Financial Risk Management
A SEMINAR PAPER ON FINANCIAL RISK MANAGEMENT
CHAPTER ONE Introduction
Risk means the possibility of loss due to exposure to certain circumstances. In any financial investment, there is a chance that the actual return will be much lesser than expected. This chance is referred to as Financial Risk. Managing this risk to minimize financial losses is the best practice known as Financial Risk Management. Managers with a finance responsibility are expected to have a working knowledge of the principles and practices of financial risk management. Whereas in the past such managers devoted their time to financial reporting, this is now seen as less important than skill in financial decision making. The rationale financial risk management is straightforward: In today’s environment the observed volatility in financial and commodity markets is testimony to the inherent risks firms face. Financial risk management is the discipline that aims to analyse, control, and if necessary reduce those risks to an acceptable level.
Therefore, financial risk management is the practice of creating 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.
The optimal level of ex-post investment risk, from the shareholders’ perspective, is determined by a trade-off between the costs of financial distress and value associated with the limited liability of the firm’s equity. Unlike the risk-shifting models such as Jensen and Meckling (1976), equity-value is not always
CHAPTER ONE Introduction
Risk means the possibility of loss due to exposure to certain circumstances. In any financial investment, there is a chance that the actual return will be much lesser than expected. This chance is referred to as Financial Risk. Managing this risk to minimize financial losses is the best practice known as Financial Risk Management. Managers with a finance responsibility are expected to have a working knowledge of the principles and practices of financial risk management. Whereas in the past such managers devoted their time to financial reporting, this is now seen as less important than skill in financial decision making. The rationale financial risk management is straightforward: In today’s environment the observed volatility in financial and commodity markets is testimony to the inherent risks firms face. Financial risk management is the discipline that aims to analyse, control, and if necessary reduce those risks to an acceptable level.
Therefore, financial risk management is the practice of creating 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.
The optimal level of ex-post investment risk, from the shareholders’ perspective, is determined by a trade-off between the costs of financial distress and value associated with the limited liability of the firm’s equity. Unlike the risk-shifting models such as Jensen and Meckling (1976), equity-value is not always
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