Types of Financial Risk to be Disclosed

Refer to Financial Derivatives and Hedging, hedging of derivatives is an extremely complicated business activities and involves many different financial risks. The financial risks must be disclosed according to IFRS 7, but unfortunately, many investors don’t read through the risk disclosures notes. Those notes are usually very lengthy, dry, and not “human friendly”. To make things worse, the notes are usually at the very last part of annual report. You are exhausted by the time you read until the last part. The following example of AirASia illustrates the risks involved in hedging.

In FY2015, AIRASIA hedged 40% of its fuel requirements at US$80 per barrel. WTI prices fell to US$36 a barrel end-2015…

Credit Risk

Credit risk – an investor’s risk of loss arising from a borrower who does not make payments as promised. Losses could include principal and interest, decreased cash flow and increased collection costs.

• Credit Default Risk
  • The risk that the obligor is unlikely to pay its credit obligations in full or the obligor is more than 90 days past due
• Concentration Risk
  • Arising from concentration of risk in one entity or industry with the potential to threaten core operations
• Country Risk
  • The risk of loss arising when a sovereign state freezes foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk)

What to Look for?

• IFRS reporters should give extensive narrative and numeric disclosure of credit risk and its management
  • Look in MD&A, policies, footnotes and separate risk management section
• Unexplained changes in % of provision to assets
  • May indicate a more/less aggressive stance to provisioning
  • Massaging of results?
• Evidence of concentration and country risk
• Securitizations:
  • Does the seller retain risk, having removed the assets from their balance sheet?
  • Does the buyer fully understand the quality of the assets?
  • Doe the buyer can adequately monitor the risk?
• Whether risks are hedged
• Changes in credit ratings.

Market Risk

Market Risk – Risk that the value of a portfolio will decrease due to change in value of market risk factors. The associated market risks are the risk of change:

• Equity price risk (of individual equities or indices)
• Interest rate risk
• Currency risk
• Commodity price risk

In each risk, the risk can be of change in value and/or of their implied volatility.

What to Look for?

• IFRS reporters should give extensive narrative and numeric disclosure of market risk and its management.
  • Identify which risks the entity is most exposed to.
  • Understand how different categories of financial asset/ liability are presented and measured in the financial statements and where the results get reported. Refer to Level of Fair Value, it is very alarming if majority of financial asset/ liability are measured by Level 3.
  • Look in MD&A, policies, footnotes and separate risk management section; this will include for financial assets and liabilities
    • Major currencies held
    • Interest rates exposed to
    • Long term pricing contracts
    • Reliability of valuations & methods used
    • Extent of trading
  • Understand whether and how these risks are hedged

Liquidity Risk

Liquidity risks involve:

1. Market Liquidity – An asset cannot be sold due to lack of liquidity in the market e.g. due to:
   • Widening bid/offer spread
   • Making explicit liquidity reserves
2. Funding liquidity – Risk that liabilities
   • Cannot be met when they fall due
   • Can only be met at an uneconomic price
3. Refinancing risk – possibility that a borrower cannot refinance by borrowing to repay existing debt.

What to Look for?

• IFRS reporters should give extensive narrative and numeric disclosure of liquidity risk and its management.
  • Look in MD&A, policies, footnotes and separate risk management section
• Future period cash requirements
  • Prepare a cash flow forecast; for next year working capital
  • Identify committed Capex / investing cash flow requirements
  • Investigate maturity profiles of financial liabilities and assets, including leases particularly over next year or two. This should be disclosed.
  • Look for future cash funding for pension liabilities should be disclosed.
• Identify which risks the entity is most exposed to
  • Whether and how these risks are hedged
  • Macro-economic factors may play a significant role in availability of credit.

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