The Objectives and Techniques of Risk Analysis in Respect to Foreign Exchange Transactions - Essay Example

The Objectives and Techniques of Risk Analysis in Respect to Foreign Exchange Transactions Student’s Name Institution The Objectives and Techniques of Risk Analysis in Respect to Foreign Exchange Transactions Introduction With the recent developments within the business environment, firms have been involved greatly with the process of ensuring that they receive great returns on their respective investments made. Due to the uncertainties which exist within the aforesaid businesses environment, it is safe to indicate that the need for establishing profitable business ventures have been a core priority for most firms. It should be noted that the fundamental objective of any given business operation rests in its ability to maximize wealth of the shareholder as well as minimize possible costs involved with this process. Such businesses which have taken it upon themselves to nurture and thus, improve on the chances of the survival into the future are financial institutions. Within any given economy including the Australian economy, the aspect of an effective and efficient financial system is paramount to catapulting economic activities of the country at large. It should be noted that countries enter into business agreements which is focused on exchanging goods and services between them. At this point in time, the financial system of the involve economies need to be effective in order to conduct business effectively. However, there are numerous challenges which face this form of agreements in respect to foreign exchange activities. Some of the possible challenges are the risks involved in the course of conducting the transactions (Kidwell, Brimble, Basu, Lenten, Thomson, Blackwell, Whidbey, & Peterson, 2010). Therefore, this paper tries to examine the objective and methodologies used by such agreements in order to access the possibility of risk evaluations presented in the course of the business activity. It should be noted that businesses embrace the methodologies as well as techniques attributed with risk analysis in order to make certain the elements which might infringe foreign exchange business activities (Kidwell, Brimble, Basu, Lenten, Thomson, Blackwell, Whidbey, & Peterson, 2010). Objectives of the Risk Analysis: First, the objective of risk analysis in respect to foreign exchange transactions is to identify the immediate performance volatility of the involved business parties. It is a crucial measurement of business risks. Within this measurement such facets as market composition, the advancements made in technology as well as the possible volatile foundations are established and their respective indexes provided for purposes of comparison as well as future referencing. Notably, the level of coefficient of variation with respect to the Return on Capital Employed depicts the form of business environments upon which the two parties operate. Thus, it is deduced that there exists a connection between imminent techniques and the performance of two different business economies. The higher the coefficient variation of ROCE, it would be safe to deduce these firms are deploying extensive risk analysis methodologies (Ho and Pike, 1998). Second, the objective of risk analysis in the course of foreign exchange transactions is involved with establishment of the beta value. Beta value is the determination of the resultant volatility index or rather systematic form of risk of a given security in respect to the underlying market upon which the transaction takes place. It is noted that it is almost impossible for any given company to avoid the presence of systematic risks given the fact that transactions happening at the international markets do not possess a similar level of systematic form of risks. The foreign exchange currencies entirely depend on the sensitivity attributed to the ever-changing conditions in the international markets. Thus, this is where the objective of measuring the fluctuations by using Beta comes in hand. In this essence Beta is perceived as the immediate extent to which the returns attributed with the foreign exchange transactions are related to the possible fluctuations in the international markets as a whole (Jacques and Sauner, 2004). Third, the objective of the risk analysis methodology in relation to foreign exchange activities is to determine the size of the business involved. Notwithstanding, there exists a positive relationship between the sizes of the business involved with the foreign transactions and their respective performance index. In respect to size, there is a possibility that a larger firm will placed at a fair position upon which to conduct businesses since it is assumed that they have larger capital base and can thus invest in large profitable business activities. In order to conduct the risk analysis using this objective such facets as the certainty of the entity to have full-time employees as well as the ability of this firm to conduct a diversified investment portfolio are put into consideration to evaluate the worthiness of engaging in the foreign exchange transactions. Narrowing it down safely, it is fair to assume that the size of entities involved with foreign business activities are greatly influenced with the level of conducting its activities and as such would deploy more relevant and reliable risk analysis techniques in order to protect them from losing their substantial levels of resources. Fourth, another objective of deploying risk analysis methodologies in the course of conducting the foreign exchange evaluation is to determine the leverage of firm. It should be noted that the leverage indicates the financial risks involved with the firms at hand. In addition to this, determining the significance of leverage through risk analysis encourages a fundamental influence on the form of managerial compensation needed in respect to the trading activities. Techniques of Risk Analysis in Respect to Foreign Exchange Transactions: The aspect of risk analysis has been made a mandatory in the course of operational activities of any given firm conducting business in the current environment. This mandatory notion has been