Financial risk management

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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[edit]

Finance theory (i.e., financial economics) 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,[1] accounting exposure,[2] and economic exposure.[3]

See also[edit]

Bibliography[edit]

  • Crockford, Neil (1986). An Introduction to Risk Management (2nd ed.). Woodhead-Faulkner. ISBN 0-85941-332-2. 
  • Charles, Tapiero (2004). Risk and Financial Management: Mathematical and Computational Methods. John Wiley & Son. ISBN 0-470-84908-8. 
  • Conti, Cesare & Mauri, Arnaldo (2008). "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 (2003). Enterprise Risk Management: From Incentives to Controls. John Wiley. ISBN 978-0-471-43000-1. 
  • McNeil, Alexander J.; Frey, Rüdiger; Embrechts, Paul (2005), 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 (2004). 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[edit]

  1. ^ http://www.emeraldinsight.com/Insight/viewContentItem.do;jsessionid=EFA8D4FB63329F2C94F48279646551BF?contentType=Article&contentId=1649008 (contrary to conventional wisdom it may be rational to hedge translation exposure. Empirical evidence of agency costs and the managerial tendency to report higher levels of translated income, based on the early adoption of Financial Accounting Standard No. 52).
  2. ^ Aggarwal, Raj, "The Translation Problem in International Accounting: Insights for Financial Management." Management International Review 15 (Nos. 2-3, 1975): 67-79. (Proposed accounting framework for evaluating and developing translation procedures for multinational corporations).
  3. ^ http://www.iijournals.com/doi/abs/10.3905/jpm.1997.409611 (Discusses the benefits for hedging in foreign currencies for MNCs).

External links[edit]