Prices of goods and services now days and in the past
have become volatile. One needs to look back at the oil crisis and its
implications on GDP in many economies of the world to understand that sudden or
unexpected shifts in operating activities resulting from economic shocks will
disrupt operating activities of firms.
In this article I will try to bring out the idea of
financial risk management which is very interesting, goes back many years back,
and is part of modern finance. If a company contemplates on reducing risk
exposure or protect itself from price fluctuations is called hedging. Risk
management in corporations involves buying and selling derivative securities. A
derivative security is a financial asset that represents a claim to another
financial asset. For example, a stock option gives one the right to buy or sell
a stock, therefore, a stock option is a derivative security
Price volatility has a historical perspective and it
is useful to look back and see volatility in oil prices, for example, as I
did here for crude oil prices dating back to 1861 to 2009. One observes the
peaks, especially after 1920. In 1929 during the US depression, GDP dropped 30%
and unemployment skyrocketed to 25%.
If we look the decades of the 70’s we see another peak
and it was during 1972 that President Richard Nixon imposed a price and wage
control to control inflation. He lifted
the ban a year later only to see the prices go up again. This was an example
of a cost push inflation, where an immediate jump in raw material prices drove
up production costs, and shift the supply curve inward to the left. We see that
Aggregate supply shifts from AS to AS2, prices increase and output drops.
Among the various volatility firms face are interest
rate risk, exchange rate risk, and commodity prices. As far as interest rate
risk, debt is an important source of financing for corporations and an
important component of the firm’s cost of capital. In the graph I found from Google, we see the federal reserve interest rates from 1950 to 2010, versus the
home price index.
An interest point here is the home price index between 2005
and 2010, how it has jumped particularly close to the home mortgage crisis in
the US. We see the various peaks in the
FED interest rates how they vary , so these peaks are what firms are
encountering. If the FED raises its overnight lending cost to member banks,
then it would shrink the supply of credit, and banks in turn, would raise
interest rates or reduce lending to companies. My point here is that this
volatility has limited the confidence of prediction of a stable interest rate
environment for companies.
Companies are in international operations and in the
business of imports and exports. Exchange rate volatility have become
increasingly important. An interesting story here that explains this increased
volatility is the breakdown of the Breton Woods accord, where the exchange
rates were partially fixed. Partially fixed exchange rates were allowed to
adjust to reflect changes in the currency values. This was known as adjusting
the peg. In 1971 the Nixon administration abandoned the dollar standard and Breton Woods, which meant that the dollar would no longer be redeemable for
gold. Under the Breton Woods, exchange rates were stable for the most part, so
importers and exporters could predict with certainty what these rates would be
in the future. Today, exchange rates are determined by market forces, and thus,
unpredictable.
As far as commodity prices as we mentioned above, oil
is one of the most important and responsible for many economic recessions.
Hence volatility has increased. This nice graph shows a historical diagram with
oil and its impact on inflation.
Besides these
risks we have financial risks, with the two most recent ones in the USA, the
Savings and Loans, where the US government came to rescue of these thrift
institutions so that it can preserve the confidence in the US banking system.
Before interest rates became volatile, these banks profited from the spread.
That is, short term interest rates were lower than long term. So they borrowed
short and lend long. The second was due to the mortgage loans, where banks
essentially loaned low - income people to purchase a home, but they were not
capable of paying off the mortgage.
In the upcoming second part we will discuss how to
manage financial risk.
