Risk management in import and export trading of Vietnamese firms

MMVCFB PROGRAMME DE MAITRIES EN MANAGEMENT VIETNAM COMMUNAUTE FRANCAISE DE BELGIQUE BÙI NGỌC PHƯƠNG HUYỀN RISK MANAGEMENT IN IMPORT AND EXPORT TRADING OF VIETNAMESE FIRMS MASTER OF

MMVCFB

PROGRAMME DE MAITRIES EN MANAGEMENT VIETNAM COMMUNAUTE

FRANCAISE DE BELGIQUE

BÙI NGỌC PHƯƠNG HUYỀN

RISK MANAGEMENT IN IMPORT AND EXPORT

TRADING OF VIETNAMESE FIRMS

MASTER OF MANAGEMENT THESIS

Ho Chi Minh City, Viet Nam

2006

ACKNOWLEDGMENTS

It is a rare pleasure for me to express my profound gratitude to Dr Vo Thi Quy - Research advisor - for her valuable guidance, constructive comments, explicit direction and encouragement throughout the research period

My acknowledgements are due to MMVCFB – the Vietnamese and Belgium Master Program, Vietnamese Professors and Belgium Professors of the program from Solvay Business School and who gave me a great chance to obtain valuable knowledge and long term relations

My thanks are also extended to the companies and organizations in Vietnam and many executives of import and export firms in Vietnam for their help and cooperation during period of my data collection

Thank all MMVCFB6 members and the faculty of the Hochiminh City Open University for their help and boundless inspiration

Last, but no least, to all my lovely friends, I give my sincerest appreciation for their warm encouragement, friendship and help at all times, especially their motivation during my studying time

ABSTRACT

International trading always contains implicit exposures to risk, especially

in the trends of globalization of trade and production That is why risk management has received increasing attention in recent years Its interests for preventing and mitigating exposures to risk are easy to recognize and are recorded by organizations all over the world However, in Vietnam, risk management has still been a new issue, at least in import and export activities of most small and medium-sized firms As a result, risks in import and export trading of Vietnamese firms are likely to occur frequently and at more serious level

This research aims to identify potential risks in import and export trading

of Vietnamese firms, the current situation in their risk management and factors influence to this process Attempts are made to propose guidelines for Vietnamese firms in risk management

The research suggests that investors should keep in mind those exposures

to risk in import and export activities seem more and more to increase due to the rise in uncertainty of the international market However, knowing risk management and applying an appropriate risk management will help them in preventing and minimizing loss

TABLE OF CONTENTS

ACKNOWLEDGMENTS I ABSTRACT II TABLE OF CONTENTS III ABBREVIATIONS VII LIST OF TABLES VIII LIST OF FIGURES X

CHAPTER 1 INTRODUCTION

1.1 BACKGROUND 1

1.2 OBJECTIVESANDSCOPEOFTHESTUDY 2

1.3 METHODOLOGY 2

1.4 RESEARCHFRAMEWORK 5

1.5 STRUCTUREOFSTUDY 5

CHAPTER 2 LITERATURE REVIEW 2.1 IMPORT ANDEXPORTTRADING 5

2.1.1 An introduction to import and export trading 5

2.1.2 Regulation of international trade 5

2.2 RISKMANAGEMENT 7

2.2.1 An introduction to risk and risk management 7

2.2.2 Risk Identification 7

2.2.2.1 Risk from Physical Environment 8

2.2.2.2 Risk from Social Environment 8

2.2.2.3 Risk from Operational Environment 8

2.2.2.4 Risk from Political and Legal Environment 9

2.2.2.5 Risk from Economic Environment 10

2.2.2.6 Risk from Cognitive Environment 11

2.2.3 Risk measurement 11

2.2.3.1 Direct and Indirect Effects 12

2.2.3.2 Dimensions of Exposure to Risk 12

2.2.3.3 Probable Maximum Loss (PML) 13

2.2.4 Risk control 13

2.2.4.1 Risk avoidance 14

2.2.4.2 Loss Prevention and Loss Reduction 15

2.2.4.3 Information management 16

2.2.4.4 Risk transfer 16

2.2.5 Risk financing 17

2.2.5.1 Retention 18

2.2.5.2 Insurance Transfers 19

2.2.5.3 Non-insurance Risk Financing Transfers 20

2.2.5.4 Hedging 23

CHAPTER 3 RISK MANAGEMENT IN IMPORT AND EXPORT TRADING OF VIETNAMESE FIRMS 3.1 RISKFREQUENCY 27

3.1.1 General Assessment of Risk Frequency 27

3.1.2 Frequency of Natural Risk 29

3.1.3 Frequency of risk due to unreliability of transportation system 30

3.1.4 Frequency of risk in handling of goods 31

3.1.5 Frequency of risk due to nature of goods 33

3.1.6 Frequency of risk due to lacking of information, differences in culture

and language 34

3.1.7 Frequency of political and legal policy risk 35

3.1.8 Frequency of economic risk 37

3.2 LOSSSEVERITY 40

3.2.1 General Assessment of Loss Severity 40

3.2.2 Loss Severity from Nature Force 43

3.2.3 Loss Severity due to problems in transportation 44

3.2.4 Loss severity due to handling of goods 46

3.2.5 Loss severity due to nature of goods 47

3.2.6 Loss severity due to lack of information, different culture and language 48 3.2.7 Loss Severity due to political and legal policy 49

3.2.8 Loss severity due to economic issues 51

3.3 ASSESSINGRISKMANAGEMENTOFVIETNAMESEFIRMSAND SOMEEXTERNALFACTORSINFLUENCINGTOIT 53

3.3.1 Assessing Risk Management of Vietnamese firms 53

3.3.1.1 Risk Management Department or Risk Specialist in the organization 53

3.3.1.2 Information system for risk management 56

3.3.1.3 Training for staffs on risk management: 58

3.3.1.4 Buying insurance of Vietnamese import and export companies.59 3.3.1.5 Knowing and using hedging: forward and option contracts 61

