Risk disclosures can convey to investors the nature and magnitude of significant financial risks and how well these risks are being managed.
Where do the largest financial risks to companies arise?
Financial risk exposures arise from a number of factors including volatile currency exchange rates, interest rates and commodity prices. They also arise from complex financial instruments. Different business models dictate a business's susceptibility to different types of risk. Companies with global operations will likely face foreign currency risk.
Why are financial risks currently so high?
Financial risks are influenced by the economic cycle. Credit risk-related losses typically materialise during strained economic environments. Credit risk can in turn exacerbate the funding risks faced by banks and cause problems refinancing the debt portion of the capital structure. The recent global crises also highlighted counter-party risk.
How well do companies communicate about financial risk management?
Financial risk management can occur through many enterprise choices. For example, banks hold liquid assets to mitigate the risk that customers will withdraw their deposits. Banks can hold greater equity capital buffers to absorb unexpected losses. Additionally, risk management entails hedging activities that are undertaken to mitigate particular risks faced by companies.
Are there specific financial risks the GCC region is exposed to?
As most of the GCC countries are pegged to the US dollar, currency risk is the predominant issue. While the-much-talked-about GCC monetary union aspires to bring about a unified currency it is still unlikely to mitigate the currency risk.
How can risk communication be improved through financial reports?
The CFA Institute conducted a study on risk disclosures under International Financial Reporting Standards (IFRS). The study made several recommendations for improving risk disclosures to convey useful and understandable information for investors. One of the key recommendations is executive summaries should be provided for all key risk categories that any company bears. Another recommendation is there should be an integrated presentation of related risk information.
High-quality risk disclosures are required to allow investors to make a more informed evaluation of the effectiveness of risk management strategies. To this end, risk disclosures need to communicate sufficient detail about the nature of applied risk management strategies.
Vincent Papa is the director of financial reporting policy at the CFA Institute, and Domluke Da Silva is with CFA Emirates