Risk Management and Financial Derivatives in Pharm Companies - Essay Example

Word Count 2,499 words (excluding in-text citation) Risk Management and Financial Derivatives In view of the challenging business climate in the global arena, industries are confronted with myriad risks that pose substantial threat to their profitability. One of the industries that are highly exposed to these risks is the pharmaceutical industry. According to a study conducted by the Wharton School of University of Pennsylvania, over the past thirteen years, pharmaceutical companies are as much as 50% riskier than the overall Standard & Poor's (S&P) 500. This is primarily attributed to the nature of the industry wherein any events, either positive or negative, are magnified and deemed to have a dramatic effect on shareholder value and brand equity. In this regard, pharmaceutical firms are relatively more volatile than most companies in other industries ("Risk Management in the Pharmaceuticals Industry" 2005). This paper discusses the major business risks that have significant impact on pharmaceutical companies, specifically AstraZeneca. Moreover, it explains how the company utilises derivative financial instruments such as interest rate swaps and forward foreign contracts to minimise its exposure to financial risks brought about by fluctuations in the interest rate and exchange rate. This paper also presents alternative strategies that the firm can adopt in order to hedge against these risks. Risk Factors Affecting AstraZeneca and other Pharmaceutical Companies Based on their annual reports, AstraZeneca and other multinational pharmaceutical companies including GlaxoSmithKline and Merck have identified risk factors affecting their operations. These are summarised as follows: Changes in Competitive Environment Most pharmaceutical companies have recognised that the pharmaceutical companies throughout the world have become highly competitive ("Risk Management in the Pharmaceuticals Industry" 2005). AstraZeneca cited that industry consolidation have resulted in the establishment of few but very large and formidable companies which are able to match, if not exceed, the firm's resources allocated for research and development as well as marketing. This threatens the company's competitive edge, thus, directly impacting its bottomline ("AstraZeneca Annual Report" 2004). Similarly, GlaxoSmithKline explained that product innovations and advent of technological advances which competitors may adopt could adversely affect the firm's operating results ("GlaxoSmithKline Annual Report" 2001). These factors have facilitated the emergence of new global players, particularly in the markets of China and India, which are playing increasingly significant roles in the business models of industry players ("China and India: Risk and Returns in Asia's Blockbuster Pharma Markets" 2005). Apart form these, AstraZeneca also mentioned that risk relative to competition is aggravated by the loss or expiration of patents, marketing exclusivity and trademarks. The company noted that once patent protection or other types of marketing exclusivity for a certain product have expired, lower priced generic copy products may be legally manufactured. The introduction of generic products generally leads to substantial loss of sales for the pharmaceutical companies' proprietary products ("GlaxoSmithKline Annual Report" 2001). The competition from generic medicines exerts downward pressure on profit margins and results in decreasing revenues. This is evidenced by the study conducted by Deloitte which asserts that the very large number of drugs coming off patent in the next three to five years equates to billions of dollars in current in potential sales. However, it is estimated that the pharmaceutical giants could lose about $35 billion to $50 billion in product sales during the said time frame due to competition from generic brands. (Rhodes & Mulder 2004) Regulatory Approvals and Price Controls Pharmaceutical companies are also facing increasing pressures from regulatory bodies in various countries. In order to enhance their product lines, these firms must comply with a broad range of regulatory controls in connection with testing, manufacturing and marketing of pharmaceutical products ("GlaxoSmithKline Annual Report" 2001). Due to the heightened awareness of the consumers with regard to safety concerns, these controls set by regulators now involve higher standards and stricter policies ("AstraZeneca Annual Report" 2004). Given these, pharmaceutical companies are impelled to invest in the improvement of productivity and the application of new technologies ("Risk Management in the Pharmaceuticals Industry" 2005) to meet both consumer demand and government regulations. Failure to adhere to these regulations may lead to difficulties in obtaining government approvals and delay market launch of new products ("AstraZeneca Annual Report" 2004) and results in an underdeveloped product pipeline ("Risk Management in the Pharmaceuticals Industry" 2005). Furthermore, most pharmaceutical firms consider the setting of price controls as another major risk faced by the industry. As cited by AstraZeneca, there have been continued economic and political pressure to limit the cost of pharmaceutical products in most countries so as to ensure the affordability of medicines for the public is maintained. For example, European countries impose sanctions and grant incentives to encourage doctors to prescribe cost effectively. United States federal legislation requires manufacturers to give rebates for drugs for state Medicaid programs. With these measures, revenues of pharmaceutical firms suffer as these policies may lead to dwindling profit margins. Exchange Rate Fluctuation Multinational companies are typically at risk of fluctuating exchange rates. Currency exposure risk, which is a main source of risk of companies with