3.3.2 External Influencing factors 63

3.3.2.1 Vietnamese legal system for import and export activities 63

3.3.2.2 Insurance market of import and export goods in Vietnam 63

3.3.2.3 Development of some risk hedging instruments 66

CHAPTER 4 CONCLUSIONS AND RECOMMENDATIONS 4.1 CONCLUSIONS 69

4.2 RECOMMENDATIONS 72

4.2.1 For import and export firms 72

4.2.2 For the economy and government: 75

4.3 RECOMMENDATIONSFORNEXTSTUDIES 77

ANNEX1 78

ANNEX2 81

REFERENCES 97

ABBREVIATIONS

AFTA : ASEAN Free Trade Area

BIDV : Bank for Investment and Development of Vietnam

CEO : Chief Executive Officer

CIF : Cost, Insurance and Freight (Incoterm)

EUR : The Official Currency of European Union member states (Euro) FDA : Food and Drug Association (of the United States)

FOB : Free On Board (Incoterm)

FTAA : Free Trade Area of the Americas

Forex : Foreign Exchange Rate

GATT : General Agreement on Tariffs and Trade

GBP : Currency of Great Britain

JPY : Currency of Japan (Yen)

MAI : Multilateral Agreement on Investment

NAFTA : North American Free Trade Agreement

PML : Probable Maximum Loss

USD : Currency of the United States

VND : Currency of Vietnam

WTO : The World Wide Organization

LIST OF TABLES

Table 3-1: Statistical record of risk frequency based on Im- Export turnover 29

Table 3-2: Statistical record of loss severity based on Im- Export turnover 43

Table 3-3: Opinions on necessity of buying insurance in the import and export trading 61

Table A2-1: Statistical record of risk frequency for group of exposures 82

Table A2-2: Statistical record of risk frequency based on company size 82

Table A2-3: Statistical record of risk frequency based on company type 82

Table A2-4: Statistical record of risk frequency based on im- export turnover 83

Table A2-5: Statistical record of risk frequency due to natural force 83

Table A2-6 Statistical record of risk frequency due to problems in transportation .83

Table A2-7 Statistical record of risk frequency due to handling of goods 83

Table A2-8 Statistical record of risk frequency due to nature of goods 84

Table A2-9 Statistical record of risk frequency due to lacking of information, difference of culture, language 84

Table A2-10 Statistical record of risk frequency due to political/ legal policy 84

Table A2-11 Statistical record of risk frequency due to economic issues 85

Table A2-12 Statistical record of risk frequency for all exposures to risk 85

Table A2-13: Statistical record of loss severity for group of exposures 86

Table A2-14: Statistical record of loss severity based on company size 87

Table A2-15: Statistical record of loss severity based on company type 87

Table A2-16: Statistical record of loss severity based on im-export turnover 87

Table A2-17: Statistical record of loss severity due to natural force 87

Table A2-18: Statistical record of loss severity due to transport problems 88

Table A2-19: Statistical record of loss severity due to handling of goods 88

Table A2-20: Statistical record of loss severity due to nature of goods 88

Table A2-21: Statistical record of loss severity due to lack of information, difference in culture, language 88

Table A2-22: Statistical record of loss severity due to political/legal policy 89

Table A2-23: Statistical record of loss severity due to economic policy 89

Table A2-24: Statistical record of loss severity for all exposures to risk 89

Table A2-25: The presence of risk specialist/risk department in the firms 90

Table A2-26: Statistics of the answer of the necessity of risk specialist/risk department in the firms 91

Table A2-27: Statistics of the answer of risk management training 92

Table A2-28: Statistics of the answer of risk handling in the organization 92

Table A2-29: Statistics of the answer of risk report in 93

Table A2-30: Statistics of the answer of information update 93

Table A2-31: Statistics of the answer of Buying Insurance and its necessity 94

Table A2-32: Statistics of the answer of the necessity of buying Insurance 94

Table A2-33: Statistics of the answer of knowing forward contracts 94

Table A2-34: Statistics of the answer of using hedging contracts 95

Table A2-35: Statistics of the answer of knowing option contracts 95

Table A2-36: Statistics of the answer of using option contracts 96

LIST OF FIGURES

Figure 1-1: Composition of the final sample, 100 Firms 4

Figure 3-1: Statistical record of risk frequency for groups of exposures 27

Figure 3-2: Statistical record of risk frequency based on company size/type 28

Figure 3-3: Statistical record of risk frequency for natural force 30

Figure 3-4: Statistical record of risk frequency for transportation problems 31

Figure 3-5: Statistical record of risk frequency in handling goods 32

Figure 3-6: Statistical record of risk frequency due to nature of goods 33

Figure 3-7: Statistical record of risk frequency due to lacking information, different culture and language 35

Figure 3-8: Statistical record of risk frequency due to political/legal policy 37

Figure 3-9: Statistical record of risk frequency due to economy issues 39

Figure 3-10: Statistical record of loss severity for groups of exposures 40

Figure 3-11: Statistical record of loss severity based on company size/type 41

Figure 3-12: Statistical record of loss severity for natural force 44

Figure 3-13: Statistical record of loss severity for transportation problems 45

Figure 3-14: Statistical record of loss severity in handling goods 47

Figure 3-15: Statistical record of loss severity due to nature of goods 48

Figure 3-16: Statistical record of loss severity due to lacking information, different culture and language 49

Figure 3-17: Statistical record of loss severity due to political/legal policy 51

Figure 3-18: Statistical record of loss severity due to economy issues 52

Figure 3-19: Average % of answer of having risk department or risk specialist in the organization 54

