This paper highlights the financial risk management by developing a deeper understanding into the topic. The paper discusses the risks involved in the business. The paper also gives insights about the risk management, what are the factors affecting the risk associated with an investment. Financial risks are discussed to gain knowledge about the risks involved in the financial matters of the organization. The paper discusses about the financial risk management at length by first defining the financial risk management then specifying the steps required to manage the financial risks. The paper then discusses about the tools and policies required to manage the financial risks associated with an investment.
The paper is designed to understand the basic concepts involved in the field of finance by taking a look at the basics of risk then getting deeper into the financial risk and thereby analyzing the financial risk management, its process and the tools required for the measurement of the risk associated with the investment.
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The purpose of the study is to understand the basics of the risks associated with the investment. It also discusses about the risk management by defining and understanding the process involved in the risk management. Further, the paper analyzes the financial risks by getting deeper understanding of the same by uncovering the hidden aspects of the financial risk. The paper gives deep knowledge about the financial risk management by giving a step to step description of the process and then describing the tools, techniques and strategies for the measurement and management of the financial risk management.
For almost ages, risks have been a part of our life, then whether it be the humans or the business. Risks have become a part and parcel of our everyday life. The intensity of the risk involved varies as per the situation at hand. Risk and Risk management are not occurring at the same time.
In laymen terms, risk is something the output of which is usually different from the expected output. But in business terms, it is the probability that an investment's desired return is different from the original return. It is the probability of losing all or part of the actual investment. There is a trade-off between the risk and the return. If the amount of risk involved in the investment in higher, then greater is the expected potential return of investment. In the recent years, risks associated with the investment in the businesses have increased. But on the other hand, the businesses which have taken risk have significantly improved their profits as against the expectations from the other businesses.
Risk management is a systematic process of identifying and assessing company risks and taking actions to protect a company against them. Broadly speaking, Risk Management is working today with the chance that future events may prove to be harmful for the organization and may cause adverse effects on the profitability of the organization or the investment. It is a two step process - determining the risks likely to occur in the investment and then managing those in the best possible way as per the investment requirements. Good risk management strategies help the organization in growing faster resulting in reduction of costs and improved performance. There are many types of Risk Management, a few of them are Financial risk Management, Operational Risk Management, Market Risk Management etc.
Organizations are getting affected either directly or directly with the continuous and increasing exposure to financial markets. When an organization exposes itself to the financial markets, there are chances of loss as against the opportunities for gain and profit. Exposure in the financial markets provides competitive and strategic benefits.
Financial risk is an umbrella term for any risk associated with any form of financing. Typically, in finance, risk is synonymous with downside risk and is intimately related to the shortfall, or the difference between the actual return and the expected return (when the actual return is less). Financial risks occur through generally uncounted dealings of financial nature, including investments and loans, sales and purchase and various other activities useful to the business. It arises when the expected return of the investment is different from the original investment. It deals with the downside factors affecting the working of the organization and hence affecting the performance and profitability of the organization.
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In today's constantly changing world, the financial prices are changing continuously which lead to increase in costs, reduce revenues and adversely affect the profitability and hence the performance of the organizations. These fluctuations in the financial prices can make it difficult to decide the price of goods and services and allocate the capital for the various process running in the organization.
There are three primary reasons for financial risk:-
Financial risks arising from the exposure of the organization to sudden changes in the market price, such as interest rates, exchange rates
Financial risks arising from the interaction with other organizations such as suppliers, customers in derivative transactions
Financial risks arising from internal failures due to people, processes and systems
The components of the financial risk are profit potential and risk, debt and risk and alpha, beta and risk. If the intensity of the investment is more, then the potential for the profit is also more and no organization would like to take risk until and unless profits exists in the investment. The intensity of financial risk taken by an organization affects the return from the potential investment. The amount of debt an organization realizes also directly affects the intensity and extent of the total financial risk associated with the investment. "Alpha" and "Beta" values of an investment play a major role in the total risk associated with an investment. Alpha risk of an investment is the risk associated with an investment of an organization in comparison to other organizations. Beta value of an investment is the risk associated with an investment's fluctuations in view of the whole market.
Financial Risk Management
Financial Risk Management is defined as the practices and procedures that a company uses to optimize the amount of risk it handles with its financial risk. Financial Risk Management is the method to deal with the irregularities resulting from the sudden changes in the financial markets. It involves assessing the financial risks facing an organization and developing management strategies consistent with the internal priorities and the policies. When the financial risks are taken into consideration, it provides the organization with a competitive advantage over other organizations. It assures that everybody in the organization agrees on key issues of risk. Managing financial risk involves the organizations to make financial decisions about acceptable risks as against the unacceptable risks.
There are different ways to manage financial risks which include a range of strategies and products. However, it is important to understand how these risks are reduced as per the organization's risk acceptance and objectives.
The strategies for risk management frequently include derivatives. Derivatives are frequently traded widely among financial institutions and on organized exchanges. Trading in derivatives spans from commodities, equity and fixed income securities, exchange rates etc. The worth of derivative contracts, like futures, options, and swaps is determined from the price of the existing investment.
