research of US nonfinancial firms in 2000 and 2002 (Covitz and Sharpe, 2005), by regression analysis, further found that the interest rate exposure and the use of interest rate derivatives decrease in larger companies.

In general, whether indicating positive or negative relationship the result indicates, previous studies all proved a significant influence of company size on derivative use in non-financial firms.

Industry sector

In addition to the effect of size, a survey in New Zealand by Prevostet al., 2000demonstrates a significant influence of industry sector on firm’s derivatives usage. The most-hedged companies belong to Utilities and Communication industries, then Energy and Chemicals. Also pointing out the influence of industry sector, however, Bodnar and Gebhardt, 1998proved that derivatives were less employed to hedge in the Construction, Consumer Goods Retail, and Utilities industry than in the Chemical, Electro, Machinery, or Metals industry. Going deeper, a research on Malaysian companies displays the evidence that only firms in a small number of industry sectors are the main hedger of foreign exchange risk and interest rate risk with derivatives. They are Plantation, Industrial product, Trading Services, and Consumer Products manufacturing sectors. A non-survey research of 443 UK non-financial firms finds that Real Estate firms try to prevent solely interest rate risk, the Industry firms mainly hedge against currency risk, High Technology companies tends to reduce both of these risks. Commodity derivatives usage, whereas, is concentrated in utilities (83%) and basic materials companies (79%).  emphasized the influence of industry factor on corporations’ applying commodity derivatives rather than interest rate and currency derivatives.

Financial leverage

As using externally sourced finance is more expensive than internal funds, companies should consider risk hedges. Using both survey data and annual reports of 441 UK non-financial firms, indicate two most important factors in hedging with derivatives: leverage level and the scale of economy whereas leverage level is the most significant reason for derivatives and level of hedging, on the basis of a non-survey research of New Zealand corporations, also find that the level of firm’s using derivatives increases with its leverage and size. Based on 169 US firms, shows that the high level of hedging is associated with high geared companies. Both an univariate test and an multiunivariate test discover a higher average leverage ratio in hedgers than in non-hedgers. However, the risk management incentive only increases with leverage ratio until an extreme level then turn to decrease. Moreover, using econometrics approach with explanatory variables including size and leverage, research reject effect of leverage ratio.

Investigating the risk management disclosure practices in UK nonfinancial firms for the year 2008 with dataset include the most recent annual reports of 145 UK companies, several conclusions can be seen as follows:

Firstly, 76.55% of UK non-financial firms limiting their exposures with financial derivatives.  All of UK firms expose the most to interest rate risk, nearly all of them must sustain foreign exchange risk and less than 30% of UK firms are sensitive with commodity price risk. However, companies have the most likelihood to enter foreign exchange derivatives. Among types of derivative, forwards is the most widely used in general, and to hedge currency risk and commodity risk in particular. Swaps contract is the most common for limiting interest rate risk. In spite of being the least common and the least hedged with derivatives in the UK, it is usually limited with several derivative instruments.

Secondly, Firm size has significant impacts on financial price risk and corporate risk management in the UK. It increases the likelihood of UK firms to expose foreign exchange rate and commodity price and encourages them to enter interest rate and commodity derivatives. Moreover, firm size also enhances the use of financial derivatives including interest rate swaps, FRAs, all currency derivative instruments, and cross-currency interest rate swaps.  In addition, the bigger UK firms are, the more variety of commodity derivative instruments they likely hold.

Thirdly, managing risks with derivatives is only common in a limited number of industry sectors. Real Estate companies has the most possibility entering derivatives to hedge market risk in general and interest rate risk in particular. The highest proportion of Consumer Goods and Consumer Services industries hold derivatives manage currency risk and commodity risk, correspondingly. Energy industry uses all types of financial derivatives to limit volatilities in interest rate, foreign exchange rate, and commodity price. Technology companies the least likely enter derivatives.

Finally, everage ratio plays a less significant role than the two factors above on determining the use of derivatives as risk management instrument. The more debt can encourage nonfinancial firms to enter interest rate hedging instrument and cross currency swap contracts. Leverage level also enhances the use of foreign exchange derivatives and cross currency swap contracts but only until leverage ratio is 75%.

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References:

1.  EL-MASRY, A. A. (2006) Derivatives use and risk management practices by UK nonfinancial companies. Managerial Finance, 32 (2), 137-59.

2. FROOT, K. A., SCHARFSTEIN, D. S. & STEIN, J. C. (1993) Risk Management: Coordinating Corporate Investment and Financing Policies. Journal of Finance, 48 (5), 1629-58.

3. GUAY, W. & KOTHARI, S. P. (2003) How much do firms hedge with derivatives? Journal of Financial Economics, 70 423-61.

4. HELLIAR, C., DUNNE, T. & MOIR, L. (2004) Derivatives reporting in the UK: A treasury perspective on the introduction of FRS 13. Journal of Applied Accounting Research 7(2), 134-80.

5. HU, C. & WANG, P. (2005) The Determinants of Foreign Currency Hedging - Evidence from Hong Kong Non-Financial Firms. Asia-Pacific Financial Markets, 12 (1), 91-107.

6. JOSEPH, N. L. (2000) The choice of hedging techniques and the characteristics of UK industrial firms. Journal of Multinational Financial Management, 10 (2), 161-84.

7. LINSLEY, P. M. & SHRIVES, P. J. (2006) Risk reporting: a study of risk disclosures in the annual reports of UK companies. The British Accounting Review, 38 (4), 387-404.

8.  NANCE, D. R., SMITH, C. W. & SMITHSON, C. W. (1993) On the Determinants of Corporate Hedging. Journal of Finance, 48 (1), 267-84.

9. PURNANANDAM, A. (2007) Financial distress and corporate risk management: Theory and evidence. Journal of Financial Economics, 87 706-39.

 

MA. Pham Thi Kim Thanh

People's Committee of Hoang Mai District

 

 

 

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