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Financial risk management is the practice of creating value in a firm by using financial instruments to manage exposure to risk. Similar to general risk management, financial risk management requires identifying the sources of risk, measuring risk, and plans to address them. 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.
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. 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 is captured by the hedging irrelevance proposition: 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. This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is that market risks that result in unique risks for the firm are the best candidates for financial risk management.
Important financial instruments
Derivatives are commonly used in financial risk management, because of their ability to offset specific risks, such as interest rate risk and exchange rate risk. Over-the-counter derivatives such as swaps and forward contracts have the advantage that they can be tailor-made to match exactly the specific risks, though they tend to be costly to create and monitor. Standardized derivatives that trade on futures exchanges, such as options contracts and futures contracts are more cost-effective, but often leave small risks, as the standardized contracts rarely match the risks exactly.
References
See also
External links
- Risk Magazine The leading title for financial risk professionals
- Capital Strategies Trade Finance Handbook delivering a practical understanding of international transactions
- The Contingency Analysis family of websites is an on-line portal for financial risk management.
- Investing and Risk
- Investing and Types of Risk
- QUANTster: The Quantitative Finance Job Market Daily THE source for Quants in North America.
- Schweser: Education for the Finance Risk Manager (FRM) Exam
Risk Management Certification Programs
Associations
- The Professional Risk Managers' International Association (PRMIA)
- Global Association of Risk Professionals
Lists
"Financial risk management"