Financial Risk Management
Financial Risk Management has increased significantly in recent years, risk and risk management are not contemporary issues. So the result of increasingly global markets is that risk may originate with events thousands of miles away that have nothing to do with the domestic market. Information is available instantaneously, which means that change, and subsequent market reactions, occur very quickly.
Although the economic climate and markets can be affected very quickly by changes in exchange rates, interest rates, and commodity prices. Counterparties can rapidly become problematic. As a result, it is important to ensure financial risks are identified and managed appropriately. Preparation is a key component of risk management.
What Is Risk?
Risk provides the basis for the opportunity. The terms risk and exposure have subtle differences in their meaning, And Risk refers to the probability of loss, while exposure is the possibility of loss, although they are often used interchangeably and arise as a result of exposure.
Exposure to financial markets affects most organizations, either directly or indirectly. When an organization has financial market exposure, there is a possibility of loss but also an opportunity for gain or profit. Financial market exposure may provide strategic or competitive benefits.
Risk is the likelihood of losses resulting from events such as changes in market prices. Events with a low probability of occurring, but that may result in a high loss, are particularly troublesome because they are often not anticipated. Put another way, the risk is the probable variability of returns.
Table Of This Ideas
|Potential Size of Loss||Probability of Loss|
|Potential for Large Loss||High Probability of Occurrence|
|Potential for Small Loss||Low Probability of Occurrence|
Since it is not always possible or desirable to eliminate risk, understanding it is an important step in determining how to manage it. Identifying exposures and risks forms the basis for an appropriate financial risk management strategy.
How Does Financial Risk Arise:
Although Financial risk arises through countless transactions of a financial nature, including:
- Sales and purchases, investments and loans, and various other business activities. So it can arise as a result of
- Legal transactions, new projects, mergers and acquisitions, debt financing, the energy component of costs, or through the activities of management, stakeholders, competitors, foreign governments, or weather.
When financial prices change dramatically, it can increase costs, reduce revenues, or otherwise adversely impact the profitability of an organization. Although Financial fluctuations may make it more difficult to plan and budget, price goods and services, and allocate capital.
There are three main sources of financial risk:
- Financial risks arise from an organization’s exposure to changes in market prices, such as interest rates, exchange rates, and commodity prices.
- Financial risks arise from the actions of, and transactions with, other organizations such as vendors, customers, and counterparties in derivatives transactions.
- Financial risks result from internal actions or failures of the organization, particularly people, processes, and systems.
What Is Financial Risk Management?
Financial risk management is a process to deal with the uncertainties resulting from financial markets. It involves assessing the financial risks facing an organization and developing management strategies consistent with internal priorities and policies.
Addressing financial risks proactively may provide an organization with a competitive advantage. It also ensures that management, operational staff, stakeholders, and the board of directors are in agreement on key issues of risk.
Managing financial risk necessitates making organizational decisions about risks that are acceptable versus those that are not. So The passive strategy of taking no action is the acceptance of all risks by default.
Organizations manage financial risk using a variety of strategies and products. It is important to understand how these products and strategies work to reduce risk within the context of the organization’s risk tolerance and objectives.
Strategies for risk management often involve derivatives. We trade derivatives widely among financial institutions and on regulated exchanges. So the value of derivatives contracts, such as futures, forwards, options, and swaps, is derived from the price of the underlying asset. Derivatives trade on interest rates, exchange rates, commodities, equity and fixed income securities, credit, and even weather.
The products and strategies used by market participants to manage financial risk are the same ones used by speculators to increase leverage and risk. Although it can be argued that widespread use of derivatives increases risk, the existence of derivatives enables those who wish to reduce risk to pass it along to those who seek risk and its associated opportunities.
The ability to estimate the likelihood of a financial loss is highly desirable. However, standard theories of probability often fail in the analysis of financial markets. So risks usually do not exist in isolation, and the interactions of several exposures may have to be considered in developing an understanding of how financial risk arises. Sometimes, these interactions are difficult to forecast, since they ultimately depend on human behavior.
The process of financial risk management is an ongoing one. We must implement and improve strategies as the market and requirements change. Refinements may reflect changing expectations about market rates, changes to the business environment, or changing international political conditions, for example.
In general, the process can be summarized as follows:
- Identify and prioritize key financial risks.
- Determine an appropriate level of risk tolerance.
- Implement a risk management strategy in accordance with policy.
- Measure, report, monitor, and refine as needed.
For many years, the riskiness of an asset was assessed based only on the variability of its returns. In contrast, modern portfolio theory considers not only an asset’s riskiness but also its contribution to the overall riskiness of the portfolio to which it is added. Organizations may have an opportunity to reduce risk as a result of risk diversification.
So in portfolio management terms, the addition of individual components to a portfolio provides opportunities for diversification, within limits.
A diversified portfolio contains assets whose returns are dissimilar, in other words, weakly or negatively correlated with one another. So it is useful to think of the exposures of an organization as a portfolio and consider the impact of changes or additions on the potential risk of the total.
Although diversification is an important tool in managing financial risks. It is among counterparties that may reduce the risk that unexpected events adversely impact the organization through defaults. Diversification among investment assets reduces the magnitude of loss if one issuer fails. It is customers, suppliers, and financing sources that reduce the possibility that an organization will have its business adversely affected by changes outside management’s control. Although the risk of loss still exists, diversification may reduce the opportunity for large adverse outcomes.
Risk Management Process
The process of financial risk management certification comprises strategies that enable an organization to manage the risks associated with financial markets. So risk management is a dynamic process that should evolve with an organization and its business. So it involves and impacts many parts of an organization including treasury, sales, marketing, legal, tax, commodity, and corporate finance.
The risk management process involves both internal and external analysis.
The first part of the process involves identifying and prioritizing the financial risks facing an organization and understanding its relevance. So it may be necessary to examine the organization and its products, management, customers, suppliers, competitors, pricing, industry trends, balance sheet structure, and position in the industry. So it is also necessary to consider stakeholders and their objectives and tolerance for risk.
Once a clear understanding of the risks emerges, appropriate strategies can be implemented in conjunction with the risk management policy. For example, it might be possible to change where and how business is done, thereby reducing the organization’s exposure and risk. Alternatively, existing exposures may be managed with derivatives. Another strategy for managing risk is to accept all risks and the possibility of losses.
There are three broad alternatives for managing risk:
- Do nothing and actively, or passively by default, accept all risks.
- Hedging a portion of the exposures by specifying which exposures can and should be hedged.
- Hedge all exposures possible.
Measuring risks provides and informs decision-makers with the information needed to implement decisions and monitor results, before and after taking strategies to mitigate them. Since the risk management process is ongoing, reporting and feedback can be used to refine the system by modifying or improving strategies.
An active decision-making process is an important component of risk management. So decisions about potential loss and risk reduction provide a forum for discussion of important issues and the varying perspectives of stakeholders.