Analyze All The Relevant Studies Finance Essay - Free Essay Example

Sample details Pages: 11 Words: 3272 Downloads: 3 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Did you like this example? In the world of certainty many Non-financial firms use hedging strategy to reduce the risk. Risk Management is the strategy tool, which helps in identifying, quantifying, monitoring, and controlling risks. Risk management basically protects the firm from insolvency. Don’t waste time! Our writers will create an original "Analyze All The Relevant Studies Finance Essay" essay for you Create order Many of the Non-financial firms use various types of derivatives like foreign exchange derivative, commodity derivative and Interest rate derivative. Of the risk that many firms try to avoid or manage is interest rate risk. In this I have analyze the information on usage of interest rate derivative by 200 Non-financial firms in 2005-2010 (past 6 years). I found that most of the firms does not use derivative for speculation. In common with several previous studies this paper recognises that different factors might be important for each type of hedging. Therefore, the empirical tests in this paper examine whether sample firms that report they hedge interest rate exposure exhibit characteristics that are consistent with the predictions of hedging theories. The currency and interest rate problems faced by firms today have been exacerbated by the breakdown of the post-war international monetary system established at the Bretton woods conference in 1944. The main features of the Bretton woods system were the relatively fixed exchange rates of individual currencies in terms of the US dollar and convertibility of the dollar into gold for foreign official transactions. The fixed exchange rates were supposed to reduce the risking of international transactions. The fixed exchange rates were supposed to reduce the risking of international transactions thus prompting growth in world trade. With the collapse of fixed parties in 1970s exchange rate were free to fluctuate according to the supply and demand for different foreign currencies. Such an environment led firms to the realisation that a large variation in interest rate could materially reduces net profits reported and could even put them out of business. Hence managing interest rate became one of the important functions of companys strategies policies. The firms which are not significantly changing the interest rate exposure of their operations, their hedging activities should not vary significantly over time. Un less their underlying liability structure is similarly changing over time, evidence that derivatives usage does vary significantly over time is consistent with firms using interest rate derivatives to speculate. An analysis of our empirical literature relates to an accurate assumption that firms that do not use derivative are not hedging. A firm that issues fixed rate debt has the same interest rate exposure and therefore receives the same theoretical benefits of smooth cash flow, as one that issues floating rate debt and swaps it to a fixed rate. If firms are hedging, then the choice of the interest rate exposure of the firms liabilities should be driven by the sensitivity of a firms cash flow to movements in interest rates. By matching the interest rate exposure of the liabilities to that of their assets, firm can reduce the variability of their cash flows. As a result, firms may lower their expected cost of financial distress ( Smith and Stulz (1985))as well as minimise how often they have to raise expensive external capital (Froot, Scharfstein and Stein (1993)). Firms may believe, as suggested in the Harvard Business school case study Liability Management at General Motors (Tufano 1995) that they can reduce their interest cost by actively managing their interest rate exposure as interest rate changes. The use of interest rate derivative has developed significantly over the past few decades. According to, (Guay and khothari (2003)) they argue that derivative positions are generally too small to significantly affect firm value, whereas (Faulkender (2004)) showed that firms in the chemicals industry emerge to use interest rate derivative to speculate rather than hedge. In this we have focused on how Determinants of interest rate derivative influence nonfinancial firm by examining the bond between derivative position and risk exposure. Our data set is consist of detailed information on 150 non- financial firms of United Kingdom for past 6 years from 2006 to 2010. The data allow us to look over the types of derivatives used by the non financial firm to hedge their Interest rate. Purpose of study Interest rate risk signifies one of the key forms of financial risk that bank face in their function as financial intermediaries. Interest rate derivatives are broadly used by Non financial firms. There are two main roles which firms can take: act as a hedger or act as a speculator, but non financial firms basically use derivatives for hedging and very few of them use it speculation. Reasons of implementing interest rate derivatives are obvious but what are the main reasons and determinants which encourage firms to use interest rate derivative. Studies that empirically explore the