Financial Risk Management: Keys to Successful Risk Management

Basics of Financial Risk Management and Why Is It Important?

Risk is simply the unpredictability of outcomes. It may have pleasant surprises or negative results. When the same concerns your finances, you risk losing money on your investment or business venture. When you risk losing your money, it is a financial risk; therefore, to mitigate the risk, proper risk management for finances is required, and hence, the term financial risk management was coined.

What is Financial Risk Management?

Financial risk management is a method to recognize, analyze, and decide the investment strategy that may accept or mitigate the identified risk. The risk may be quantitative or qualitative, and the finance manager is provided with the job of using the financial instruments to hedge a business against such risk. Finance manager take suitable actions or avoid specific actions that may or may not align with their goals and risk tolerance.

Key Highlights

  • Financial risk management is a process of recognizing, evaluating, and managing potential financial risks that may impact the financial performance of an organization.

  • By making well-informed decisions and implementing successful financial risk management practices, a business can mitigate and sustain losses throughout economic uncertainty or market turbulence.

  • Financial risk management strategies include hedging, diversification, insurance risk transfer, analyzing scenarios, etc.

What are Different Types of Financial Risks?

Risks are categorized based on their nature and impact. As far as financial risk is concerned, it is the highest priority risk type for every business, government, individual, and market. Financial risk is further categorized into five broad categories.

  1. Market Risk: Market risk surfaces due to the movement of prices of the financial instruments. This risk may be a directional risk or a non-directional risk.

  2. Credit Risk: When one fails to fulfill its obligation towards counterparties, then credit risk arises. It is further classified as sovereign risk and settlement risk. 

  3. Liquidity Risk: This risk arises due to an inability to execute transactions. It is further classified into asset liquidity and funding liquidity risk.

  4. Operational Risk: This risk arises due to operational failures such as mismanagement or technical failures. It is further classified into fraud and model risks arising from a lack of control and incorrect model application.

  5. Legal Risk: Such risk arises out of legal constraints like lawsuits. Legal risk often involves compliance with regulations, contractual disputes, or other legal actions that can impact the financial well-being of an organization.

Who is Prone to Financial Risks?

Financial risk is not concerned only with individuals or businesses; people worldwide, companies, markets, and even governments are prone to financial risk.

1- Financial Risk for Businesses

Businesses may face financial risk due to macroeconomic factors, like fluctuating market interest rates and the possibility of large organizations or sectors defaulting. The inability to make the right decisions to pay debt or income may also put the businesses at financial risk.

When a business is willing to repay its loan, investors may experience reduced income from repayment interest, and such risks are categorized as credit risk or default risk.

Some companies struggle with their financial situation. Businesses are at specific risk when companies are concerned about capital structure and when investors are uncertain about their returns and potential money loss.

2- Financial Risk for Individual

People like you and me are also prone to financial risk. Such risk involves unemployment and highly speculative investment. Many people are inclined to such risks that cannot be controlled. 

Individuals are prone to liquidity risk where few buyers and many sellers are available. The second risk is funding or cash flow liquidity risk, which arises due to the inability of corporations to pay off their debts, forcing them to default and ultimately harming the stakeholders.

When one speculates uncertainly in the hope of gaining profit, he puts him at a speculative risk.

3- Financial Risk for the Market

Markets are the hub of financial risk as several situations and circumstances impact them. The global financial crisis of 2007 and 2008 are the most extensive examples where the market bears the testimony of financial risk. The financial risk directly impacted the businesses, investors, and the government, forcing them to close their businesses, lose their fortune, and reconsider their monetary policy.

Volatility is another situation that impacts the market. It brings uncertainty to the market. It brings steep price swings in stock market shares. Market rate interest and default can also result in financial risk for markets.

4- Financial Risk for Government

When the government loses control of its monetary policy and cannot control inflation and defaulting bonds, it results in financial risk for the government. 

The government issues debts called treasury bonds; several countries, like Venezuela, Russia, and Argentina, have defaulted on these debts. Some governments delay paying these debts while others pay less, ultimately making the government fall into the financial risk category.

Why is Financial Risk Management Important?

Financial risk management is critical because

1- It Protects Against Financial Losses

Risk management strategies are designed in a way that helps to identify, assess, and mitigate the financial risk that an organization, individual, or government may face. By implementing these strategies, one can protect against substantial financial losses that may occur during an economic downturn or market volatility.

  • For example, A company diversifying its investment to spread risk across different assets can significantly shield itself from potential losses if one sector faces a downturn.

2- It Improves Decision-Making:

Risk management provides organizations or governments with a systematic way to understand and analyze the risk. This helps them make more informed decisions to assess the potential impact of their choices on overall risk.

