Financial Risk Management
Financial Risk Management – A part of the ERM Framework
An organization’s exposure to business risk is the direct result of past investment and financing decisions. Risk is connected with downside risk or the probability of unfavorable business condition. Risk management is the process of identifying, monitoring, measuring risk and then developing and implementing strategies to manage that risk. Financial risk is usually any risk related with any form or type of financing or investment decisions. Financial risk management is therefore concerned with the probability of actual return being less than expected financial return in projects or financial assets. Financial risks are broad and encompass Investment risks, Credit Management risk, Insurance Cover risks, Liquidity risk, Interest Rate risk, Forex risk, Stock Price risk.
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What is Financial Risk Management
As an important aspect of enterprise wide risk management, financial risk management is concern with the practice of creating more economic value in an organization and preserving shareholders value through the use of financial instruments to manage exposure to financial risks that may threaten the value of shareholders’ funds. The major financial risks are broadly classified as credit risk and market risk.
Financial risk management focuses on risks that can be hedged using traded financial instruments. These risks are usually movements in commodity prices, interest rates, stock prices, foreign exchange rates.
Derivatives are the instruments most commonly used in financial risk management. As unique derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk management methods usually involve derivatives that trade on well-established financial markets or exchanges. These standard derivative instruments include options, futures contracts, forward contracts, and swaps. Transactions exposure, accounting exposure, and economic exposure in foreign exchange earnings can be managed by forex contracts.
Other market sector risks include liquidity, inflation risks and other financial-related risks.
The methodology and processes of financial risk management is similar to other areas of enterprise risk management, and therefore requires identifying its sources, measuring it, and plans to address them.
Financial risk management can be qualitative and quantitative. As a major component of enterprise risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to different risks.
Financial risk management also play an important role in cash management.
When to use Financial Risk Management
Organizations exist to make profit for its shareholders and therefore management must properly manage financial risks and threats to its existence to preserve the organization value.. This is in line with the finance theory and sound ecomomic theory that a firm should only take on a project when it increases shareholder value. It goes without saying that management is unable to create additional value for shareholders by undertaking projects that shareholders (investors) could do for themselves at the same cost.
When this theory is applied to financial risk management, this implies that it is of no value for management to hedge risks that investors can hedge for themselves at the same cost.
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. In imperfect markets, management are likely to have many chances to create value for shareholders using financial risk management tools and techniques. The question is to determine which risks are cheaper for the enterprise to manage than the shareholders. In general, financial risks that result in unique risks for the firm are the best candidates for financial risk management.
All large and small organizations should practice some element of financial risk management, whether formal or informal, to preserve the value of their firms. By having risk management teams, this aspect of enterprise risk mangement will not be neglected
A financial risk management may help you identify, analyze, evaluate, and treat the bad sector of your business. It is focused basically on hedging, which involves the use of two counter-balance investment strategy to ward off the negative effects of price fluctuations. Financial risk management helps you understand the market better. It gives you an insight about how much to invest in any particular sector and how much will be the loss if that sector fails. However the different market risks are completely avoidable. Today, you may use the services of various financial manager as well as financial risk management software before you plan to make an investment.