Figure 3-20: Average % of answer of necessity of having risk specialist 55

Figure 3-21: Average % of firms making reports on risk incidents 57 Figure 3-22: Frequency of update relating information for im- export trading

activities 58 Figure 3-23: Average % of firms provides risk training to their staffs .59 Figure 3-24: Frequency of buying insurance in import –export trading of firms.60 Figure 3-25: Average % of answer “yes” on knowing forwards and options 61 Figure 3-26: The frequency of using forward and option transactions in import

and export trading of Vietnamese firms .62 Figure 4-1: Combination of risk frequency and risk severity 73

CHAPTER 1 INTRODUCTION

1.1 BACKGROUND

In the process of integration with the international economy, Vietnam government has had efforts to achieve the progress on many areas of economy, politics and society Especially, the foreign trade activity has obtained encouraging results and had a great contribution to the general development of the country’s economy

According to the statistics of the Ministry of Trade1, the total turnover of export in the duration of 2001 – 2005 was US$110.6 billions with the increase rate of over 16% per year The export turnover per head was US$370 in 2005 – a double number of 2000 The import also developed quite well last year with the turnover of US$37 billions, a rise by 15.7% in comparison with the previous year The country’s import and export activities have been expanded to all over the continents By 2005, Vietnam has established commercial relations with over

220 countries and territories among the total number of 250 countries and territories in the world2 Although obtaining remarkable improvement in turnover and market for international trading, Vietnamese firms have faced a number of problems in their activities The reason is that they have not got accustomed with the international custom, practices, regulations and law systems, lacking of information and knowledge of risk management…Therefore, risk in import and export activities is inevitable The situation may be more serious, because now

1 Source: The Ministry of Trade, March 2006

2 Source: The Ministry of Planning and Investment, The Five Year Socio-Economic Development Plan 2006-2010, Hanoi March 2006

Vietnam has became the 150th member of WTO and has officially participated into the larger playing field with many opportunities and a great number of

threats

This study aims to indentify risks that Vietnamese firms frequently face in the international trading, their risk management and influencing factors From that, some recommendations for the improvement in risk management is given

1.2 OBJECTIVES AND SCOPE OF THE STUDY

Although Vietnamese firms have experienced and paid further attention to risk management in the international trading, exposures to risk are likely to

increase in many import and export activities of the country, especially when Vietnam integrates more deeply with the global economy

The objectives of this research are:

• Identify risks of Vietnamese firms in the import and export trading through assessment of risk frequency and loss severity

• Assess the risk management in import and export activities of Vietnamese firms and factors that may influence to it

• Give concluding remarks and recommend solutions to Vietnam firms for better risk management in the international trading

With the above objectives of study and due to a limit of research time, the study is carried out on firms that are located in Hochiminh City that have import

or export activities

1.3 METHODOLOGY

This research is conducted in 3 stages:

1 Review literature on:

- Import and export activity with its trends and regulations in international trade

- Risk management in identification, assessment, some methods for preventing and minimizing risk, including: risk control and risk financing

2 Survey risks in import and export activities of Vietnamese firms:

To indentify risk Vietnamese firms in international trading and evaluate the current situation of their risk management, the study concentrates on the assessment of risk frequency, loss severity and factors influencing to risk management of firms A suitable strategy is to conduct research by interview with questionnaires3, which is designed with three main parts Firstly, it is group

of questions for general information of the surveyed firms Secondly, qualitative questions on risk frequency and loss severity require interviewees to choose the most appropriate answer [interval scale]4: (1)Almost Nil å (5)Definite Last group of questions concentrates on risk management of firms

There are two stages in the survey A pre-test with 30 response questionnaires was carried out to identify main sources and types of risk that are considered to be most popular to Vietnamese companies before the official research took next steps After the pre-test survey, the questionnaire was revised They were sent to key persons of companies from import – export departments, and the CEOs, interviewing through telephone and direct in-dept interview A total of 500 questionnaires were delivered The number of collected answer was 100 This represents a response rate of 20% The data was processed

by the software “SPSS 14.0 for Windows”, mainly by descriptive statistics method

3 See the Questionnaire in ANNEX 1

4 The interval scale is designed only for the research since data of risk frequency and loss severity of Vietnamese firms are not available in a form that can be used directly for measurement in quantity

by Stock firms, while 9% for Joint Venture firms State-owned firms and liability limited Co account only for 2% and 4% respectively

Figure 1-1: Composition of the final sample, 100 Firms

(Soursce: The survey result)

5 Small firms have less than 200 employees, medium firms have between 200 and 499, and large ones over 500

3 Conclusions and recommendations:

Following the survey result and the current situation of Vietnam as well as

a comparison with the literature of risk management, some conclusions and suggestions are given to help Vietnamese firms better in risk management

1.4 RESEARCH FRAMEWORK

1.5 STRUCTURE OF STUDY

The thesis includes the following parts:

̇ Chapter 1: Presents the research background, targeted problems, research methodology, research framework and limitation of the study

̇ Chapter 2: Introduces the literature review of import and export trading and risk management theories

̇ Chapter 3: Assessments of risk management in import and export trading

of Vietnamese firms and influencing factors

̇ Chapter 4: Conclusions and recommendations to help Vietnamese firms have more solutions for risk management

Current situation in Risk management of Vietnamese firms

- Risk frequency

- Loss severity

- Influencing factors

Objectives of study

Literature reviews on:

- Import & export activities

- Risk management

Conclusion and recommendation

CHAPTER 2 LITERATURE REVIEW

2.1 IMPORT AND EXPORT TRADING

2.1.1 An introduction to import and export trading

Import and export trading is the exchange of goods and services across international boundaries or territories While international trade has been present throughout much of history (see Silk Road, Amber Road), its economic, social, and political importance has been on the rise in recent centuries Industrialization, advanced transportation, globalization, multinational corporations, and outsourcing are all having a major impact Increasing international trade is the usually primary meaning of "globalization" [Wikipedia]