determinants of interest rate risk have usually used asset-debt maturity as the key factor in explaining firms interest rate exposure. While this topic is quite getting on and researched broadly and there is no clear understanding of determinants. Results of empirical studies oppose each other and there is a need for sorting and fine research. Research Questions Research question helps to split the topic of the dissertation and make it more clear in understanding it easily and aim behind it. It is crucial to build up a set of question which would be based on secondary data and would reveal all undiscovered problems in whole research and define everything clearly. By conducting literature review the lack of studies of the topic was discovered. In this Dissertation after collecting all primary data and secondary data we established to fulfil the following objectives: Analyze all the relevant studies. Determine the main determinants of interest rate by UK non financial firms. In this dissertation we are having both primary and secondary data which is being collected annual reports of the firms and sites from internet respectively. All data and information used are highly reliable. Internet is a basic source of information used for various purposes like education. All risk were minimised by using official reports and sites to get reliable information. Limitation of study The main problem in primary data was while analysing annual reports we encountered the lack of satisfactory information about derivatives usage and notional values of firms and in secondary data the foremost problem which would be encountered by researchers is the lack of suitable exposà © of information concerning Interest rate. We couldnt find the annual reports for some firms because it was not available on internet. Chapter2. LITERATURE REVIEW Risk is basically a probability of loss or the danger of realising a loss or profit bigger/smaller than the one assumed in some specific operation or transaction. Or in short its an exposure to danger. The concept of risk is commonly used in two different meanings. First, there is the definition, where risk is measured in terms of variability of possible outcomes around their averages. Capital pricing model is based upon this statistical definition. (Franks 1986). Secondly, risk can be defined as the probability of the occurrence of unfavourable outcomes. (Weston and Brigham 1981). Preference is given to the former definition since it gives interest and exchange rate exposure rate exposure a resultant positive or negative outcome. Financial risks are of various types which are being explained below: Basic risk Ups and down in interest rate will cause interest bearing liabilities to redetermine the price at a higher rate than that of it was fixed earlier. Capital risk Amount of loss from unrecovered loans will affect the financial institutions value of capital. The capital may include factories, liquid securities and equipment. For example a person invests  £5000 in stock market, he or she faces capital risk of  £5000 invested. Country risk Country risk is collection of risk attached with investing in foreign country. Various economic and political changes in foreign country will affect loan-repayments. These risks include political risk (political changes in debtors country), economic risk (changes in the state of economy), exchange rate risk (risk which includes appreciation and depreciation of a currency) and transfer risk. Default risk In this borrower of loan is not able to pay back the whole amount. Delivery risk The person buying or selling foreign currency will not be able to deliver on maturity. Interest rate risk Decline in net interest income will result from changes in relationship between interest inco me and interest expense. Liquidity risk Liquidity risk is of two types: funding liquidity risk and asset liquidating risk. Funding liquidity risk- unable to meet payment obligation. Asset liquidity risk-situation when a transaction cannot be carried on at dominating market price due to the size of the position. Operational risk It is basically a human risk. It is caused by human error in business operations. Operational risk differs from industry to industry. Industries which have less human interaction bear less operational risk. Commodity Risk Commodity risk rise due to uncertainty of outcome that arises because commodity price changes unpredictable which lowers the producers profit margin and makes budgeting difficult. Futures and options are two financial derivatives used to hedge against commodity price risk. In this dissertation we are looking at Determinants of interest rate and how non financial firm uses various derivative of interest rate for hedging. The approach to interest rate risk management and valuation developed and often used by actuaries assumes a single interest rate. This rate is used to value cash flows and to determine the sensitivity of the value of the cash flow to interest rate changes. Related studies Interest rate risk management has been targeted in some of the previous studies. In the previous study of Hakkarainen et al. (1997). They studied exchange rate and interest rate risk management in major Finnish non financial firms in the spiral of 1994. They approached 100 