Financial Risk Management

What is Risk and how do we manage it? Risk is merely an uncertainty of an outcome and Risk management is “the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities.”  Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary.

In terms of finance, financial risk management is itself a very big and interesting field. The management of financial risks has many dimensions and involves many types of decisions. The more important decisions are the choice among alternative portfolios, whether and how to hedge risks, the decisions about leverage and capital allocations. In other words financial risk management is basically a way to create economic value in the firm using financial instruments like derivatives etc. to manage exposure to risk, particularly credit risk and market risk.

In general terms there are two totally different attitudes toward risks:

Risk aversion: quantify an identified risk and control it, i.e., to devise a plan to manage the  exposed risk and convert it into a desired form. Basically, two kinds of plans are available:

• Replace the uncertainty with a certainty to avoid the risk of adverse outcomes even if this requires giving up the potential gaining opportunity.
• Be willing to pay a certain price for the potential gaining opportunity, while avoiding the risk of adverse outcomes.

Risk seeking: willing to take the risk with one’s money, in hope of reaping risk profits from investments in risky assets out of their frequent price changes. Acting in hope of reaping risk profits from the market price changes is called speculation.

Risks are common and inherent in the financial markets and commodity markets: asset risk (stocks…), interest rate risk, foreign exchange risk, credit risk, commodity risk and so on. Risk can bring unexpected gains. It can also cause unforeseen losses, even catastrophes.

References

[1]        Financial Analysts Journal © 1999 CFA Institute.

[2]       http://en.wikipedia.org/wiki/Financial_risk_management