In this lesson, we're going to tackle financial risk management. If we return to our conceptual model of finance, notice how the cash flows and the financial returns vary. This conceptual representation is intentional. Imagine a company that exports its products that are priced in foreign currencies, as these currencies fluctuate in value. So to will the sales of the company would translate it back into domestic currency. Another example might be a commodity price, such as an oil price.

If a company is an oil company, then its sales will fluctuate based on the market price of oil. These sorts of fluctuations create volatility in severe cases, such as in 2014 and 15, when oil prices went from $110 a barrel to under $50 a barrel. This put a number of smaller high cost producers out of business. So modern finance has created tools and industry. treatments that address these types of risks, which can have the effect of changing this sort of conceptual model. To this one, notice how at least conceptually, the firm makes a decision to forego some of the potential upside to protect against the downside.

And as a result, financial returns tend to be a little flatter and more predictable. Let's talk about some of the ways that finance makes this happen. To illustrate the idea of risk management, let's return to our buddy Bob. At the end of the last lesson, we had solved his retirement planning dilemma using financial leverage. His objective was to have a million dollars of proceeds available at the end of five years so that he could move to Florida and live by a pool. Let's say that Bob's plan is to invest in shares of Microsoft Corporation.

And just for argument's sake, and because I'm a Canadian, let's just assume that the dollars presented on the screen before you are in Canadian dollars, not US dollars. Because Microsoft Corporation is a US company. It shares trade in US dollars on a spreadsheet. This all appears plausible. However, in real life. This financial plan has considerable risks associated with it that we're going to explore more in this lesson.

Risk Management is the practice of identifying and mitigating risk. Can you identify the sources of risk in Bob's retirement plan? There are four primary risks associated with his retirement strategy. How many did you come up with? First, if interest rates rise, we might have to pay the bank more than 4%. At the time we took the loan out, this will erode the spread we're making on our financial leverage.

Secondly, capital markets could decline taking the company's value Down with it. This is another way of saying that the market has changed their expectation of return. That expectation might have been say 9%. At the time Bob acquired his position. But say in the fifth year, the market now expects the onset of a global recession. When this happened, share multiples contract that 9% expectation might turn into, say, a 12% expectation.

That translates into an eight times multiple from previously and 11 times multiple of cash flow when he bought his shares originally. In this case, the value of our shares decreases even though the forecasted cash flow hasn't changed one iota. A third risk comes from the currency exposure. Bob has invested his Canadian dollars to purchase an investment that is denominated in US dollars, to the extent that the Canadian US dollar exchange rate fluctuates between the time Bob made his investment and the time he sells it, he could win or lose due to this exposure. If the Canadian dollar strengthens, the US proceeds he receives on the sale of the US denominated shares will be worth less in Canadian dollars when he repatriates the funds or vice versa. A fourth risk is that his cash flow forecast itself could turn out to be wrong.

Maybe Microsoft underperforms and cash flows are weaker than expected, impacting both the expected investment income in this case dividends, which we're hoping to reinvest as well as the stock price when we go to sell our shares, both of which hurt Bob's chances of retiring in five years. Let's turn our attention now to the mitigation measures we could take and there are four general approaches to risk management. The first one is avoidance. Which is choosing not to assume the risk. This isn't going to help Bob in this situation unless he can find another investment that meets his retirement objectives. acceptance of the risk is to do nothing about the risk per se, you accept the outcome for better or worse.

Controlling the risk is to monitor it is to understand and measure the factors influencing risk, and then take actions accordingly when the risk changes from our initial assessment. And finally, Bob could find ways to share the risk that is engaging others to take on some of these risks for him. In the same way that say an insurance company takes on the risk of your house burning down. The finance world has created special instruments called derivative instruments that can help share risk in a situation like this. A derivative instrument is basically an agreement between two parties to exchange cash in the future based on the change in value. Some underlying thing, and either party can win or lose, depending on how the value of the underlying thing changes over time.

