Financial risk management
Encyclopedia
Financial risk management is the practice of creating economic value in a firm
by using financial instruments
to manage exposure to risk
, particularly credit risk
and market risk
. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk management
, financial risk management requires identifying its sources, measuring it, and plans to address them.
Financial risk management can be qualitative and quantitative. As a specialization of risk
management, financial risk management focuses on when and how to hedge
using financial instruments to manage costly exposures to risk.
In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.
) prescribes that a firm should take on a project when it increases shareholder
value. Finance theory also shows that firm managers
cannot create value for shareholders, also called its investors
, by taking on projects that shareholders could do for themselves at the same cost.
When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. This notion was captured by the hedging irrelevance proposition: In a perfect market
, the firm cannot create value by hedging a risk when the price of bearing that risk
within the firm is the same as the price
of bearing it outside of the firm.
In practice, financial markets are not likely to be perfect markets.
This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is that market risk
s that result in unique risks for the firm are the best candidates for financial risk management.
The concepts of financial risk management change dramatically in the international realm. Multinational Corporation
s are faced with many different obstacles in overcoming these challenges. There has been some research on the risks firms must consider when operating in many countries, such as the three kinds of foreign exchange exposure for various future time horizons: transactions exposure, accounting exposure, and economic exposure.
Megaprojects (sometimes also called "major programs") have been shown to be particularly risky in terms of finance. Financial risk management is therefore particularly pertinent for megaprojects and special methods have been developed for such risk management.
Business
A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...
by using financial instruments
Financial instruments
A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....
to manage exposure to risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
, particularly credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
and market risk
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
, financial risk management requires identifying its sources, measuring it, and plans to address them.
Financial risk management can be qualitative and quantitative. As a specialization of risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
management, financial risk management focuses on when and how to hedge
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
using financial instruments to manage costly exposures to risk.
In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.
When to use financial risk management
Finance theory (i.e., financial economicsFinancial economics
Financial Economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment"....
) prescribes that a firm should take on a project when it increases shareholder
Shareholder
A shareholder or stockholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders own the stock, but not the corporation itself ....
value. Finance theory also shows that firm managers
Management
Management in all business and organizational activities is the act of getting people together to accomplish desired goals and objectives using available resources efficiently and effectively...
cannot create value for shareholders, also called its investors
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
, by taking on projects that shareholders could do for themselves at the same cost.
When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. This notion was captured by the hedging irrelevance proposition: In a perfect market
Perfect market
In economics, a perfect market is defined by several conditions, collectively called perfect competition. Among these conditions are* Perfect market information* No participant with market power to set prices* No barriers to entry or exit...
, the firm cannot create value by hedging a risk when the price of bearing that risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
within the firm is the same as the price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
of bearing it outside of the firm.
In practice, financial markets are not likely to be perfect markets.
This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is that market risk
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
s that result in unique risks for the firm are the best candidates for financial risk management.
The concepts of financial risk management change dramatically in the international realm. Multinational Corporation
Multinational corporation
A multi national corporation or enterprise , is a corporation or an enterprise that manages production or delivers services in more than one country. It can also be referred to as an international corporation...
s are faced with many different obstacles in overcoming these challenges. There has been some research on the risks firms must consider when operating in many countries, such as the three kinds of foreign exchange exposure for various future time horizons: transactions exposure, accounting exposure, and economic exposure.
Megaprojects (sometimes also called "major programs") have been shown to be particularly risky in terms of finance. Financial risk management is therefore particularly pertinent for megaprojects and special methods have been developed for such risk management.
See also
- Market riskMarket riskMarket risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
- Corporate governanceCorporate governanceCorporate governance is a number of processes, customs, policies, laws, and institutions which have impact on the way a company is controlled...
- Liquidity riskLiquidity riskIn finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
- Risk adjusted return on capitalRisk adjusted return on capitalRisk adjusted return on capital is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept was developed by Bankers Trust and principal designer Dan Borge in the late 1970s...
- Risk modelingRisk modelingFor risk modeling in general see risk modelingFinancial risk modeling refers to the use of formal econometric techniques to determine the aggregate risk in a financial portfolio...
- Risk poolRisk poolA risk pool is one of the forms of risk management mostly practiced by insurance companies. Under this system, insurance companies come together to form a pool, which can provide protection to insurance companies against catastrophic risks such as floods, earthquakes etc. The term is also used...
External links
- CERA - The Chartered Enterprise Risk Analyst Credential - Society of Actuaries (SOA)
- Financial Risk Manager Certification Program - Global Association of Risk Professional (GARP)
- Professional Risk Manager Certification Program - Professional Risk Managers' International Association (PRMIA)
- Managing a portfolio of stock and risk-free investments: a tutorial for risk-sensitive investors