Financial risk management is a process to deal with the uncertainties resulting from financial markets. It involves assessing the financial risks facing an organization and developing management strategies consistent with internal priorities and policies. Addressing financial risks proactively may provide an organization with a competitive advantage. It also ensures that management, operational staff, stakeholders, and the board of directors are in agreement on key issues of risk. Managing financial risk necessitates making organizational decisions about risks that are acceptable versus those that are not. The passive strategy of taking no action is the acceptance of all risks by default.Organizations manage financial risk using a variety of strategies and products. It is important to understand how these products and strategies work to reduce risk within the context of the organization’s risk tolerance and objectives. Strategies for risk management often involve derivatives. Derivatives are traded widely among financial institutions and on organized exchanges.The value of derivatives contracts, such as futures, forwards, options, and swaps, is derived from the price of the underlying asset. Derivatives trade on interest rates, exchange rates, commodities, equity and fixed income securities, credit, and even weather.The products and strategies used by market participants to manage financial risk are the same ones used by speculators to increase leverage and risk. Although it can be argued that widespread use of derivatives increases risk, the existence of derivatives enables those who wish to reduce risk to pass it along to those who seek risk and its associated opportunities.The ability to estimate the likelihood of a financial loss is highly desirable. However, standard theories of probability often fail in the analysis of financial markets. Risks usually do not exist in isolation, and the interactions of several exposures may have to be considered in developing an understanding of how financial risk arises. Sometimes, these interactions are difficult to forecast, since they ultimately depend on human behavior. The process of financial risk management is an ongoing one.Strategies need to be implemented and refined as the market and requirements change. Refinements may reflect changing expectations about market rates, changes to the business environment, or changing international political conditions, for example. In general, the process can be summarized as follows:
• Identify and prioritize key financial risks. • Determine an appropriate level of risk tolerance. • Implement risk management strategy in accordance with policy. • Measure, report, monitor, and refine as needed.
Purposes
A financial risk management process includes all mechanisms and policies that a company's top management puts into place to avoid (or limit) losses due to security prices or trade partner defaults. For example, a financial risk management program at Company A, a larger retailer in California, may cover policies that managers establish to avoid losses that may originate from customer defaults. Company A's policies may require credit history checks for all customers who use corporate credit cards to purchase more than $1,000 worth of goods.
Functions
Financial risk management professionals help a corporation prevent losses inherent in financial transactions. A financial risk management specialist typically holds an advanced degree--for instance, a master's or a doctorate degree--in mathematics, statistics or investments. A financial risk management specialist uses math skills to build complex tools and computer models that appraise and monitor financial risks. A financial risk management specialist also may be a financial auditor working for a public accounting firm or the internal audit department of a company.
Types
Financial risk management activities focus primarily on two types of risk---market and credit. Market risk is the risk of loss that may arise if security prices vary. For example, Company B, a beer distribution company, owns $1.5 million worth of stock in its short-term portfolio. After three months, the portfolio's value fell to $1 million. The loss of $500,000 is due to market risk because security prices in the portfolio dropped. Credit risk is the risk of loss that arises when a business partner files for bankruptcy. For example, Company B may lose if a major customer (who owes $1 million) files for bankruptcy.
Benefits
Financial risk management activities benefit firms because they prevent major losses in corporate transactions. A company may need to make large investments in financial risk management systems in the short term, but future benefits may exceed initial costs. A company also may need to train financial risk management specialists to ensure that they understand the latest tools and methodologies used in managing financial risks.
Types of Financial Risk Faced by Banks
Banks constantly deal with money and face a number of risks involving how much money they have in their accounts, to whom they are issuing loans and when these loans are being paid back. These risks can cause the bank to go out of business if not handled correctly, and bank employees can face criminal charges if money is mishandled or lost.
Repaying Creditors
Banks often use their clients' invested or deposited money to issue loans or make other types of investments designed to make money for the bank. The bank pays their clients for renting their money by giving them a small percentage of the interest rate the bank charges for loans. However, if every bank client wanted to withdraw his money at the same time, a bank with insufficient funds available would not be able to pay the money back to its all customers or creditors. This could cause a bank to fail. This creditor panic is known as a run on a bank, and it was a major reason America was sent into the Great Depression of the 1930s. At that time, there was no system in place to ensure everyone would receive a certain amount of money back.
Being Paid by Debtors
Banks regularly loan money to people or businesses, charging the borrower interest on the loan and requiring monthly payments while allowing the borrower an extended period to pay back the loan. The banks make money based on interest rates they charge and other fees. However, the bank may lose money if the loan is not paid back. While a bank can destroy someone's credit and take legal action against the borrower, the loan remains a financial risk. This is why banks need knowledgeable and perceptive loan officers to decide who should be issued loans.
Human or Electronic Error
Banks operate like other companies, which means electronic equipment and human judgment are involved. Errors can be made, sometimes for large sums of money that can be costly to the bank. For example, according to a 2009 report on the ABC News website, a couple in New Zealand obtained $8 million in a bank error and fled the country, essentially stealing the money and costing the bank a large amount of money. While this rarely happens, banks are vulnerable to this type of risk.
