Financial risk management is the practice of 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.
When to use financial risk management Finance theory 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 risks 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 Corporations 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.
See also Bibliography
Crockford, Neil. An Introduction to Risk Management. Woodhead-Faulkner. ISBN 0-85941-332-2.
Charles, Tapiero. Risk and Financial Management: Mathematical and Computational Methods. John
Wiley & Son. ISBN 0-470-84908-8. Conti, Cesare & Mauri, Arnaldo. "Corporate
Financial Risk Management: Governance and Disclosure post IFRS 7", Icfai Journal of
Financial Risk Management, ISSN 0972-916X, Vol. V, n. 2, pp.20-27.
Lam, James. Enterprise Risk Management: From Incentives to Controls. John Wiley. ISBN 978-0-471-43000-1.
McNeil, Alexander J.; Frey, Rüdiger; Embrechts, Paul, Quantitative Risk Management. Concepts,
Techniques and Tools, Princeton Series in Finance, Princeton, NJ: Princeton University
Press, ISBN 0-691-12255-5, MR 2175089, Zbl 1089.91037 van Deventer, Donald R., Kenji Imai and Mark
Mesler. Advanced Financial Risk Management: Tools and Techniques for Integrated Credit
Risk and Interest Rate Risk Management. John Wiley. ISBN 978-0-470-82126-8.
References
External links CERA - The Chartered Enterprise Risk Analyst
Credential - Society of Actuaries Financial Risk Manager Certification Program
- Global Association of Risk Professional Professional Risk Manager Certification Program
- Professional Risk Managers' International Association
Managing a portfolio of stock and risk-free investments: a tutorial for risk-sensitive
investors