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Risk management in financial markets

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There is a common adage in finance that “risk and return are proportionate”.

Well-diversified portfolio protects investments from the downside risk and this follows the principle that diversification reduces risk which is true at least for the lovers of Means-Variance Analysis (MVA).

Hedge funds, nonetheless, often make this risk-return efficiency irrelevant by employing effective asset allocation strategies and tactics and often using financial derivatives to ensure portfolios outshine benchmarks at lower-than-expected risk.

Derivatives

Derivatives can play an important role in optimising a portfolio’s performance and in managing risk, making it an inescapable imperative to build capacity and deepen knowledge in this area.

To dive that deep, practitioners need to have the penchant for rigor in derivatives and financial engineering. Ghana, and for that matter Africa, has several trained analytical minds (from PhD mathematics, physics, computer science to PhD “rocket science”) to fill the quantitative analysis needs of our industries and economies.

But most institutions have ignored risk management in business and economic management to the peril of the enterprise (like the case of Anglo Gold Ashanti where management could have taken an upside position with another counterparty to benefit from the now upside movement of gold prices).

African economies and enterprises lose  more due to lack of proper risk management than any other form of human and business dynamics.

Projects and businesses are prune to risk–cutting across operational, financial (market, credit, liquidity), asset and liability management, reputational, business, strategic and model risks.

There are various risks associated with infrastructure projects and businesses and they can be mitigated using different risk management strategies and structured finance products.

The importance of mathematics and programming are invaluable tools in this respect and applying technical knowledge to the field of finance and business as a whole would be highly beneficial in crystallising the goals and expectations of risk management.

The need to understand and develop new financial instruments to evaluate and hedge risk applicable to Ghana’s economy and businesses cannot be underestimated.

Financial engineering

In order to use financial engineering pro-actively and dynamically for optimum hedging, finance and investment professionals should be well versed with practical mathematics that underlies finance and investment theory.

A strong grasp of investment and risk management fundamentals, an insider’s experience of an emerging financial market, and latest theories and practices in the field of financial engineering are needed to thrust the Ghanaian economy and capital market forward–at least regulators should not be oblivious of the importance of managing risk in the economy and financial markets to ensure liquidity doesn’t drain out from the system.

New financial and investment products can be structured by incorporating cutting edge methodologies and sophisticated tools in order to cater for the above-mentioned requirements.

To achieve this, one would need to gain exposure to the latest practices adopted in the field of financial engineering and risk management. Leading investment banks or treasuries of commercial banks should brace themselves up to manage own and client risks, and risk management. Problem-solving and analytical expertise are undoubtedly needed in the 21st century to make Ghana a thriving and dynamic economy.

This has become necessary because of the gradual convergence of economies around the world and possible financial contagion that may creep into African markets as a result of their relations  with major developed markets. What is needed is a robust risk management infrastructure to mitigate risk and to insulate the economies from major mishaps in the event of global crisis.

The current state of the stock market in Ghana is likely to be short-lived because it is driven by sentiments and behavioural heuristics which have little empirical basis to sustainably drive markets.

The existing economic fundamentals and the beautiful trade-off between growth and inflation coupled with the high momentum the market was enjoying a while ago make it impossible for the recent state of the market to stretch over a long duree.

The caution to drop here is that in future investors should be well informed and discouraged from margin trading without requisite and proper risk management in place to cap off portfolios from downside fall.

Again, the largely informal nature of most African economies (a blessing in disguise) ensures the distance from major developed systems is long enough to insulate our economies ensuring low financial contagion (at least for now).

Entities like the Agricultural Development Bank (ADB) and her clients can particularly benefit from good risk management infrastructure by virtue of mandate and her socioeconomic development agenda.

So selling off is not the solution to bridging the strategic gap of the bank but building capacity in the area of capital complexion management, risk management, securitization and financial engineering. Unlike Nigeria, Ghana’s financial capital in the financial services industry is largely foreign and “immoral”.

To develop agribusinesses and microenterprises, citizenship of financial capital is more important than the quantum required – which allows strong collaboration with government to dwell deeply in enterprise development. ADB, for instance, can rely heavily on securitization to mobilise required capital to push her agenda.

Securitization relies on a special purpose vehicle (SPV) to facilitate collections and rally investors along. A credit derivative is generally used to augment or change the credit quality of the underlying portfolio to make it acceptable to the final investors (Ghanaians, foreigners in Ghana and in the Diaspora).

The best package, nonetheless, is a heat-warming conflation of Securitization, Credit Derivatives, OTC Forex Arrangements and Warehousing.

For the real sector, a highly equipped human resource in the area of financial engineering can help mitigate various risks industries face, including:

Types of risks

Most companies are exposed to market risks arising from international business. Derivative financial instruments can be used to trim down funding costs, to diversify sources of funding, to alter interest rate exposures arising from mismatches between assets and liabilities or to achieve greater certainty of future costs.

To a large extent all financial instruments economically should hedge specifically identified actual or anticipated transactions.

It is mostly known that movements in their fair value are highly negatively correlated with movements in the fair value of the transactions being hedged and the term of such instruments is not greater than the term of the transactions or any anticipated refinancing or their extension.

Such anticipated transactions are all in the normal course of business and is highly probable that they will occur and companies will not spared any negative price movements.

Sensitivity of asset and liabilities to interest rates adjustments should, therefore, be tracked and modelled to ensure management possess a decision trajectory to manage liquidity.

Interest rate risk

Most often, firms have exposure to interest rate fluctuations on borrowings which could be managed by employing immunisation strategies such as the use of interest rate swaps, cross currency interest rate swaps, futures options, swaptions and forward rate agreements.

The objectives for the mix between fixed and floating rate borrowings are set to reduce the force of an upward change in interest rates whilst enabling benefits to be enjoyed if interest rates fall.

Duration and convexity become the watch words in this instance and changing convexity of a loan portfolio, for instance, can be helpful. The strategy allows the setting of minimum and maximum levels of the total of net debt and preferred securities consented to be at fixed or capped rates in various time bands.

Credit: Samuel Frimpong Boateng

Source: Daily Graphic

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