Financial risk management

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 risk, Shape risk, Volatility risk, Sector risk, Liquidity risk, Inflation risk, etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them.^[1]

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.^[2]

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.^[3][4]

When to use financial risk management

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.^[5]

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 so-called "hedging irrelevance proposition":^[6] 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.^{[7][8][9][10]}

This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management, wherein they have to determine which risks are cheaper for the firm to manage than the shareholders. Market risks that result in unique risks for the firm are commonly the best candidates for financial risk management.^[11]

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,^[12] accounting exposure,^[13] and economic exposure.^[14]

See also

Discussion Asset liability management cash management Cash flow hedge Corporate governance Credit risk Default (finance) Enterprise risk management Financial risk Financial engineering Foreign exchange hedge Interest rate risk Insurance Investment risk

Liquidity risk Market risk Operational risk Risk adjusted return on capital Risk modeling Risk pool Settlement risk Treasury management Value at risk Volatility risk

Institutions American Risk and Insurance Association Association of Insurance and Risk Managers in Industry and Commerce Global Association of Risk Professionals Institute of Risk Management Professional Risk Managers' International Association Risk and Insurance Management Society Certifications Certified Risk Analyst (CRA) Certified Risk Manager (CRM) Chartered Enterprise Risk Analyst (CERA; Society of Actuaries credential) Financial Risk Manager (FRM) Chartered Enterprise Risk Actuary (CERA; Institute and Faculty of Actuaries credential) International Diploma in Risk Management (MIRM designation; ERM focused) Professional Risk Manager (PRM)

Bibliography

• 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

1. Peter F. Christoffersen (22 November 2011). Elements of Financial Risk Management. Academic Press. ISBN 978-0-12-374448-7.
2. Allan M. Malz (13 September 2011). Financial Risk Management: Models, History, and Institutions. John Wiley & Sons. ISBN 978-1-118-02291-7.
3. Van Deventer, Donald R., and Kenji Imai. Credit risk models and the Basel Accords. Singapore: John Wiley & Sons (Asia), 2003.
4. Drumond, Ines. "Bank capital requirements, business cycle fluctuations and the Basel Accords: a synthesis." Journal of Economic Surveys 23.5 (2009): 798-830.
5. EMMANUEL ATTAH KUMAH. COST OF CAPITAL (A FINANCIAL TOOL TO CREATE AND MAXIMIZE SHAREHOLDER VALUE). Lulu.com. pp. 39–. ISBN 978-1-304-26045-1.
6. KRISHNAMURTI CHANDRASEKHAR; Krishnamurti & Viswanath (eds.) "; Vishwanath S. R. Advanced Corporate Finance. PHI Learning Pvt. Ltd. pp. 178–. ISBN 978-81-203-3611-7.
7. John J. Hampton (1982). Modern Financial Theory: Perfect and Imperfect Markets. Reston Publishing Company. ISBN 978-0-8359-4553-0.
8. Zahirul Hoque (2005). Handbook of Cost and Management Accounting. Spiramus Press Ltd. pp. 201–. ISBN 978-1-904905-01-1.
9. Kirt C. Butler (28 August 2012). Multinational Finance: Evaluating Opportunities, Costs, and Risks of Operations. John Wiley & Sons. pp. 37–. ISBN 978-1-118-28276-2.
10. Dietmar Franzen (6 December 2012). Design of Master Agreements for OTC Derivatives. Springer Science & Business Media. pp. 7–. ISBN 978-3-642-56932-6.
11. Corporate Finance: Part I. Bookboon. pp. 32–. ISBN 978-87-7681-568-4.
12. 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).
13. 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).
14. http://www.iijournals.com/doi/abs/10.3905/jpm.1997.409611 (Discusses the benefits for hedging in foreign currencies for MNCs).

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