Financial Risk Management

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Financial Risk Management

Financial firms mainly encounter four common risks: funding risk, market risk, operational risk and credit risk. Market risk involves the possibility of experiencing huge losses as a result of adverse changes in the prices of commodities, such as interest rates or stock prices. Standard risk management consists of using statistical models to predict magnitudes and probabilities of huge adverse changes in prices. Value at risk models is usually used in setting up capital to offset any potential losses. Practically, there are numerous limitations to the ability of models to predict the intensity of potential losses despite the fact that models give a reliable method for computing market risks. As a result of this, many firms have adopted the use of stress tests to observe the impact of huge theoretical movement of markets on their theoretical values.

Credit risk is the risk involving a company when the credit borrowers do not offset their debts when the time is due. Traditionally, this kind of risk has been overcome through establishment of credit limits depending on the financial capability of the individual borrower, geographic area, and industry sector. The limits are usually dependent on internal credit rates. However, quantitative approaches are progressively being adopted in measuring and managing credit risks. Liquidity or funding risk is the risk involving a firm that is unable to acquire the funds it requires to meet its financial objectives such as short-term loan obligations. The three most common methods for mitigating liquidity risk are holding liquid assets, diversifying over funding sources, and setting up contingency plans, for example backup lines of credit. Normally, most firms set goals for funding as reference to track their levels of funding, and take mitigating measures anytime they hit below some specific thresholds.

Operational risk is the risk involving loss of money as a result of failed or inadequate internal operations, systems, and people or from external events. Even though management of operational risk is a field that is rapidly developing, standard techniques of mitigating it are still not developed.

A major aspect of financial risk management is determining which kind of risk to degree and which one to bear. Every financial firm’s value-added is usually its take up some kinds of risks. Similarly, management of risk involving proper evaluation on the kind of risk a financial firm generates and ways that can be employed to effectively avoid the unprofitable risk positions. Equally important is learning the methods of bearing the risks whenever they come about and any workable approaches that the undesirable risks can be given whenever they come about by shifting them to other parties.

To protect themselves from potential risks, financial firms set aside insurance funds to cover losses whenever they arise. These funds are referred to as capital and provisions. Provisions are finances set aside to take care of average or expected losses while capital are finances set aside to compensate extraordinary or unexpected losses whenever they occur. Capital may take different forms on the balance sheets of various financial institutions, though it often includes items such as shareholder equity. The dependence on capital and provisions often vary among various financial institutions that engage in securities, banking, and insurance activities as a result of variances in their fundamental risks.

Due to the similarity in the general goals that financial institutions have regarding bearing of risks, they have almost similar similarity in the methods they use in managing the risks. For example, all financial establishments have techniques to see to it that independent assessment of risk are carried out and that controls are established to regulate the level of risk each business unit takes. In addition, hedging-paying a third party to assume some of the risk is a practice common with all financial activities. Similarly, market risk remains the easiest form of financial risk to hedge. This is because of the different varieties of over-the-counter and exchange traded derivatives available. Progressively, credit risk is getting hedged by use of credit derivatives, that are mainly over the counter derivatives through which payments made are based on credit quality of the borrower. Use of reinsurance market can also be used as an approach in hedging some types of risk exposure that arise from insurance activities.

Reference

Christoffersen, P. F. (2012). Elements of financial risk management. Academic Press.Polak, P., Robertson, D. C., & Lind, M. (2011). The New Role of the Corporate Treasurer: Emerging Trends in Response to the Financial Crisis. International Research Journal of Finance and Economics, (78).Hull, J. (2012). Risk Management and Financial Institutions,+ Web Site (Vol. 733). John Wiley & Sons.