affected by the numerous changes which have occurred in respect to the ever-changing financial economic standings between countries, the immediate form of competitions which have been witnessed from other global business players as well as the ever-changing position of the technology at hand (Jacques and Sauner, 2004). In an effort to effectively deploy the different types of risk analysis techniques such facets as the firm’s size, the amount of profits or rather revenue posted, the numerous environmental facets as well as other reward strategies are first considered. The methodologies used in risk analysis techniques include; Sensitivity analysis, simulation models, the probability tree model, the Adjustment Payback Period as well as the Adjustment of discount rate technique (Jacques and Sauner, 2004). Sensitivity Analysis; is the risk analysis methodology used in order to provide alternative decisions for a substantial extent of values for those decisions which made in an unclear circumstance. In this form of risk analysis, the following facts are evaluated; first, there is the time-to-situation form of data which provides relevant information pertaining to the apportionment of reviewed information conducted earlier. Second, there is the commencing-level of information whereby the notions concerned with standard deviations are reflected and provided in that matter. third, there is a favorable environment which is created for the purpose of providing an effective cross-over forms of information” piloting”. In this case, it is the trials made before the actual foreign transactions are conducted in that matter. Thus, in a much broader term, the notion of sensitivity analysis is performed through setting of pre-specified evaluation within the information under study. Simulation Models: is used a technique in risk analysis through creation of electronically-operated gadgets in order to access the performance of the business trading within a real-life scenario. In this methodology, risks are analyzed first before they can be foreign exchange transaction can be left to take place in a real-life scenario. The main advantage of this risk analysis technique lies in the fact that it reduces the possibility of loss of the resources deployed in the course of conducting businesses. It is also used to test the “business environments” before the exact deals are made pertaining to the financial activity as a whole. Thus, a simulation model analysis technique ensures that definite facets are considered and their effects put-down in case they interfere with the process of trading as a whole (Hogan, Avram, Brown, Ralston, Skully, Hempel & Simonson, 2001). Probability Tree; is a risk analysis technique which is involved with determination of possible results of foreign exchange transaction undertaking place. After the possible outcomes are established and their values noted down the subsequent fundamental step is to compute the values of the probability in respect to the manner in which they could occur. It should be noted that within this methodologies foreign exchange facets are categorized into dependent and independent facets so that their effects are determined without hindrances (Smith, 1994). Adjustment of Required Payback Period (ARPP): is a risk analysis technique which allows for alterations to be made for the exact period of time for which the business activity was to take place. It is a risk analysis technique that uses simple formulas and applications in order to effectively conduct the process of evaluating foreign exchange analysis. The period which is created as a result of the alterations is significantly used to figure out the different variables necessary in effecting the activity as a whole (Smith, 1994). Adjustment of Discount Rate (ADR): is a risk analysis methodology which is used for high-levels of investments. It is determined through computing the summation of risk free rates in comparison to the risk premium of the fundamental foreign exchange activity. This form of risk analysis is sometimes adjusted in order to fit in with the ever-changing rates of discounts which are highly dependent on the risks attributed with the foreign exchange transactions. The main advantages of this form of risk analysis methodology over the other are that it is simple to compute and comprehend, it allows for incorporation of numerous business attitudes with the prevailing uncertainty levels. It should also be noted that the technique has fairer perception of appeal in the risk aversion processes involved with business partners (Smith, 1994). However, this risk analysis technique is only applicable on the assumption that the business partners under the agreement are always practicing risk aversion techniques. Furthermore, there is no clear way of obtaining a concise altered discounted rate. To sum up, it is fair to indicate that the activity involved with foreign exchange transactions rely heavily on the objectives of risk analysis as well as methodologies in order to conduct the business activity effectively and efficiently. Such risk analysis methodologies as the sensitivity analysis, probability tree analysis, as well as adjusted discounted rates are some of the approaches used in conducting the activity as a whole. References Ho S M and Pike R H (1998), “Organizational Characteristics Influencing the Use of Risk Analysis in Strategic Capital Investments”, the Engineering Economist, Vol. 21, No. 83, pp. 227-238 Hogan, W., Avram, K., Brown, C., Ralston, D., Skully, K., Hempel, G., & Simonson, D. (2001), Management of financial institutions, Brisbane: John Wiley and Sons, Australia Jacques, B and Sauner, L. (2004), “Managers and Productive Investment Decisions: The Impact of Uncertainty and Risk Aversion”, Journal of Small Business Management, Vol. 42, No. 1, pp.1-18 Kidwell, D.S., Brimble, M., Basu, A., Lenten, L., Thomson, D., Blackwell, D.W., Whidbey, D., & Peterson, R. (2010). Financial markets, Institutions and money,2nd Ed, Milton, Qld: John Wiley & Sons Australia Smith D J (1994), “Incorporating Risk into Capital Budgeting Decisions Using Simulation”, Management Decision, Vol. 32, No. 9, pp. 20-26 Veronika K. 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