2.1.2 Regulation of international trade

Traditionally trade was regulated through bilateral treaties between two nations For centuries under the belief in Mercantilism most nations had high tariffs and many restrictions on international trade In the 19th century, especially in Britain, a belief in free trade became paramount and this view has dominated thinking among western nations for most of the time since then In the years since the Second World War multilateral treaties like the GATT and World Trade Organization have attempted to create a globally regulated trade structure

Free trade is usually most strongly supported by the most economically powerful nations in the world, though they often engage in selective protectionism for those industries which are politically important domestically, such as the protective tariffs applied to agriculture and textiles by the United States and Europe As tariff levels fall, there is also an increasing willingness to

negotiate non tariff measures, including foreign direct investment, procurement and trade facilitation The later looks at the transaction cost associated with meeting trade and customs procedures

Traditionally agricultural interests are usually in favor of free trade while manufacturing sectors often support protectionism This has changed somewhat

in recent years, however In fact, agricultural lobbies, particularly in the United States, Europe and Japan, are chiefly responsible for particular rules in the major international trade treaties which allow for more protectionist measures in agriculture than for most other goods and services

During recessions there is often strong domestic pressure to increase tariffs to protect domestic industries This occurred around the world during the Great Depression (economic downturn which started in 1929 and lasted through most of the 1930s) leading to a collapse in world trade that many believe seriously deepened the depression

The regulation of international trade is done through the World Trade Organization at the global level, and through several other regional arrangements such as MERCOSUR in South America, NAFTA between the United States, Canada and Mexico, the European Union between 25 independent states and AFTA between ASEAN countries including Vietnam The 2005 Buenos Aires talks on the planned establishment of the Free Trade Area of the Americas (FTAA) failed largely due to opposition from the populations of Latin American nations Similar agreements such as the MAI (Multilateral Agreement

on Investment) have also failed in recent years [Wikipedia]

2.2 RISK MANAGEMENT

2.2.1 An introduction to risk and risk management:

There are many definitions of risk depending on the specific application and situational contexts Generally, risk is potential variation in outcomes When risk is present, outcomes cannot be forecasted with certainty [Williams, JR, Smith and Young, 1998] As a result, risk gives rise to uncertainty for loss and gain However, people often see the bad effect of risk than its opportunity for gain, so it is considered to be related to the expected losses which can be caused

by a risky event and to the probability of this event The harsher the loss and the more likely the event, the worse the risk Risk entails two essential compoment: exposure and uncertainty Risk, then, is an exposure to a proposition of which one is uncertainty [Holton, 2004]

Risk management is is a general management function that seeks to assess and address the causes and effects of uncertainty and risk on an organization The purpose of risk management is to enable an organization to progress toward its goals and objecties (its mission) [Williams, JR, Smith and Young, 1998]

2.2.2 Risk Identification

Risk identification is the process by which an organization is able to learn

of the areas in which it is exposed to risk Ordinarily, risk identification proceeds

as if the set of risks faced by the organization is given However, the identification of risk could just as well reveal areas of exposure that the organization does not now face but might find profitable to enter The investigation of new risks is part of risk identification process The notion of integrating new risks into the risk identification process springs from a belief that the attempt to systematically identify all risks – present and future - is in the

organization’s best interest Risk can be classified in several ways One of them

is based on the sources of risk [Williams, JR, Smith and Young, 1998]

2.2.2.1 Risk from Physical Environment

The physical environment is a fundamental source of risk Bad weather, earthquakes, storm, drought, or excessive rainfall can all lead to loss The ability

to fully understand our environment and the effects we have on it – as well as those it has on us – is a central aspect of this source of risk The physical environment may be the source of opportunity as well, for example, real estate

as an investment, agribusiness and weather as a contributing factor to tourism [Williams, JR, Smith and Young, 1998]

2.2.2.2 Risk from Social Environment:

Changing mores and values, human behavior, social structure, and institutions are a second source of risk Many business executives become frustrated when they move into the international domain For example, differing social values and norms in Japan have proven to be a particular source of uncertainty for American and European business managers [Williams, JR, Smith and Young, 1998] Risk from culture can cause companies loss of billions US dollars through timely negotiation but without success, loosing business opportunities and perhaps loosing customers Cultural risk comes from lacking information, knowledge of culture of different overseas partners, customers and markets, such as ways of thinking, making decision based on role of personal relationship,…It may be the misunderstanding due to incompetence in language

2.2.2.3 Risk from Operational Environment:

[Williams, JR, Smith and Young, 1998]

Processes and procedures of an organization generate risk and uncertainty A formal procedure for promoting, hiring, or firing employees may

generate a legal liability The manufacturing process may put employees at risk

of physical harm Activities of an organization may result in harm to the environment International businesses may suffer from risk or uncertainty due to unreliable transportation systems, the handling of goods or the nature of goods The operational environment also provides gains, as it is the ultimate source of the goods and services by which an organization succeeds or fails

Examples of operational risk include:

̇ technology failure

̇ business premises becoming unavailable

̇ inadequate document retention or record-keeping

̇ poor management, lack of supervision, accountability and control

̇ errors in financial models and reports

̇ attempts to conceal losses or make personal gains (rogue trading)

