In business world today many companies are faced with the increase in volatility of financial markets which has lead to increase in financial price risk. Many companies are faced with exposure to financial risk which are caused by unanticipated exchange rate and interest rate movements. These unanticipated movement in exchange rate which is caused by international competition can results into large gain or loss if the risk is not managed properly. Exchange rate movement generate business risks which can vary the current foreign assets and liabilities and interest rate movement can have indirect impact on company’s value on its future cash flows.
Domestic and multinational companies who are faced with these kind of risks must assure that they control these risks otherwise if they are unmanaged then this can result into total failure of business. Financial Institutions have introduced different products to help companies in risk management. These products are Forward contracts on exchange rate, Futures contracts, Interest rate swaps and Options. Forward contract being the oldest product to be introduced to manage both foreign exchange and interest rate risks.
1.1 Problem statement
Changes in business environment and increase in movement of interest rate and exchange rate has resulted into rise in financial risk exposure. These movements can affect not only company’s profit but also company’s survival in indirect way. Financial risks management has turn to be a significant area of pertain for UK corporations.
Therefore this proposal attempt to find out how UK Telecommunications industry handle financial risks in an increasing business risk environment.
Research aim and objectives
The main aim of the study is to determine how firms in UK Telecommunications industry manage interest rate and foreign exchange financial risks by looking into use of derivatives.
1.3 Research Objectives
The primary objectives of the research will be;
- To determine how companies manage risk
- To determine whether derivatives are used or not
- To determine which derivatives are used and for what purpose
- Disclosure of financial instruments
1.4 Research Questions
The following research questions will guide this research
- How companies manage risk?
- Are derivatives used or not used?
- Which derivatives are used and for what purpose?
- What are the disclosure of financial instruments?
2. LITERATURE REVIEW
Derivatives are financial instruments whose values are deduced from some underlying assets or rate/price. Derivatives are now of paramount importance to the business world, with imaginary value of more than $200 trillion of these derivatives are being traded on coordinated and over the counter markets in 2004 (Bank for International Settlements, 2004).
The financial products which are provided by FinanciaI Institution are options, futures contract, forward contract and interest rate swap. The common Interest rate derivative is Interest rate swaps and others are future contracts and interest rate options while for foreign exchange derivatives are forwards contracts, currency swaps, foreign exchange futures and options. Forward contract gives the owner the obligation to buy an asset at set price and maturity date as agreed in the contract. Future as like forward but in futures are public traded while forwards are private contracts. Unlike future and forward, options give the owner the right but not obligation to buy or sell an asset at a fixed price on or before specified date (Prevost et al, 2000).
Derivatives are used to cut down cash flows and earnings volatility caused by changes in foreign currency exchange rates, commodity prices, interest rates and other risk factors (Barton J, 2000).
Use of financial derivatives is widespread, especially among large publicly traded companies and is still increasing sharply.
For example, in a study done by Guay and Kothari, (2003) based on annual reports information of 413 largest firms in the U.S revealed that 57% were using derivatives. In another study of 314 Fortune 500 firms showed that 72% were using derivatives (Barton J, 2001). Mallin et al. (2001) did survey analysis on the use of derivatives in risk management, he mailed questionnaire to 800 UK non financial firms listed on London stock exchange. Results showed that of 231 respondents 32% were applying at least one derivative instrument. Another researchers Bodnar et al (2003) studied derivative usage in managing risk to 167 non-financial Netherlands firms and revealed 84 usable responses which is 50.3%. In India a study was conducted to examine derivatives usage in managing foreign exchange risk to 640 companies which were faced with foreign exchange exposure and results showed that 70.4% of respondents used foreign exchange derivatives to manage risk (Anand and Kaushik 2007).
Whilst many firms use derivatives in managing risk, misuse of it may result into major losses. This was proved by Karpinsky (1998) who revealed companies like Sumitomo Corporation lost $3,500 million in 1996 because of copper future.
On the other hand El-Masry (2003) collected data from questionnaire mailed to 401 non financial companies listed on London stock exchange, 50% of respondents did not use derivatives because the risk exposure was not substational. Likewise suryey done by Bodnar et al (1995) revealed lower use of derivatives and the reason being low insignificant exposure.
Regarding to mostly used derivatives to manage risk exposure, survey done by Marshall (1997) pointed that options, swaps and forwards were normally used to manage interest rate and foreign exchange risks. In El-Masry (2003) survey of UK non financial firms, results indicated that firms use options at 29.4%, forward/future at 23.7% and swaps 23.1%.
3.0. RESEARCH METHODOLOGY
This study will be conducted as a quantitative survey
Sources of data
The main source of data will be the annual reports of 10 companies in the UK telecommunications industry for the past three years.
Bell (1999) state documentary source involves the reading of relevant information from library source such as text books, journals, newspapers and internet. Secondary source will enable a researcher to conduct broad investigation and help confirm the reliability of the findings given that the findings may be subjective and this source will be used as well to cut down reliance on the annual reports as the main source of data used in the study.
Selection of sample will be based on the public data information of the companies and the eligibility criteria will base on following factors;
- The company must be in the telecommunication services industry
- The company must be either a Domestic or a Multinational one which is exposed to financial risks as an outcome of international competition
- The company should be among of the listed London Stock Exchange companies
Data collected will be analysed using Statistical Package for Social Sciences (SPSS) and presented using frequency table.
Measuring and managing financial risk exposure are crucial functions in cutting down companies’ vulnerabilities from major exchange and interest rate movements.
Financial derivatives are very important in risk management of corporations
Anand m., Kaushik k. p., (2007).”Management Motivations for Use of Foreign Currency Derivatives in India”, IIML Working Paper Series.
Bank for International Settlements. (2004). Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2004. http://www.bis.org/publ/rpfx05.htm.
Barton, J. (2001). Does the Use of Financial Derivatives Affect Earnings Management Decisions? The Accounting Review, 76, 1-26.
Bell, Judith. (1999). Doing your Research Project: A guide for first time researcher in Education: 3rd Edition Buckingham, Open University press.UK
Bodnar g. m., de jong a., macrae v., (2003). “The impact of Institutional Differences on Derivatives Usage: a Comparative Study of US and Dutch Firmsâ€?, European Financial Management vol. 9, No. 3, pp. 271-297.
El-masry a.,(2003) “A survey of derivatives use by UK non financial companies”, Social science research network Manchester Business School pg.455.
Grant, K. and Marshall, A. P. (1997), â€œLarge UK companies and derivativesâ€?, European Financial Management, vol. 3 no. 2, pp. 191-208.
Guay W & Kothari, S. P. (2003). How Much Do Firms Hedge with Derivatives? Journal of Financial Economics, 70, 423-461.
Hentschel, L., & Kothari, S. P. (2001). Are Corporations Reducing or Taking Risks with
Derivatives. Journal of Financial and Quantitative Analysis, 36, 93-118.
Mallin c.; Ow-yong k. and Reynolds m.,(2001) “Derivatives usage in UK non-financial listed companies”, The European Journal of Finance Vol. 7 (2001), pp. 63-91.
Saunders, M., Lewis, P. & Thornhill, A. (2007). Research Methods for Business Students. 4th Edition. Pearson Education Limited UK.
Prevost, A. K., Rose, L. C., & Miller, G. (2000). Derivatives Usage and Financial Risk Management in Large and Small Economies: A Comparative Analysis. Journal of Business Finance and Accounting, 27, 733-759.
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