Both swaps to modify the interest characteristics
Both BP and Logica face political risk. It is another major risks that multinational companies face. It concerns government’s actions, which affect the companies’ value and activities. Action could be war, revolution, expropriation, taxation, devaluation, exchange control, and import restriction, etc. Especially, at 1999, the acquisition of ARCO by BP is intervened by US Federal Trade Commission. Further, the foreseeable loss due to politics is the withdrawal of the operating licenses as a consequence of political backlash in response to environmental damage. Comparison of Logica and BP AMOCO’s policies towards risk management
BP and Logica both have their own Risk Management Committee (RMC) for managing risk. The committee reviews their business, financial, operational and compliance risk regularly. In BP, specialist teams with appropriate skills, experience and supervision carry out all financial instrument and derivative activities whereas in Logica, RMC determines current procedures and processes for detecting and addressing risks. Insurance Generally, BP only insures the property in respect to legal or contractual reasons. It is because of the management thinks that external insurance is not an economic means for the group.
In the past, it purchased considerable external insurance protection which covers losses. Recently, it undertakes a comprehensive re-examination of its insurance strategy. However, Logica hasn’t portrayed any insurance policy in its annual report. Gearing and interest rate risk Both BP and Logica expose to interest rate risk. BP uses interest rate swaps to modify the interest characteristics of its long-term borrowings from a fixed to a floating rate basis or vice versa. During 2000, it hedges its interest rates risk by keeping floating rate debt below an upper limit of 65% i. e. at least 35% of total net debt at fixed rate.
Logica uses interest rate swaps and forward foreign currency contracts to hedge the risk. During the financial year 2001, it hedges its interest rate risk by maintaining up to 50% of its borrowings at fixed rates and it funds its operations through a mixture of retained earnings, equity and bank debt. Nevertheless, they both manage interest expense by interest rate swaps and through a balance between fixed rate debt and floating rate interest. Consequently, they are capable of keeping BP gearing level at 28. 6% and interest cover at 11 times and Logica interest cover at 59 times. Foreign exchange risk
For minimizing economic and material transactional exposures arising from currency movements, BP and Logica have their group policies for managing its FOREX rate risk respectively. BP hedges it by using a range of derivatives which are netting, currency swaps, forwards and options. Logica, however, hedges it by only using forward foreign currency contracts. Oil and gas prices fluctuation risk BP uses financial and commodity derivatives such as futures contracts, swap agreements, options and cash-settled commodity instruments – forward contracts – to manage certain of its exposures to price fluctuations in oil and natural gas transactions.
Credit risk In order to prevent the exposure from credit risk, only higher credit rating counterparties will be enters into BP’s and Logica’s derivative contracts. Specifically, BP controls the related risk via credit approvals, limits, and monitoring procedures to control the credit risk. Political risk BP mainly adopts the pattern of joint venture to invest in different countries, for example in Russia, China, Abu Dhabi, etc. In addition, it uses local manager to manage the local company. These two strategies are capable of helping to minimize the political risk.
Possibly it might reduce the chance of expropriation in certain extent. Relationship between risk management strategies of BP AMOCO and established theories relating to risk management In the risk of FOREX rate, BP uses forward contract to hedge it. There is relationship with the expectations theory. It is because in BP, those experts involved in risk management think that the forward contract is an unbiased predictor of the spot rate at the point in the future. They use it to hedge the FOREX risk. However, the forward rate will sometimes lower or higher than the future spot rate.
In an efficient market, market force will bring them into equilibrium, in which the forward price equals the market consensus view on the future spot price. This is supported by empirical studies investigating the truthfulness of this theory. Rather, it is clear that BP is using risk reduction approach. Under this approach, derivatives and insurances are suggested to hedge risks. Derivatives are financial instruments including future contract, forward contract, swap and options. BP manages its financial risk by using those derivatives.
Although theory suggested that companies should insure their properties, BP only insures its properties which under legal or contractual requirements. Theory also suggests that oil companies need not using derivatives to hedge oil price risk, because oil industry already has something of build-in hedge. Despite it, BP still use derivatives to hedge oil price risk, which is different of the theory. In the political risk aspect, theory suggests using joint venture and negotiating with government in order to reduce the conflicts. Hence, BP uses joint venture in some high political risk countries, such as China and Russia.
Stultz (1998) demonstrated three different situations of company AAA, BBB and S&L rectectively. BP are in the same situation as Company AAA which has little debt and very high debt rating. Thus, based on the theory of risk management, there is no reason for BP to hedge it financial exposure. Because the potential outcomes never reach the range where low value begins to impose financial distress costs on it. Further, shareholder can do the same job more cost-effectively. Shapiro stated that if shareholders can diversify risk themselves, there is no point for directors to hedge risk, but with big assumption of perfect market.