  • For example, a business considering expansion into a new market might conduct a thorough risk analysis to evaluate potential challenges. This will help the business make more strategic decisions as they clearly understand the associated risks.

3- It Enhances Investors' Confidence

Investors are more confident in those organizations that demonstrate a proactive approach to risk management. When a company or business effectively manages risk, investors see it as they are more prepared to navigate the market's uncertainties. 

  • For example, when a company communicates its risk management strategies to the stakeholders in a financial report, it attracts more investors who are willing to invest more in the company.

4- It Improves Regulatory Compliance

Regulatory bodies ask businesses to adhere to specific risk management practices to guarantee financial stability and protect their stakeholders. The organization may face penalties and legal issues if it doesn't comply with these regulations.

  • For example, all financial institutions must implement risk management practices in line with base III regulations to minimize risk.

How Does Finacial Risk Management Work?

Financial risk management is a procedure that involves specific steps that must be undertaken to analyze and mitigate the risk appropriately.

1- Risk Identification

It is a crucial part of the process of risk management. It involves overall consideration of all events that could result in a negative impact on the financials. In this process, a finance manager categorizes all risk categories, such as credit, liquidity, market, and operational risks. For an individual, the risk may be unemployment or income risk, expense risk, asset or investment risk, or credit or debt risk. 

2- Assessment and Quantification of Risk

After listing all the potential financial risks, the next step is to assess and quantify those risks. In this process, the finance manager prioritizes those risks that need urgently addressed. The risk can be evaluated through quantitative and quantitative methods. The financial industry gives more importance to the quantitative risk assessment method. However, they also pay attention to the qualitative aspect as both approaches play an important role in understanding and managing the risk effectively.

  • Quantitative Assessment involves numerical values where risk is assessed using numbers. The finance manager utilizes statistical models and financial metrics to assess quantitative risk.

  • The Qualitative Assessment method involves subjective analysis and factors that are not quantifiable.

3- Identifying Strategies

After assessing and quantifying the risk, the finance manager implements strategies according to the severity of the risk. These are also called the 4 R's of risk management.

  • Risk Avoidance: It means eliminating all the activities or practices that could put the business at risk.

  • Risk Reduction: It means implementing practices or methods that could help mitigate potential losses or decrease the severity of the risk. This strategy aims to minimize the impact of identifying the risk.

  • Risk Transfer: This strategy means shifting the burden of risk to a third party. Insurance or contractual agreements are essential in assuming responsibility for certain risks.

  • Risk-Retention: This strategy means accepting the responsibility of the given risk. Instead of fighting, transferring, or avoiding the risk, this strategy involves acknowledging and managing the risk internally.

4- Implementing and Monitoring the Strategy

Selecting an appropriate strategy to manage risk is quite challenging, but choosing a plan that aligns with the risk and the current situation is crucial. After implementing the suitable strategy, it is also essential to monitor continuously. If financial risk is not stable, a new risk may emerge, and existing risk may evolve. Therefore, it is crucial to monitor the effectiveness of the strategy.

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Example of Financial Risk Management

A US-based manufacturing company expanded its operation into Europe and established a subsidiary for production and sale. However, the company encountered the risk of exchange currency rate fluctuation as its revenue is in Euros while its costs are in US dollars. This could potentially impact profitability due to the fluctuation of Euros to the dollar exchange rate. 

What Did the Company Do to Manage the Risk?

The company simply adopted a hedging strategy utilizing future contracts. Through these contracts, the company agreed to sell euros at a fixed exchange rate, ensuring a predictable revenue stream in dollars. This approach will protect the company from volatile movements in the exchange rate and safeguard its profit margin.

The company can now operate with great confidence anywhere in Europe. They can pay attention to their core business activities without worrying about external factors like currency volatility.

Conclusion 

Risk is a fundamental aspect of the financial world and is often associated with the potential for capital and investment loss. Risk, however, is negatively connoted, but it is not always detrimental. It means investments with higher risk can yield better returns. But before investing in any risky asset, it is vital to assess the nature of the risk, identify it, and implement the appropriate strategies to manage it. This balanced approach helps individuals and organizations to navigate the complex aspects of finances and make informed decisions to tolerate the risk and harness more return on investment.

FAQs

How do you handle financial risk?

Mitigating financial risk is important, although it may be difficult or expensive for some to eliminate the risk entirely. To handle the risk properly, you need to have the right insurance, diversification of investments, sufficient funds for emergencies, and different income streams.

Why is risk management important?

Risk management is an essential part of investment in the financial world. It requires identification, analysis, and making important decisions about the uncertainty that may come between the goals.

What are the four types of Financial risk?

Financial risk is broadly categorized into four categories: market risk, credit risk, liquidity risk, and operational risk. Some risks can be directly managed, while others are largely beyond management's control.

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12 Jan, 2024

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