financial risk management

financial risk management

The Importance of Financial Risk Management in Today’s Business Environment

1. Introduction to Financial Risk Management

Over the past three decades, risk management has become a well-studied discipline among financial economists and operations research specialists, and as a subject, risk management is a bullet service at many a financial intermediary. Sadly, this elite group is a tiny minority compared to the mass of the financial community who simply fail to appreciate the increasingly relevant role that financial risk management is playing for the time ahead. Even those that do understand risk properly ought to reach out to some practical role in today’s financial markets, which merely adds up to a share approach that financial innovation has sought but failed to address. The extent of this failure is rumple shown by the banking crisis in the developing world. These countries have adopted a wholesale European model of active financial markets and deregulation, and both of these have created the situation where financial intermediaries have had their balance sheets exposed to more risk than they need have done, and coming at a time when the risk is least affordable. Since the scale of the problems (both individually and collectively) is so small and since there is no significant cost for puno private sector, we can expect these sovereign debts to be addressed through a series of ‘quick fix’ bore solutions which essentially mean that the weaker banks and corporates get bailed out by the host governments. This amounts to going from the frying pan into the fire.

What do we mean by financial risk management in the current era of globalization and deregulation? If you were to ask this question of a number of financial intermediaries, there is cause to believe that you would have great difficulty in getting a consistent answer. If we seek ten different answers from ten different firms of similar size and character, we may well get ten different solutions to the problem. Sadly, in today’s high-speed business environment, we can see little measure of consistency and few signs of progress in the solutions being developed and applied. Such a random approach gives cause to worry that the financial community does not generally know the purpose of risk management in the business environment.

2. Types of Financial Risks

The management of risk has become an essential function of any company or financial large and small institution. Firms have to understand how to manage and deal with financial risk in order for any loss that it can face in view of this problem with effective risk management. All of the main financial risk management instruments have some negatives and in calculating the risk involved in any of these instruments, we must also consider the credit risks that are also on some of the financial instruments. Some instruments carry implicit and sometimes explicit credit risks that cannot be covered meaning that with risk cost, there is an inherent legal risk.

There are different types of financial risks that exist in today’s business environment: – Accounting risk: the risk of incorrect financial statements or material misstatements. It could be as a result of an inherent error in the financial statements or fraud. – Compliance risk: arises from the possibility that a company or the person he appoints to represent him may act in a way that violates the terms of the loan agreements, derivative contracts or other agreements related to how revenues are deposited and managed. – Market risk: the risk of financial loss from adverse changes in stock, commodity prices or foreign exchange market rates are risk that financial firms, investors or corporations face owing to potential losses. – Settlement risk: exposure to loss from a counterparty defaulting on a contract in return for good or charge a fee for the service. – Reinvestment risk: the risk that future proceeds generated from an investment will have to be reinvested at a potentially lower price. – Regulatory risk: the risk of having one’s operations restricted or producing excessive costs due to legal regulations.

3. Tools and Techniques for Managing Financial Risks

An often-used method to hedge a foreign currency risk is to use a forward foreign currency contract. As the advantages of hedging foreign currency risk have been recognized by financial executives, the use of derivatives for foreign exchange risk management has increased over the past few decades. Under normal circumstances, the hedging of a forecasted transaction leads to an inescapable, transitory, and moving-cover exposure. The major problem faced by corporate managers is to decide on the appropriate time to add a hedge in order to cope efficiently with the adverse influences of foreign exchange risk.

Companies actively search for tools that can assist them in managing financial risks. Such tools can include financial derivatives (forwards, futures, swaps, options) and techniques such as portfolio analysis, stress testing, value-at-risk, and simulation. Even when the instruments and methods used are similar, such financial risks must be managed within the context of the specific corporations and their existing and potential exposure. There are, however, certain considerations in terms of choosing the most suitable tools to manage such financial risks.

4. Case Studies and Best Practices in Financial Risk Management

Abstract: There is an increasing and understandable concern among stakeholders with market situations and practices in connection with corporate takeover incidents. Inadequate transparency – a lack of transparency of a company’s financial state of affairs – is a factor that could ignite the takeover drama. If the organization tries to resolve the problem of inadequate organization information and control, it would, as a consequence, lead the organization to depend on the adequacy of the internal control and internal understanding of the business. Failing such a move toward adequate control, business management turns to its risk and finance specialists for assistance. Someone other than top business management is turning to the specialist within the organization. We would ask: Why isn’t the specialist consulted in the first instance? The question is: Are you recognized as a financial risk manager in your enterprise? Is the function of financial risk management a specific part of an organization’s responsibilities? Are specialist skills related to financial risk management clearly defined in the occupying department or business manager concerned with financial risk management? These questions are agreed to define and constitute a properly extended role for financial risk management in the business environment. Be specific and create an environment for financial managers and risk specialists to function effectively.

The key question when discussing best practices in financial risk management is: Can the lessons learned from managers of a multinational corporation (MNC) be applied to any business irrespective of size? The answer is yes. It is interesting, however, to note that the comparisons and contrasts between MNCs and other businesses have been stimulated largely by academic research concerned with finance theory and practice. Practical applications or implications of empirical research – i.e., what business managers actually do – have unfortunately lagged behind. Emphasis, therefore, is placed on research and education about financial management. From the research and empirical studies undertaken, however, useful models have been developed, which can be evenly applied to all businesses – straightforward corporate members, unincorporated and small organizations, and the managing directors, or sole traders of partnerships. These are the key business professionals – individuals who make the decisions who in theory, then, should be capitalized on to a greater extent than is generally recognized or appreciated.

5. The Future of Financial Risk Management

Accordingly, the years ahead will see a continued growth overtly predictive models, demonstrating more complex dependencies that may exist between different risk factors, and transmitting the results through an organization. The means by which such help is communicated to the business manager must, however, change so that we avoid the financial sector’s vulnerability to tying an increased number of subtle dependencies that remain unobservable in practice. Despite this, it remains our view that the core values of this approach will remain for the more predictable risk, and that the tools outlined in this book will have an important continued relevance for all banks and other businesses. Overall, our experts seek to appropriate and develop further in the future the patterns that can be viewed today of the voyage from an age where power and credibility are secured by doing, to one where their acutely critical management attributes are wisdom borne of understanding that shapes both in the doing and the sharing of it.

The future of risk management will continue to involve advances in technology. As we have seen in this book, there is a growing recognition that risk management is a critical management skill that must be integrated into an organization’s decision-making process. In order to make the process effective, however, we recognize that those involved, at any level in a business, need help. That help in the management is largely, but not exclusively, in the ability to accurately and effectively assess the significance of risks, and to make judgments about exposures and potential losses. The expert systems that we see today in various business areas have had a profound effect on both the availability of such help and the way it is delivered.