So for instance, the interest rate on the bank loan is a floating rate. If the Federal Reserve decides to raise interest rates to curb inflation or to prop up the currency, then lenders will follow suit and borrowers will pay a higher rate of interest. This is a risk to Bob's retirement plan. To address this risk, Bob could enter into an interest rate swap, which is a derivative instrument that derives value from changes in the interest rates. if interest rates rise, Bob gets paid money under this derivative contract. if interest rates fall, Bob pays money under this derivative contract to his Counterparty when you stand back and look at the two transactions Together, both the loan with the bank and the derivative instrument, Bob has essentially swapped his variable interest rate for a fixed interest rate.

When used as a tool for risk management, the derivative instrument offsets his risk exposure. Another risk confronting Bob is that the trading price of his investment in Microsoft shares might drop in value for any number of reasons. Now, Bob wants and needs the upside, but he can ill afford the downside if he's wrong. Once again, we have a derivative instrument that can protect the downside without impacting the upside. What Bob can do here is purchase an option, which is another type of derivative instrument that derives its value from the price of the underlying shares of Microsoft. Now, there are two types of option contracts.

When you purchase a call option. You have the rights But not the obligation to buy a specified number of securities at a specified price at a specified time. a put option is the opposite the right but not the obligation to sell a specified number of securities at a specified price at a specified time. In this case, Bob would look to purchase a put contract to offset his downside exposure should the price of the Microsoft shares decline. The Counterparty to the contract agrees to purchase the shares at the protected price. If Bob exercises his option, this allows Bob to offset his downside exposure and protect the principle of his investment.

Another risk confronting Bob was the foreign exchange exposure. Because we're talking about Bob's retirement plan. We don't want to fool around here and if we can, we want to eliminate this risk. Here we can use a forward contract Which is just another type of derivative instrument, a forward contract obligates Bob to deliver a fixed amount of US dollars at a future date. In this case, it might be five years from now and return the counterparty agrees to give him a fixed sum of Canadian dollars. When taken together with Bob's US dollar investment exposure, the risks offset.

The final risk Bob has is whether his investment will appreciate in value as he's predicted. This will depend on whether his assessment of Microsoft's earnings for the next five years is accurate, as is often the case he cannot offset all your exposures. This is an example of a risk that can be controlled through ongoing investment analysis and monitoring, but one that must be accepted in the context of earning a return by assuming some level of risk. Another approach for managing risk which does not involve using a drip An instrument is diversification. And we're all familiar with the adage don't put all your eggs in one basket, which loosely translated in the finance world means don't invest all your money in a single security. Diversification can be accomplished by assembling a portfolio of investments, ideally, whose individual values are not highly correlated.

So for example, buying 10 different oil companies does not help mitigate the exposure to oil prices. However, if you were to buy a broader index of stocks, the risk of falling oil prices would be mitigated as some companies benefit from higher oil prices. Say the oil companies and others benefit from lower oil prices say the airlines and portfolio diversification is not only a concept relevant for investors, companies use it as well. Consider which of the following companies is more risky Copy that sells one product line, or multiple product lines. Right, a company with one product line, heaven forbid Apple come along and decide to revolutionize that product line. The same goes for companies with geographical diversification, customer diversification, channel diversification, manufacturing, diversification, and the list goes on.

So don't walk away from this lesson believing that risk management only relates to derivative instruments. It's just as much an element of corporate strategy. In this lesson, we talked about how finance can help an organization manage risk. Let's recap the important points. Risk Management is a process of identifying and mitigating risk. Secondly, there are four ways in which risk can be managed, avoid, accept, control, or share.

And finally, derivative instruments are contracts between two parties. derive value based on changes in the value of some underlying thing. Derivative instruments and thoughtful diversification can both be used as tools in finance to offset risk exposure inherent in the business. Risk Management can be a very complex aspect of finance and we've only touched on the basics. But hopefully you now have a higher awareness of the various types of risks that commonly arise in business and the sorts of tools finance has at their disposal for mitigating these risks. That's all for this lesson.

So until next time, I'm Blair.