There is similarity between the products and strategies used by market participants for managing the financial risk as that used by the speculators for increasing the risk associates with the investment and the leverage. As the use of derivative increases risks associated with the investment, the existence of derivatives allows one to pass the risk to the people who look for risk and its associated opportunities.
The probability of a financial loss is highly desirable. The analysis of financial markets is very crucial as often the standard theories of probability fail in such situations. Risks usually exist in combination with other exposures. The interaction between these types of exposures is important to understand how the financial risk stems up. Sometimes, these type of interactions to exposures is difficult to forecast as they usually depend on human behaviour.
The process of financial risk management is a continuous process and keeps on going continuously in the organization. The strategies used for managing financial risk are implemented and revised as the market situations and the requirements change. Refinements may reflect changing expectations about market rates, changes to the business environment, or changing international political conditions.
The risk management process consists of strategies that allow the organization to handle the risks associated with investment in financial markets. The risk management is a dynamic process which evolves inside the boundaries of the organization. It involves and adversely affects many roles in the organization including tax, commodity, treasury etc. The risk management process involves the analysis of both the internal and external risks associated with the investment.
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The risk management process is a four step process which includes:
Identification and setting the priorities for the major financial risks associated with the investment
Determining accepted level of tolerance of risk
Applying the risk management strategies in lieu of the policies developed by the organization
Compute, report, examine, and revise the risks associated with the investment if required
The first step in the risk management process is the identification of the financial risks associated with the investment and setting the priorities for the same in the organization. For this purpose, it becomes necessary to examine the entire portfolio of products in the organization ranging from management to competitors to pricing and position in the whole industry. After a clear view on the financial risks is established, the strategies developed by the organization can be implemented in combination with the risk management policies framed by the organization to minimize the potential effects of financial risks. Computation and reporting of risks enables authorities to implement the decisions for the financial risks and to evaluate their outcome, both in the past and in the present after strategies are taken to tone down the risks in the investment.
The risk management is a continuous process, reporting and feedback can revise the whole system by modifying or improving the strategies taken to manage the financial risks involved. A dynamic decision making authority plays a significant role in the risk management process. The decisions regarding the probable loss and various risk minimization techniques provide a stage for the discussion of important at length and the differing opinions of the stakeholders.
Broadly speaking, there are three main ways for managing risk:-
Accepting all the risks as they by sitting dormant and doing nothing
Hedging a part of the risks by identifying risks which can be hedged
Hedging all the risks possible
Factors affecting Financial Rates and Prices
There are a number of factors which affect the financial rates and prices of the investment. These factors include the fluctuations in the interest rates, exchange rates, commodity prices etc. These factors are important to understand as they directly or indirectly affect the risk associated with the investment by an organization.
Interest rates are considered as the economic barometer for analyzing the financial risks associated with an investment. Interest rates are made up of two parts, namely the real rate and expected inflation. If the maturity period for an investment is higher, then the uncertainty associated with the investment if higher. Interest rates form an important part in cost of capital. Companies opt for debt financing for the purpose of extension and projects relating to the capital in the organization. Borrowers are adversely affected when there is sudden change in the interest rates. Level of inflation also affects the interest rates in turn affecting the financial risk associated with an investment. Economic situations prevailing in the world and market actions of the foreign exchanges also affect the financial risk. Some other factors affecting financial risk include monetary policy and the stand of apex bank of the country, financial and political steadiness in the country. Yield curves serve as the basis for providing useful information about the future level of interest rates. The form of the yield curve is generally analyzed and evaluated by market forces prevailing in the market. It provides insights into the changing economic situations in the market as a result of sudden changes in the economy of the country. Several theories have suggested for the determination of interest rates and as a result the yield curve. Some of them are Expectations theory, Liquidity theory, Preferred Habitat Hypothesis theory and Market Segmentation theory.
The demand and supply of the currencies in the market predict the foreign exchange rates. The factors affecting the supply and demand are the sudden changes in the economy of the country, the activity of foreign trade and international investors. Capital flows play an important role in the determination of exchanges rates prevailing in the market. Some factors affecting the exchange rates and the interest rate level are common. Some of these factors are floating or market-determined currencies. Currencies are very critical as even a slight change in the market situations affect the interest rates and the risk factors associated with the investment. Some of the major factors affecting the exchange rates are buying/ selling activity in other currencies, international capital and flow of trade in the global market, views of the foreign institutional investor (FII), financial and political steadiness in the country, monetary policy and the stand of the apex bank of the country, in-country debt levels, economic situations prevailing in the country. Earlier, trading of goods and services with other nations was considered as the key for determining the exchange-rate changes. Nowadays flow of capital in the market is considered very crucial and evaluated very closely. Some theories for the determination of the exchange rates are Purchasing power parity based on "the law of one price", Balance of payments, Monetary approach and Asset approach.