international diversified holdings, has escalated with the volume of world trade (Maurer &Valiani 2003). In the case of AstraZeneca, the firm's operations are accounted for in US dollars since about 49% of its sales are attributed to the North American market. Even sales in other currencies are expressed in US dollars. However, major cost components of the company are located in Europe wherein majority of its labor force is based. Given this scenario, the company is highly exposed to currency risk such that movements in the exchange rates, on which translation of foreign currencies into US dollars are based, may have materially adverse effect on the firm's financial condition ("AstraZeneca Annual Report" 2004). As noted by the company's treasurer Per Nordberg in an interview ("bfinance" 2000), fluctuations in foreign exchange rate, say the US dollar to Swedish kroner, make it more difficult to establish clear-cut decision-making framework, thus, volatility of the company becomes higher. As observed in 2004, there was significant weakening of the US dollar against the sterling and Swedish krona. This entailed servicing of higher research and development cost in US dollars for AstraZeneca. Another example as to how the company is exposed to exchange rate risk is when certain subsidiaries of AstraZeneca import and export goods and services in currencies, which are different from local currencies ("AstraZeneca Annual Report" 2004). If the exchange rate fluctuates between the transaction dates and the settlement dates for such transactions, subsidiaries are burdened with the resulting foreign exchange losses. Interest Rate Risk In the same way, pharmaceutical companies are facing risk in relation to interest rate regimes. These companies usually borrow funds from banks and other sources in order to finance their operations. These borrowings are subject to interest rate terms, which may be either fixed or floating. This also means that they are obligated to service interest cost despite their cash flow stream. In case of floating rate term, companies face the risk of higher cost of borrowing should the interest rate increase during the loan term. It should also be noted that inflation is a function of the interest rate. As such, similar to exchange rate, the interest rate regime, through inflation, is affected by a country's economic and political conditions (Samuelson & Nordhaus 1993), over which pharmaceutical companies have no control over ("GlaxoSmithKline Annual Report" 2001). Other Business Risks Aside from the risks discussed above, AstraZeneca also considered other business risks such as those brought about by taxation policies which differ in every nation. For instance, to date, the company is able to circumvent double tax charges to both the United Kingdom (UK) and foreign tax jurisdiction because of double tax treaties. However, should these treaties be withdrawn or amended, additional tax expense would be burdened by the company ("AstraZeneca Annual Report" 2004). In addition, AstraZeneca and other pharmaceutical companies are exposed to risk from global supply chain. Most pharmaceutical companies rely on third party suppliers for the timely supply of raw materials, formulation, packaging and delivery of products. With these, the financial condition of pharmaceutical companies are placed at risk should these suppliers fail to provide these specified services or become involve in the increasing cases of counterfeiting, diverting and stealing of transported medical products ("Coming and Going: What's Really Going on in Your Global Supply Chain" 2005). Risk Minimising Strategies - Utilisation of Derivative Financial Instruments In its 2004 annual report, AstraZeneca disclosed that in line with its risk management strategies, it utilises interest rate swaps and enters into forward foreign contracts. These are the derivatives primarily used to hedge against financial risks in terms of interest rate and foreign exchange, respectively. The specific functions of these financial instruments are described as follows: Interest Rate Swap As part of AstraZeneca's risk management, the firm aims to match its interest rate exposure on its gross debt balance with that arising on its surplus cash position. In this regard, the company opts to use interest rate swaps to receive fixed rate interest on outstanding bonds in exchange for paying floating interest based on the six-month US dollar LIBOR (London interbank offered rate). ("AstraZeneca Annual Report" 2004) An interest rate swap, one of the common forms of over-the-counter derivatives (Ludwig 1993), is an agreement between two parties, dubbed as counterparties, wherein one party's stream of future interest payments is exchanged for another's based on a stipulated principal amount ("Investopedia"). This instrument is typically used by companies to re-allocate their exposure to interest rate fluctuations, usually by exchanging fixed-rate obligation for floating rate obligation (Miron & Swannell 1995). Seen in another way, interest rate swap is like exchanging the cashflow linked to the loan or an asset as the case may be ("Economist.com"). In the event that AstraZeneca's management projects that the firm's financial condition would improve, utilising interest rate swaps would enable the firm to hedge against changes in market interest rates while avoiding excessive fixed-rate premiums it would have otherwise serviced (Kuprianov 1994). Similarly, swaps allow the firm to exchange variable rate payments for known fixed cash flows as in a fixed-rate debt (Kawaller 2005). Given these functions, interest rate swaps helps pharmaceutical companies to manage its exposure to changes in interest rate, reduce overall cost of borrowing, and control payout of interest based on expected cash flow stream ("Merck & Co., Inc. Annual Report" 2004). Forward Foreign Contracts As mentioned, AstraZeneca considers