Questions for members

We have developed a set of questions exclusively for our Members to use when trying to identify financial risk.

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The type and extent of an organisation’s exposure to financial risks will depend on the nature of its borrowings and its underlying business. Analysis of the contractual maturity of debt or lending relative to projected net revenues will indicate the timing and amount of mismatch in cash flows and therefore point to any potential interest rate risk. Where some or all of these cash flows are denominated in foreign currencies, a foreign exchange risk will emerge.

The financial risk categories typically managed by a treasury operation include:

Liquidity risk

Liquidity risk is the risk that the entity will not have sufficient funds available to pay creditors and other debts. This includes the risk that loans may not be available when the organisation requires them or they will not be available for the required term or at an acceptable cost. There is also a risk that bank credit lines may be terminated if borrowers breach loan covenants. The organisation may have to keep unused funding sources in reserve for potential outlays such as future debt repayments, capital expenditure, seasonal fluctuations, acquisitions and contingencies. Funding sources may include equity issues (in all forms), debt, supplier finance and leasing.

Funding risk

Funding risk is most often faced by highly rated large-volume borrowers who issue debt securities. These borrowers rely on liquidity of their securities (the degree to which they are readily bought and sold in financial markets) to maintain prices, smooth out price volatility and facilitate future issues. The risk is that for some reason investors may judge the securities to be insufficiently attractive, with the result that prices may fall and access to the market may become difficult.

For small organisations, funding risk exists in the extent to which they can rely on the support of their bankers and shareholders as a substitute for issuing debt securities in the wider market.

Interest rate risk

Interest rate risk is the risk that movements in variable interest rates will affect financial performance by increasing interest expenses or reducing interest income. Changes in market rates of interest may also affect fixed-rate securities where they are marked to market, in which case the capital value of the securities will change.

Management needs to use sensitivity analysis to predict the impact on profit and loss of a given change in interest rates. The substantial effect of volatile interest rates is demonstrated by experiences in the 1990s when variable rates in Australia suddenly increased to nearly 20 per cent and then declined to less than 10 per cent.

Foreign exchange risk

Foreign exchange risk describes the risk of variation in the rate of exchange used to convert foreign currency revenues and expenses and assets or liabilities to Australian dollars.

Foreign exchange exposures are of three types:

  • transaction exposures resulting from normal operational business activities (for example trade purchases and sales, short-term borrowing)
  • translation exposures resulting from conversion of long-term foreign currency assets and liabilities into Australian currency (for example equity investments, capital items)
  • competitive exposures that may result (profitably or otherwise) from adopting a different approach to managing foreign exchange exposures from that taken by the organisation’s competitors.

Where shareholder wealth is denominated in Australian dollars, a rise in the value of the $A relative to another currency has a positive impact for foreign currency liabilities. This will reduce cost on conversion to Australian dollars and have a negative impact on assets that reduce in value expressed in Australian dollars. Conversely, in the case of a fall in the value of the Australian dollar, the cost of foreign currency assets would increase.

Where there are assets and liabilities denominated in the same foreign currency (a natural hedge), the effect of a change in Australian dollars will reflect the net change in value.

Commodity price risk

Commodity price risk is the risk that a change in the price of a commodity that is a key input or output of a business will adversely affect financial performance. It should be noted that many commodities have a foreign exchange component in their $A price – for example, oil, gold and sugar.

Credit risk

Credit risk is the risk that another party in a transaction will not be able to meet its financial obligations. The general term "credit risk" may include:

  • counterparty risk, which is the risk that the other party to a transaction will not meet its obligations as to timing or amount of settlement
  • country, political, or sovereign risk associated with government directives and policies that may affect the contractual performance of either party to the transaction, and that are generally beyond the direct control of the counterparty
  • settlement or delivery risk that may exist if there is a default in a single settlement or delivery, in which case all other exposures or positions with that counterparty will be closed out, thus establishing claims for transaction costs.

Business or operating risk

Business or operating is the financial risk generally associated with internal and external systems for the monitoring, negotiation and delivery of financial transactions. The risks are wide-ranging and can include natural disasters, human error, and breakdown of financial systems or failure of electronic systems.