̇ third party fraud

In short risk associated with non-availability of environment to function

2.2.2.4 Risk from Political and Legal Environment:

Within a single country, the political environment can be an important source of risk A new president can move the nation into a policy direction that might have dramatic effects on particular organizations (cuts in aid to local governments) In the international realm, the political environment is even more complex [Williams, JR, Smith and Young, 1998] Different countries have different political environment with differences in policies toward business Foreign assets might be confiscated by a host government or tax policies might change dramatically [Williams, JR, Smith and Young, 1998] An adjustment of the United States in interest rate policy even impacts to the whole international economy This has direct or indirect effect to trading firms The political

environment also can promote positive opportunities through fiscal and monetary policy, enforcement of laws, and the education of the populace

Like political policy, a great deal of uncertainty and risk arises from the legal system Not only are standards of conduct upheld and punishments enforced, but as the system itself evolves new standards arise that may not be fully anticipated In the international domain, complexity increases because legal standards can vary dramatically from country to country The legal environment also produces positive outcomes in the sense that rights are protected and that the legal system provides a stabilizing influence on society [Williams, JR, Smith and Young, 1998]

Some risks for import and export firms from political and legal environment will be discussed in the thesis: political crisis, trade embargo policy, barriers in the import and export control system, tax policy, price control policy, fiscal and monetary policy

2.2.2.5 Risk from Economic Environment:

Although the economic environment often flows directly from the political realm, the dramatic expansion of the global market place has created an environment that is greater than any single government [Williams, JR, Smith and Young, 1998] Changing of goods, fuel, materials on the international market can

be harmful to most of countries, organizations and individuals, while be a benefit for others Although a particular government’s action may affect international capital markets, control of capital markets is beyond the reach of a single nation Inflation, recession, and depression are now elements of interdependent economic systems [Williams, JR, Smith and Young, 1998] The fluctuation of foreign exchange rates can affect to organizations trading in the international

domain On a local level interest rates and credit policies can impose significant risk on an organization [Williams, JR, Smith and Young, 1998]

2.2.2.6 Risk from Cognitive Environment

[Williams, JR, Smith and Young, 1998]

A risk manager’s ability to understand, see, measure and assess is far from perfect An important source of risk for organizations is the difference between perception and reality The cognitive environment is a challenging source of risk to identify and analyze The analyst must contemplate such questions as “How do we understand the effect of uncertainty on the organization?” and “How do we know whether a perceived risk is real?”

2.2.3 Risk measurement

[Williams, JR, Smith and Young, 1998]

Once a risk has been identified, its importance can be assessed Risk measurement evaluates a risk’s importance to an organization or individual In practice, risk measurement is unlikely to be distinct from risk identification Even if all of the risks that have been identified are important, however, the task

of ranking their levels of importance still remain before a plan of action is developed Formal methods for measuring risk are helpful, if only to set guidelines for resource allocation

Risk measurement requires the risk manager to (1) develop yardsticks for measuring the importance of risks to the organization and (2) apply these yardsticks to the risks that have been identified Many measurement methods have been developed and applied depending on the specific areas of exposure to risk In some circumstances, data are not available in a form that can be used directly for risk assessment Qualitative aspects of risk measurement can be used

as outlined later

2.2.3.1 Direct and Indirect Effects:

In estimating the financial effects of an incident, direct effects usually are obvious, but indirect effects also can be significant and in some cases may dominate direct effects In most cases, direct effects are apparent and can be assessed easily prior to the occurrence of an incident Anticipating indirect effects requires more thought The risk manager’s role in risk assessment is to identify all consequences of a given event, for which the possibility of indirect effects must be kept in mind

2.2.3.2 Dimensions of Exposure to Risk:

Methods of assessing exposure to risk depend on the area of application

In the case of losses that might be covered by insurance, data often are available

on “loss frequency” and “loss severity”

- Loss frequency is a measure of how often a loss occurs, on average within

a given period such as a calendar year If more than one loss is possible during the period, loss frequency is the expected number of losses If no more than a single loss can occur during a period, probability of loss and loss frequency are identical measures

Richard Prouty, the risk manager of a large business, suggested over 30 years ago that instead of using numerical estimates, risk managers might classify probabilities as (1) “almost nil” (meaning in the opinion of the risk manager the event will not happen), (2) “slight” (though possible, the event has not happened

to the present time and is unlikely to occur in the future), (3) “moderate” (it has happened once in a while and can be expected to occur some time in the future),

or (4) “definite” (it has happened regularly and can be expected to occur regularly in the future (Prouty, 1960)

- Loss severity gauges how serious the losses are when they occur An assessment of severity requires the risk manager to consider whether an outcome can impair the organization’s progress toward its mission

2.2.3.3 Probable Maximum Loss (PML)

In assessing the importance of a risk to an organization, the largest loss can occur under foreseeable circumstances is valuable information The term often applied to this estimate is “probable maximum loss” (PML), which is the largest amount of damage that is likely to occur Essentially, a risk manager believes that damage exceeding the PML is very unlikely to occur, but not necessarily impossible

Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four categories: transfer, avoidance, reduction and acceptance [Dorfman, 1997] These techniques will be discussed into two strategies of firms: Risk control and Risk Financing

2.2.4 Risk control

[Williams, JR, Smith and Young, 1998]

Risk control methods seek to alter an organization’s exposure to risk Effective risk control includes techniques, tools, strategies, and processes that seek to avoid, prevent, reduce, or otherwise, control the frequency and/or magnitude of loss and other undesirable effects of risk; risk control also includes methods that seek to improve understanding or awareness within an organization

of activities affecting exposure to risk

The use of risk control methods in an organization can be based on criteria applying generally to nearly all areas of management activity including risk management: a balancing of benefits against costs In some instances, external influences such as state and federal governments may mandate the use of risk

control methods or provide other incentives affecting the use of risk control This statement is based on three considerations:

(1) The cost of risk financing commonly is greater than the cost of losses themselves

(2) Losses typically generate indirect or hidden costs that may not be revealed until the distant future