companies and 84 agreed to take part in the survey. The participants were mailed a questionnaire, which they filled and returned. Hakkarainen et al. analysed that the main target of the non financial firms in their interest rate risk management were to reduce the outcome of the interest rate movements on the firms income, and minimizing net interest rate expenses. Apart from all companies 28% of the company did not perform interest rate ris k management. Interest rate swap (IRS) was the most commonly used hedging instrument, followed by forward rate agreement. The method which is being used in the interest rate risk analysis is duration analysis and average interest rate period. Maximum of the firms assessed having been fairly successful in their interest rate risk management. In the words of Harju and Martikainen (1997) they studied the management of foreign exchange and interest rate risk among small and medium-sized Finnish companies. Their original sample consisted of 64 companies, of which only 23 returned the mailed questionnaire. Their results, as well as their final sample, were quite limited regarding interest rate risk management. Fatemi (2000) The basic factors affecting the approach of a company towards its risk management have not been studied that much. Kasanen et. al. (1997, p46, p 54) recommend that at least firms size and structure, the existence of a written risk management policy and the fir ms attitude towards risk affects the companys risk management. Moreover, they advised (p-220) that the sensitivity of a companys financial profit to a rise in interest rate risk is a main issue that should be taken into consideration. On the other hand, if the goal of financial risk management is to minimise the fluctuations in income (stulz, 1996), the cyclicity of the industry should not be forgotten either. In the words of Shapiro and Titman (1985), debt structure is also a key determinant. Chapter3. The Data and the Methodology 3.1 Research question Research question helps to split the topic of the dissertation and make it more clear in understanding it easily and aim behind it. It is crucial to build up a set of question which would be based on secondary data and would reveal all undiscovered problems in whole research and define everything clearly. By conducting literature review the lack of studies of the topic was discovered. We pay different interest rates every time, thats why we will look over the determinants of interest rate and explains how rates derived. In this Dissertation after collecting all primary data and secondary data we established to fulfil the following objectives: Analyze all the relevant studies. Determine the main determinants of interest rate by UK non financial firms. 3.2 Research Method In this part collecting and analysing the data has been defined. We are screening how usage of derivatives of interest rate affects the United Kingdom firms and what are the v arious determinants of interest rate. The core material of this study is from information of 200 non financial firms for past 6 years, the reason behind not including financial firms in our research is because financial firms use derivatives for both risk management and trading purpose. Whereas, in Non-financial firm they use derivative for only risk management and very few firms uses derivatives for trading purpose. Both financial and non financial firm have different motives for using derivatives In this dissertation we have used quantitative method of research, this method has its own advantages and disadvantages. In our research we have analysed around 150 United Kingdoms Non financial-firms. We have collected annual reports of 150 firms for past 6 years. There are many ways to analyse this research it can be either with empirical analysis with hypothesis testing and so on or descriptive statistics. Advantages for quantitative data are that it helps in broader study, allows having greater objectivity and better accuracy of analysed result. Quantitative data usually provide complete summary of data from the annual report and helps in performing various tests. In order to accomplish this, quantitative research usually involves variables. Using data from the annual reports of the companies which can be analysed and compared with some similar or recent studies. It helps in conducting vast data from the annual report and facilitates comparison over the time. 3.3 Data Collection In this dissertation we have used primary data which is being collected for the first time. The process includes collection of original data for the first time. We have used companys annual report and data stream to collect primary data. All the firms included in the sample have a complete set of past 6 years. This procedure results in total of 150 firms. We have collected the panel data for 150 firms and various variables. To collect information on firms usage of interest rate we started screening for keywords in each firms annual report to check what type of derivative does the firm use for hedging like FX derivatives (FX forward, FX swap and FX option), IR derivatives (IR forward, IR caps, IR collar and IR swaps), commodity derivatives (commodity forward, commodity swaps, commodity futures and commodity option). Firms usage for interest rate derivative