Issues in financial risk management in Australia

Abstract

This thesis involves a theoretical and empirical examination of issues in financial risk management with a focus on the Australian environment. The primary aim of the thesis is to contribute to the understanding of the use and impact of derivative financial instruments for financial risk management. The majority of published work in this area is from the U.S.A. Therefore, the analysis and results contained in this thesis are of interest to an international audience. The results provide new evidence, in addition to confirmatory evidence, in relation to a number of issues. The thesis is divided into three sections with the conclusions provided in chapter eleven. The thesis is divided into three sections with the conclusions provided in chapter eleven. Following the introduction in chapter one, the first section (chapters two to five)examines issues associated with risk management. Chapter two considers some of the professional standards for the management of risk that have been issued by various professional and regulatory bodies. Chapter three examines different types of derivative contracts and how derivatives may be used. Measuring risk is an essential part of managing it. Financial risk is often difficult to identify from outside the organisation because organisations may hedge any portion of the exposure. Furthermore, financial risk may arise and then cease to exist as contracts are settled in such short periods that there is little evidence outside the firm to allow identification of them. However, there have been attempts to measure exposure to financial risk and these are covered in chapter four. Chapter five examines the theoretical issues associated with hedging financial risk and the potential benefits obtained from hedging. Section two (chapters six and seven) considers the use of derivatives in Australian Commonwealth public sector organisations. Risk management has traditionally been seen within the context of private sector organisations. However, the issue is becoming increasingly relevant and important to public sector entities as governments around the world implement policies that involve corporatisation, devolution of financial responsibility and impose competitive neutrality on their departments and bodies. Australia is no different and in some circles is seen as a world leader in the evolution of a business-orientated public sector. However, the strict translation of private sector theories and practices to the public sector, in which there are fundamental differences, may not be feasible nor desirable. Further, risk management in the public sector may require different practices and methods to achieve the desired outcomes. Chapter six introduces the empirical aspects of the thesis by considering the legal power of Commonwealth organisations in Australia to enter into derivative contracts. Public sector organisations, in particular Commonwealth statutory authorities, do not always have the powers 'of a natural person' afforded to companies governed under Australian corporations law. Such inconsistency is the base for uncertainty and possible additional costs for parties contracting with these organisations. Chapter six concludes with possible solutions to remove the uncertainty with respect to the legal power of Commonwealth organisations to enter derivative contracts. Chapter seven examines the use of derivative contracts in Commonwealth organisations through financial statement analysis and a questionnaire survey. This chapter represents the first public study of derivative use in Commonwealth organisations in Australia. Section three (chapters eight, nine and ten) considers important issues in the efficiency of derivatives markets. Three issues are considered. Chapter eight considers the price and volatility effects surrounding expirations of 90-day Bank Accepted Bill futures contracts. The evidence as presented in chapter eight for the Australian 90-day Bank Accepted Bills market is not sufficient to conclude that there are abnormal price or volatility effects surrounding the expiration of equivalent futures contracts. Hedgers therefore are unlikely to experience higher volatility if contracts are closed out or rolled over on maturity day. Another potential problem when hedging is pricing derivative contracts, such as options. When derivatives, in particular option contracts, are used in risk management the price of the contract must be ascertained. The Black-Scholes option pricing model is commonly used to price options. If the model incorrectly prices options then risk management strategies will be less effective. One bias, which has been identified in studies using overseas data, is the volatility 'smile'. Risk management strategies using options should take account of the effect of this bias. Chapter nine documents the volatility smile in the Australian stock options market. Chapter ten extends chapter nine by considering time varying volatility in option prices. Obtaining estimates of the volatility of the underlying asset price that provide more accurate Black-Scholes option prices is important. Generally, for options already trading, the implied volatility of previous day option prices is found to produce lower pricing errors over a range of different volatility estimates, including those obtained from a Generalised AutoRegressive Conditional Heteroscedastic (GARCH) model. However, if the option is not traded, GARCH estimates provide a better alternative than historical estimates.