(3) Losses can have effects outside an organization

Although risk control programs can vary from organization to organization

as a consequence of creativity and innovation, a typology of risk control tools and methods still exists Risk control tools and techniques can be categorized as risk avoidance, loss prevention, loss reduction, information management and some types of risk transfer

2.2.4.1 Risk avoidance:

One way to control a particular risk is to avoid the property, person, or activity giving rise to possible loss by either refusing to assume it even momentarily or by abandoning an exposure to loss assumed earlier The first of these avoidance activities is proactive avoidance; the second is abandonment

Avoidance is an effective approach to the handling of risk By avoiding a risk, the organization knows that it will not experience the potential losses or the uncertainly that the risk may generate However, it also loses the benefits that may have been derived from that risk Indeed This very fact often makes avoidance an unacceptable option A particular activity – the production of some product, the provision of some service – may provide economic rewards whose expected value far exceeds potential loss costs at the margin

There are other circumstances when avoidance simply is not possible The more broadly the risk is defined (say, property damage), the more likely this is to

be the case The context of the decision to avoid also may make avoidance impossible Finally, a risk may be so fundamental to the organization’s reason for being that avoidance cannot be contemplated

2.2.4.2 Loss Prevention and Loss Reduction

Loss prevention and reduction measures attack risk by reducing the number of losses that occur (i.e., loss frequency is reduced) or by mitigating the amount of damage when a loss does occur (i.e., loss severity is reduced)

- Loss prevention: Loss prevention programs seek to reduce the number of

losses or to eliminate them entirely Loss prevention activities are focused on:

1 Altering or modifying the hazard

2 Altering or modifying the environment in which the hazard exists

3 Intervening in the processes whereby hazard and environment interact

− Loss reduction: Loss reduction programs are designed to reduce the potential

severity of a loss Loss reduction activities are postloss measures Although such measures may be planned prior to any loss, their function or purpose is to minimize the impact of losses that occur Loss reduction programs are a tacit admission on the part of the risk manager that some losses will occur despite an organization’s best efforts Therefore, steps should be taken to control the loss and reduce its potential severity

A somewhat related loss reduction technique is commonly identified by the term subrogation When an insurance company pays a claim to a policyholder there may be an opportunity for the insurer to seek reimbursement from a negligent third party in the claim

Loss reduction seeks to reduce the impact of loss either through controlling the event as it occurs, controlling the immediate outcome of the

event, or controlling the longer-term consequences of the event A catastrophe or contingency plan is an integrated approach to loss reduction A catastrophe plan

is an organizationwide effort to identify possible crises or catastrophes and develop plans for responding to such events

Separation offers a final illustration of a loss reduction technique Separation is a technique that isolates exposures to loss from each other instead

of leaving them vulnerable to single event

2.2.4.3 Information management

Information emanating from an organization’s risk management department can have important effects in reducing uncertainty in an organization’s stake holders Communication from an organization’s risk management department conveys information describing the effectiveness of loss control measures and the intent of the department’s future actions Another area in which communication can reduce uncertainty involves individual’s awareness of the loss-causing process, for example, the risk chain Knowledge of the process by which hazards evolve into injuries can reduce uncertainty in affected parties, as the awareness allows better forecasts of the consequences of action For example, employees’ awareness of the circumstances leading to possible injury can alert them to situations requiring preventive action One possibility for enhancing this awareness is a reporting method and system of rewards for employees who make suggestions leading to safer practices

2.2.4.4 Risk transfer:

Risk transfer is a risk control tool that causes some entity other than the one experiencing the loss to bear the burden of the loss Transfer may be accomplished in two ways First, the property or activity responsible for the risk may be transferred to some of the person or group of persons A general

contractor concerned about possible increases in the cost of labor and materials needed for the electrical work on a job which he or she is already committed can transfer the risk by hiring a subcontractor (with a fixed price contract) for this portion of the project Second, the risk, but not the property or activity, may be transferred, usually by contractual agreement A trading exporter may assume responsibility for any damage to products that occurs after the products leave the manufacturer’s premises even if the manufacturer otherwise would be responsible In a risk control transfer, the transferee (the party accepting the risk) excuses the transferor (the party transferring the risk) from liability The transferor’s exposure is eliminated

2.2.5 Risk financing:

[Williams, JR, Smith and Young, 1998]

In most risk management programs, some losses occur in spite of the best risk control efforts The failure to control all risks means that some measures must be taken to finance losses that occur Risk financing is a passive activity when compared with risk control Risk financing techniques are reactive in the sense that they are activated only after a loss occurs This is not to say that risk financing strategies and activities are unplanned The risk assessment process plays an important role in helping to plan and implement a rational risk financing program However, losses must occur before the financing mechanism comes into play Risk financing methods fall into two classes: Retention and transfer The choice between retention and transfer is based on considerations such as:

- The maximum probable cost relative to the organization’s capacity for bearing risk

- Restriction or legal limitation applying to risk transfers

- The organization’s degree of control over the risk

- Loading fees associated with the transfer

- The value of services provided by insurers and other financial institutions

- Opportunity costs related to investment of funds

- The availability of alternatives to retention

2.2.5.1 Retention:

The most common method of financing risk is retention by the organization Retention may be passive or active, unconscious or conscious, unplanned or planned Retention is active or planned when the risk manager considers other methods of handling the risk and consciously decides not to transfer the potential losses Retention is passive or unplanned when the risk manager is not aware that the exposure exists and consequently does not make plans to finance it By default, therefore, the organization has elected to remain the risk associated with that exposure Few, if any, organization has identified all their exposures to property, financial, liability, and human asset losses Consequently, some unplanned retention is commonplace and inevitable Unplanned retention may, by chance, be the best approach to a particular exposure, but it is never a rational way of handling the matter Self-insurance is

a special case of planned retention Self-insurance occurs when the organization has enough resources to easily absorb a loss that it retains Typically, self-insurers have a large number of units exposed to loss, in which case the self-insurer resembles an insurer that has written large number of insurance policies