includes in these four categories: forwards, swaps, collar and caps. For all firms we tried finding out their outstanding notional values for all derivative usage to pay. We are also having secondary data in our data collection which helped us to conduct broad literature review and research. The main benefit in this type of data was that all the empirical analyses and hypotheses tested are studied and summarised and considering this as a base we took a new approach to the research question. This type of data provided different view on problems by various researchers and collect necessary information on o ur research topic. Secondary data is of two types such as external and internal and so on. In this dissertation we collected information from periodical academic journals, articles, internet and statistical databases. 3.4 Data Sample In this research we are using panel data for 150 UK non financial firms with various variables and it contains firms annual data for past 6 years. To collect the data for research we have used firms annual reports and data stream. Unfortunately, DataStream and firms annual report cannot provide notional value of derivatives like interest rate, foreign exchange rate and commodity derivatives. Then information was structured, combined and organised in one excel document which consisted of 150 UK Non financial firms 3.5 Research variables 3.5.1 Firm size To measure the size of the firm I have a variable called logarithm of assets is a proxy for firms size. It is possible to suggest that participation in a swap market requires from financial institution justification of a transaction. It is proved that a large non-financial firm would have a comparative advantage in transaction support. Block and Gallagher (1986), smith and stulz (1984), greczy, minton, and schrand (1997), john R. Graham, and Daniel A.Rogers (2000), argue that larger firm are more likely to employ managers with specialised information to manage a hedging program employing these instruments. They also argued that small firms do limited hedging because of their set up cost. They note that the size of the firm is positively related to the decision to hedge, stating that larger the firm more chances to hedge as compared to smaller firms. Larger firm are less likely to fail (jagtiani, 1996). The object of research is primary data of non financial firms. Larger non-financial firms can perform economics of scale and such firms are more creditworthy good support for transaction and efficient personnel (Kim and koppenhaver, 1993). Thats the only reason for incl uding this variable. Estimating firms size give us a perfect picture of hedgers and non-hedgers. 3.5.2 Firm Capitalization To measure the firm capital we have variables called equity to assets ratio is employed as a proxy for firms capitalization. Firm is able to bear and take more risk if its capitalization grows at the same point of time need for hedging instruments also get decreased (Kim and koppenhaver, 1993)if the firm is not doing good and is not having enough capital or low capital which discouraged the firm from interest rate swaps because it requires high regulations ( Simons, 1995). So therefore its clear from the previous readings that the firm with large capital are more likely to hedge as compared to those firms which have low capital with them. The amount of capital should be sufficient with the firm to bear its cash flow requirement of the firms billing and collection. Firm should always keep on re-examine its capital annually because of payments of account rec eivables, firm debt, increase in client cost and whenever the firm increases its number of lawyers. 3.5.3 Interest Rate Risk Exposure 3.5.4 Cost of financial Distress Firms with greater variability of cash flows are more likely to find themselves in financial distress, ceteris paribus. Smith and Stulz (1985) suggested that the transaction costs of financial distress can induce firms to hedge financial price risks because this can reduce the probability of incurring costs. . According to their theory, hedging may be particularly more valuable for firms with a higher probability of financial distress. In contrast, the benefits of hedging for financially strong borrowers may be more marginal. We have use the leverage ratio as an indicator of the likelihood of financial distress to measure expected costs of distress. High level of debt doesnt mean that firm has higher probability of distress, important is the ability to service the debt and pay it off at maturity. We have use t he total debt to total asset as measure of the leverage ratio for the year 2005 to 2010. It is important to note that the higher probability of financial distress implies higher expected costs. VARIABLES DEFINITION HEDGER 1= HEDGER ; 0=NON-HEDGER LEV TOTAL DEBT/ TOTAL ASSET SIZE Ln (Total Assets) Empirical Analysis The assumptions in all empirical analysis is that the use of derivatives by the firms is for hedging purpose and the risk firm faces in interest rate is from two sources assets and their debt, they hedge by avoiding market fluctuations because no one can predict the market. Investors are also unsure about the market. Thus, there are many variables that explain different derivative usage for the hedging. Firm faces a