The demand and supply also affect the price of the physical commodity. The value of commodities also gets affected by location and physical quality of the commodity. Supply of commodities to the end customer is a part of the production function. Supply of the commodity gets significantly affected if the production schedule of the organization is disturbed. Demand of commodities gets affected if the end user is getting the same or similar commodity at lower rates than that offered by the organization. Some of the major factors affecting the commodity prices are prevailing interest rates in the market, level of inflation especially of precious metals, currency exchange rates in the market, economic situations governing the country, production costs and capability to deliver to the end users, political steadiness, and availability of alternatives. There are no defined models for the determination of price of the physical commodity.
Tools for Financial Risk Management
It is an important and widely used tool in financial risk management. In the past, the risk in the investment was judged only on the basis of changeability of its returns. In recent times, theories not only consider investment's riskiness but also the overall riskiness of the portfolio. Organizations can reduce the investment's risk through the diversification of the risk.
Portfolio Management provides the opportunities for the diversification of the risk by the combination of individual entities to the portfolio. A diversified portfolio includes investments which are loosely interrelated to each other. Diversification among intermediaries of the organization may reduce the risk caused due to unpredicted events impacting the organization through defaults. It also significantly decreases the impact of loss if one issuing party fails. Diversification among customers, suppliers and financing sources reduces the downside effects that adversely affect the organization's business by the risks which are not under management's control.
Hedging is another method through which the financial risks associated with an investment can be minimized. It is the business of seeking assets that offset, or have weak or negative correlation to, an organization's financial exposures.
Correlation is another method measuring the financial risks associated with the investment. It measures the tendency that two assets can go together or not. The value of the correlation coefficient lies in between +1 and -1. If the value of the correlation coefficient is +1 (positive correlation), then the two assets can go together. If the value of the correlation coefficient is -1 (negative correlation), then the two assets can go together but in opposite directions. Negative correlation is the central element for hedging and risk management.
Some other tools for the financial risk management are as follows:-
Value at Risk (VAR) model - It is a type of quantitative risk management tool and is widely used model for the measurement of risk for the loss of money on the portfolio of investments in the financial assets. It is the process of providing an answer to the investor regarding the investor's potential loss of investment within reasonable bounds. It measures the loss in the value of an investment for a definite period of time. Thus, if the value at risk for an investment is $50 million for a week at 90% confidence interval then probability that the value of the investment falls below $50 million is only 10% for a definite time period of a week. It is generally used by commercial and investment banks to grab the loss in the portfolio.
Stress Testing - It is also a type of quantitative risk management tool. These types of tests are generally used in the banks for the risk management system to evaluate the sudden changes in the financial components resulting in the risks for the whole system. Stress tests are usually of two types, sensitivity tests and scenario tests. Sensitivity tests analyze the impact of one component on the position of the bank in the financial market. Scenario tests involve simultaneous analysis of an event which occurred in the past or is yet to happen.
Risk and Control Assessment - The heads of the various business units continuously review the organization practices and guidelines set by the organization to prepare the "risk and control self-assessment" or RCSA reports. A "risk and control self-assessment" report is a document containing the internal risks and controls. It rates the risks as "low", "medium", "high" depending on the expected losses from the investment. Higher management usually focus on risks designated as "high" and "medium". Government authorities like Securities and Exchange Board of India often provide instructions o the company to include the RCSA reports.
Insurance Coverage - Insurance coverage of the financial risks allows the firm to escape from potential losses of credit transactions in the market. This type of protection is very useful in exchange between international partners because fluctuations in the currency and risks arising from political instability which usually increase the financial risk associated with the investment.
Financial Risk Audit - The Company's audit department performs timely review of controls and practices ensuring that such controls are sufficient and working. The company assigns a risk auditor to analyze the procedures for ensuring accuracy and completeness in the financial statements.
Credit risk management - It is the loss generating from the borrower's inefficiency to pay back the loan on the maturity or adhering to the financial promises. Defaulters arise as a result of the invisibility of money from the organization (bankruptcy) or unexpected cash problems.
Risk is something the output of which is usually different from the expected output. Risk Management is working today with the chance that future events may prove to be harmful for the organization and may cause adverse effects on the profitability of the organization or the investment. If the risks associated with the investment are higher, it leads to higher returns from the investment. Financial risks occur through generally uncounted dealings of financial nature, including investments and loans, sales and purchase and various other activities useful to the business. The components of the financial risk are profit potential and risk, debt and risk and alpha, beta and risk. Financial Risk Management is the method to deal with the irregularities resulting from the sudden changes in the financial markets. The strategies for risk management frequently include derivatives. There are a number of factors which affect the financial rates and prices of the investment. These factors include the fluctuations in the interest rates, exchange rates, commodity prices etc. Some of the tools for the financial risk management are diversification of risks, value at risk model, stress testing, risk and control assessment etc. Financial Risk Management reduces the risk associated with an investment by properly defining the process to be followed for the risk management. It increases the efficiency of the organization and also increasing the profitability of the investment.