the US dollar as its base currency while manufacturing and research and development costs are denominated in sterling and Swedish krona. The observed weakening of the US dollar in 2004 against these currencies increases the dollar cost of servicing these operational costs. In order to manage foreign exchange movements resulting in the firm's currency exposure, transaction exposures that arise from non-local currency intercompany sales and or transactions with third parties are fully hedged through the use of forward foreign exchange contracts. ("AstraZeneca Annual Report" 2004) This financial instrument is defined as an agreement to buy or sell an asset at a specified later date, the terms of which are tailor made to fit the preference of parties involved (Brealey, Myers & Marcus 1995). As such the agreement can be customised to allow for timing flexibility (Smith, Smithson & Wilford 1990). It should be highlighted that the forward contract is related to another financial instrument, the futures contract, such that these derivatives basically have similar functions. The difference is that futures contract are standardised and are traded on an exchange. (Duffie 1989) By entering into a forward contract, the exchange rate to which a particular transaction is subjected to remains constant from the time of purchase of the foreign asset to its sale, thus, currency risk has had nil impact on the company (Srinivasan & Youngren). For example, should AstraZeneca invest in a new machinery to be used in its manufacturing plant in the UK, the company should enter into a forward foreign contract with the bank or other financing institution. If, based on the forecasted cash flow and movement of the US dollar against the sterling, the US dollar is expected to weaken against the sterling, the forward foreign contract would enable AstraZeneca to pay its sterling-denominated debt with a fixed dollar amount as agreed upon. In the absence of such agreement, the company is confronted with an increase in the cost of investment or debt to be serviced in light of the flagging dollar against the sterling. Given these functions, according to studies, forward contracts have been deemed to be advantageous for managing single currency as well as multiple currency exposures (Srinivasan & Youngren). As such, companies have increasingly entered into such agreements to allow them to fix in advance the exchange rate at which they borrow or lend (Brealey, Myers & Marcus 1995). Alternative Means to Manage Interest Rate and Currency Risk Profile Generally, in order for any company to efficiently hedge against financial risk relative to fluctuations in interest rate and foreign exchange, it should begin by establishing a solid hedging program. This involves the designing and implementing of risk policies that would identify the sources of risk, acceptable instruments and counterparties, as well as position limits that would render some form of discipline to the hedging program (Kawaller 2005). The implementation of such program also facilitates easier decision-making process for operating managers and key officers since they have fewer risk factors to worry about and are better able to predict cash flow stream for financial planning. (Brealey, Myers & Marcus 1995) A crucial part of hedging strategies would be the selection of financial instruments to be used to effectively mitigate business risks faced by pharmaceutical companies. Aside from those already discussed, companies may also opt to utilise other forms of derivatives such as the following: Currency Swap This instrument, which is also used by AstraZeneca, involves the trading of future dollar liability such that the company is able to buy currency and pay in another currency (Smith, Smithson & Wilford 1990). For instance, AstraZeneca decides to borrow sterling-denominated funds to finance its UK operations. However, its financial head reckons that the firm can obtain more attractive terms on a dollar loan. With this, the company borrows in the US and would then simultaneously arrange with the bank to trade its future dollar liability for sterling. As agreed upon, the bank would pay AstraZeneca in dollars corresponding to its loan while the latter makes a series of annual payments in sterling (Brealey, Myers & Marcus 1995). The desired net effect is for the company to obtain better loan terms when its foreign-denominated borrowing is translated to the local currency. Options This derivative instrument is often used by firms to limit their downside risk. For instance, a company that wishes to buy US dollar at the current exchange rate. To hedge against currency risk, it may purchase a one-year option to buy US dollar at the current exchange rate. Should the US dollar strengthen, the firm would exercise the option to insure itself from foreign exchange loss. On the other hand, should the US dollar weaken, the company may discard the option and buy at the cheaper rate. (Brealey, Myers & Marcus 1995) Options are widely used by multinational companies because this instrument provides them with the right, not an obligation, to sell or buy foreign currencies in the future at a pre-determined price. Interest Rate Caps As an alternative to interest rate caps, companies may consider using interest rate caps. If a company recognises its exposure to the rising interest rates relative to a variable rate funding, utilising an interest rate cap would assure that it would realise no more than the maximum interest expense. This is accompanied by the prospect of allowing for lower interest cost should interest rates stay below a critical level as defined by the strike rate of the interest rate cap. It should be noted though that, as opposed to swaps, caps require the payment of premium to the cap seller (Kawaller 2005). Works Cited AstraZeneca Annual Report. 2004 Bfinance. 2000. 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