- No Advance Funding: Many decisions to retain property and liability

losses do not involve any formal advance funding The organization simply bears the losses when they occur This approach cuts administrative detail to a minimum; but if the losses fluctuate widely from year to year, the organization may experience distress when large losses occur

- Earmarked Liability Accounts: A risk manager for a self-funding entity

who is concerned about possible impact of uninsured losses on the entity’s financial reports might be tempted to create a liability account to absorb fluctuations in uncovered losses Each year a provision for loss would be added

to the account, with profits or other financial gains reduced by the same amount Technically, this earmarked account is not a funding method because it does not provide resources to finance losses It is a bookkeeping method to account for the cost of losses

- Earmarked Asset Accounts: An organization may hold cash or investments

that can easily be turned into cash for the purpose of paying uninsured losses This approach could be used when uninsured could possible exceed the cash available for emergencies and the amount the organization could borrow A disadvantage of the earmarked asset account is the possibly low return on assets held as cash or near-cash when investing them elsewhere, especially within the organization, provides a higher return

- Captive Insurers: A captive insurer is an insurer that is owned by the

insured The parent organization establishes a captive insurance subsidiary that writes insurance against the parent’s insured risks These captive insurers may write insurance for other parties that are not affiliated with the parent and also may be active in reinsurance markets (reinsurance is coverage written between insurers rather than with the ultimate consumers of insurance)

insurer and the insured Under the agreement, the insurer agrees to reimburse loss (as defined in the insurance contract) in return for the insured’s premium payment

- Elements of an Insurance transaction: Four elements are required for an

insurance transaction under this definition: (1) a contractual agreement (2) a premium payment (or a promise to pay) by the insured (3) a benefit payment conditioned on circumstances (usually of misfortune) defined in the insurance contract and (4) the presence of a pool of resources held by the insurer to reimburse claims Normally, the pool of resources consists of premium payments accumulated from insureds, although premium payments are not required for a transaction to be considered insurance

- Pooling Agreements and Combination: A pooling agreement can take the

form of an agreement to share losses that occur among pool participants For example, a group of municipalities may agree to share liability exposures arising from police and fire protection activities through a pooling agreement Under the pooling agreement, the financial impact of the liability exposure tends to become more predictable per municipality as compared with its impact in the absence of the pooling agreement Pooling of risk exposures also is called combination, which refers to the combining or pooling of losses arising from a large number of exposures As a result of combination, the loss per unit tends to become more predictable

2.2.5.3 Non-insurance Risk Financing Transfers:

- Instruments of Trade Credit: Whenever goods or services are sold without immediate payment, the seller faces the risk of not being paid If the customer defaults on promised payments, the seller cannot require that the goods be returned Instead, the seller becomes a general creditor against the customer,

assuming much the same status as holders of unsecured debt An exception could occur when the seller retains title to goods until full payment is made, in which case the seller’s status is analogous to the holder of secured debt Even when the seller retains title, however, repossessing the goods may not be practical Therefore, using the safe means of payment is one of the methods to secure risk

Some means of payment that sellers often use to provide assurance of payment through the banking system are: drafts, acceptances, or letters of credit These arrangements are widely used in international trade and when uncertainty exists about the customer’s ability to pay For example, a seller may draw up a draft and ship it to the customer’s bank along with the shipping documents The customer either pays the draft of acknowledges the debt prior to being given the shipping documents, and the customer’s bank forwards the payment or the acknowledgment in the form of a trade acceptance to the seller When uncertainty is present about the customer’s ability to pay, the seller may ask the customer’s bank for a guaranty of payment called a bank acceptance, which obligates the bank as well as the customer

When an even stronger guaranty of payment is required, especially in international transactions, the seller may ask the customer to arrange for a letter

of credit The letter of credit from the customer’s bank states that a credit in the seller’s favor has been established in a bank in the seller’s country The seller holding the letter of credit then has recourse against a bank in its own country instead of a foreign bank The seller has recourse against a bank in its own country instead of a foreign bank The seller presents the draft against the customer’s bank, along with the shipping documents and the letter of credit, to the bank at which the credit has been established Very often, the condition required for the letter of credit to be honored is presentation of shipping

documents showing that the vessel has departed from port In domestic transaction, a standby letter of credit serves the same purpose, but it may apply

to a category of transactions rather than being tied to a specific transaction

A letter of credit could be used in international transactions to provide financial security for a number of different types of transaction However, the holder of a letter of credit faces possible default if the customer’s bank or the government of the country of the customer’s bank defaults on the transaction; hence, the letter of credit should be confirmed by a bank in the seller’s country

or by a very reputable bank outside the customer’s country

A letter of credit resembles insurance coverage in some respects Insurance contracts typically include specific conditions that must be met for the insurer to pay a claim As in the case of insurance coverage, a letter of credit is very specific as to what conditions are required for it to be honored Default by the customer’s bank raises the possibility of the confirming bank looking carefully for technical errors in the shipping documents so it can claim that the conditions leading to payment have not been met

- Other Non-insurance Risk Financing Transfers: Non-insurance risk financing transfers often occur as a result of provisions in contracts dealing primarily with other matters In some cases, transfers occur through contracts specifically designed to shift financial responsibility Many of these contractual arrangement transfer financial responsibility for direct property losses or loss of income, some deal with human asset losses, others transfer financial responsibility for liabilities to third parties The transfers differ as to the extent of responsibility shifted At one extreme, the transferor shifts only his or her financial responsibility (vicarious liability) for the negligent acts of the transferee At the other extreme, the transferor is to be indemnified for losses

covered under the contract no matter who (the transferee, some third party, or an act of God) caused the loss An example for this method: a retailer may insist on

a hold-harmless provision in its purchase contracts under which the manufacturer agrees to indemnify the retailer for any liability sustained because of defective products unless that defect was caused solely by the retailer’s negligence

