Pros and Cons of Risk Management Essay

1.0 The pros of risk managementMaintaining competitivenessAdverse changes in intimacy and deepen says may reduce the competitive position of a community against those with lower levels of gearing or smaller exchange gait exposures, or compared with companies that have taken the precaution of hedging against rate changes.Reduction of bankruptcy riskAdverse movements in interest and exchange rates may queer the continued operation of a company. A classic example is that of a highly geared company with a large proportion of floating rate debt being forced into bankruptcy due to an increase in interest rate.Restructuring of capital obligationsInterest rate hedging instruments can be exercisingd to re mental synthesis a companys capital profile by altering the nature of its interest obligations, thereby avoiding the repayment of existing debt or the issuing of saucy securities. In consequence, considerable savings can be made in respect of call fees and issue costs. At the same ti me, a wider range of financial sources becomes visible(prenominal) to the company.Reducing in the volatility of corporate cash flowsReducing the volatility of net cash flows may increase the market rating of the company and will facilitate the process of forward planning.2.0 The cons of risk managementThe complicated nature of hedging instrumentsA combination of unfamiliarity with the range of hedging methods available and a belief by potential users that such methods are complex may result in treasurers choosing not to hedge exchange and interest rate exposures.The risks associated with using external hedging instrumentsThe perceived risk associated with in using hedging instruments can sometimes dissuade potential users. Instead of providing protection from steeply increasing interest rates, the transactions turned out to be highly speculative bets.The complicated tax and financial reporting discourses of derivativesThe accounting and tax treatment of derivatives has tended to lag behind the pace of their development owing to the dynamic nature of their markets. The major problem regarding the accounting treatment of derivatives is knowing exactly what information to break away and how to disclose it.Diversification by shareholders may be superior to hedgingAn alternative to hedging by individual companies is for shareholders to diversify away interest and exchange rate risk themselves by holding a diversify portfolio of shares, hence saving the costs associated with hedging at a corporate level. If shareholders hold diversified portfolios, some commentators argue that hedging of exposures by individual companies is motivated purely by managements zest to safeguard their jobs, rather than a desire to enhance shareholder wealth.3.0 ConclusionAs a conclusion, exchange rate risk and interest rate risk can be managed by the use of both internal and external techniques. Internal techniques allow companies to hedge risk within their own balance sheet by the w ay in which they structure their assets and liabilities. Alternatively, companies can employ one or more of the many external techniques now available, such as swaps, options, futures and forwards. While these derivative instruments give more circumstance and flexibility to companies to manage their risk, their associated costs and their complicated nature must be taken into account.