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 call 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
Because of their ability to offset specific risks, derivative securities (also called derivatives) are commonly used in financial risk management. The most commonly traded derivatives include options, futures, forwards, and swaps. Market risk factors that derivatives are commonly based on include stock prices, stock indices, commodity prices, interest rates, and foreign exchange rates. Because unique derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk management methods usually involve derivative that trade on well-established financial markets.
References
Learn More
Alexander, Carol and Sheedy, Elizabeth (2004). The Professional Risk Managers' Handbook: Volume I: Finance Theory, Financial Instruments, Markets (1st ed.). Wilmington, DE: PRMIA Publications. ISBN: 0-9766097-1-1.Learn More
Alexander, Carol and Sheedy, Elizabeth (2004). The Professional Risk Managers' Handbook: Volume II: Mathematical Foundations of Risk Measurement (1st ed.). Wilmington, DE: PRMIA Publications. ISBN: 0-9766097-2-X.Learn More
Alexander, Carol and Sheedy, Elizabeth (2004). The Professional Risk Managers' Handbook: Volume III: Risk Management Practices (1st ed.). Wilmington, DE: PRMIA Publications. ISBN: 0-9766097-3-8.Learn More
Stulz, René M. (2003). Risk Management & Derivatives (1st ed.). Mason, Ohio: Thomson South-Western. ISBN: 0-538-86101-0.
See also
Risk Management Certification Programs
Associations
Lists
Last updated: 08-21-2005 02:09:08