2.2.5.4 Hedging:

Hedging is financial transaction in which one asset is held to offset (hedge) the risk of holding another asset A simple illustration is an individual who has bet one way on the outcome of a sporting event betting the other way as well The outcomes of the two bets (if they both are honored) tend to cancel each other Typically, a hedge is used to offset price risk; an organization acquires an asset whose price changes are negative correlated with changes in the price of another asset Hedging could employ assets merely because their returns are observed to have a negative correlation More commonly, hedging employs assets whose returns are negatively correlated by design There are some kinds

of hedging contract: future, forward, option contract and swaps

- Future and forward contracts: The delivery of a specified asset at a future

point in time is promised in a future or forward contract The holder (buyer) of a futures or forward contract has agreed to take delivery of a stated quantity of the asset (e.g., a standard futures contract for light crude oil is for 1,000 barrels) at a future point in time (say, February of the following year), which the writer (seller) of the contract has promised to deliver Futures and forward contracts are examples of financial derivatives whose value is derived from underlying asset

For example, an organization can use a commodity futures contract to offset the risk of price changes in a commodity that will be consumed at a future point in time, but without actually storing the commodity Futures contracts on

commodity are often considered a form of synthetic storage, in that the contracts substitutes for the physical storage of the commodity Because the price of the futures contract is known today, an organization can agree to deliver finished products in the future at predetermined prices For example, the current price of

a futures contract for delivery of light crude oil the following February may be

$22.00 per barrel An oil refiner can agree to deliver refined products next February at a price based on a crude oil cost of $22.00 per barrel because it knows it can purchase the oil at that price

Futures contracts are standardized and traded on organized exchanges The market price of a futures contract is known at the time of transaction in the futures market, although actual payment is not made at that time Both the buyer and the seller are required to post a margin in the form of cash or near-cash to show that they have liquid assets sufficient to meet the requirements of the future transaction Each day, the futures contract is “marked to market” when the exchange posts gains and losses to each party’s account

A corporation could use a futures contract to reduce the effect of fluctuating prices of raw materials on the profitability of fixed-price agreements that will be carried out in the future For example, an oil refiner that has signed a fixed-price agreement to deliver products refined from crude oil is exposed to the risk of changing crude oil prices prior to the time the agreement has been met By holding the futures contract, the refiner has acquired an asset that offsets the effect of changing crude oil prices A rise in crude oil prices would reduce profits on the transactions with the refinery’s customer, but this loss would be offset by the gain on the crude oil futures Similar reasoning applies to the seller, who presumably is holding an inventory of oil or is engaged in the extraction of

oil The $0.55 gain in the price of the futures contract is a loss to the seller, but the loss is offset by a gain in the price at which the oil will be sold

A forward contract is a private agreement that is not traded on an exchange Unlike futures, forward contracts are not marked to market The payment between the parties to the agreement occurs at the contract’s maturity

Forward and futures contracts require the delivery of the asset; the writer

is obligated to deliver and the holder is obligated to accept the quantity of the asset specified in the agreement

Futures and forward contracts are available on a wide variety of assets, including physical assets such as commodities and financial assets such as foreign currencies For example, organizations often use swaps to offset significant exposure to foreign currency exchange risk A swap is an agreement

to exchange a series payment such as loan repayment, where the two loans are denominated in different currencies

- Options: An option contract provides the holder the right to buy or sell an

asset at a stated price, called the exercise or strike price on or before a given date A put option conveys the right to sell; a call option conveys the right to buy [Williams, JR, Smith and Young, 1998] For example, the holder of call options

on EUR 1 million with a strike price of USD/EUR= 0.9 has the right to purchase EUR 1 million at the above rate The option expires at the expiration date (the maturity date of the option) [Jaffe, Westerfield, Ross, 2001]

Options are a unique type of financial contract because they give the buyer the right but not the obligation to buy or sell the asset An American option may be exercised anytime up to the expiration date A European option differs from an American option in that it can be exercised only on the expiration date Options do not require delivery of the asset, unlike futures and forward contracts

Option can be used like futures and forward contracts to offset the effect

of price changes, although the design of futures and forward contracts appears to

be more directly related to hedging The hedging effectiveness of an options contract depends on how responsive the price of the options contract is to changes in the price of the underlying asset

At expiration, a call option on an asset whose price is greater than the strike price is said to be in the money If the price of the underlying asset is less than the strike price, the option is out of money These conditions are reversed for put option An option that is in the money at its expiration can be exercised for a gain, whereas the out-of-the-money option expires without value

CHAPTER 3 RISK MANAGEMENT IN IMPORT AND EXPORT

TRADING OF VIETNAMESE FIRMS

3.1 RISK FREQUENCY

3.1.1 General Assessment of Risk Frequency

The statistic of risk frequency on 100 firms shows that on average, import and export companies have the lowest frequencies of getting risk due to goods nature in their import and export activities with the score of 1.94 On the opposite, economic risk is the most concerned factor when it is scored at 2.58 Risks happened due to legal and political policy and handling of goods are considered as the second group of high frequency with the average score of 2.47

To be classified as risk from social source, culture differences stand the next position with the number of 2.36 Risks due to natural force and transportation reliability system are relatively low They are scored 2.19 and 2.22 respectively (See figure 3-1)

Figure 3-1: Statistical record of risk frequency for groups of exposures

2.22

2.47 1.94 2.36

2.47

2.58 2.19

1 2 3 4 5

Natural Force

Transport Problems

Handling of goods

Nature of Goods Lack of Information

Political and legal policy

Economic issues

Mean SD