Financial Risk Management

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Financial risk management is not a new area of corporate finance but it certainly is not the most glamorous or favorable area to be in and is gaining more attention in the current economic crisis. Risk management is a part of many different lines of work, but all have the same purpose; identifying risk is imperative to success so that you can also discover ways to mitigate or avoid the problem and make sounds decisions. “Financial risk is the loss expectation arising from adverse security prices or a business partner's default.” (Codjia, n.d.) It is a given in all economic activities regardless of the type whether it be charities, schools, government, or business; every organization will have financial risk. Accounting principles require a company to record operating losses at market values in their financial statements. Every business has two major responsibilities as Jeffrey Immelt, Chairman and CEO at General Electric Co. out it, “My job is to figure out how to grow and manage risk and volatility at the same time” (Enterprise, 2007)

Financial risk includes losses due to undesirable changes in commodity and security prices as well as negative variations in currency and interest rates. Companies tend to hire specialists, such as statisticians, to develop quantitative financial risk management tools.

(Codjia, n.d) The center of risk identification may be at any level of management, such as the overall company, a specific business unit, functional area, project, or process. Because of this, one must have clear objectives to consistently identify events that might give rise to risks that could prevent reaching a goal, strategy or objective. The key questions to ask in risk management are: “What could stop us from reaching our top goals and objectives?” and “What would materially damage our ability to survive?” (Enterprise, 2007)

There are a few major areas of financial risk management; credit risk management, risk and control assessment, and quantitative market risk control. (Codjia, n.d) Quantitative risk management uses complex formulas and computer algorithms to identify, evaluate and monitor financial risks in corporate transactions. Market risk is “the loss probability stemming from adverse security price instabilities with respect to a company's investment portfolio.” (Codjia, n.d) A market risk manager usually applies his statistical expertise to create tools specific for their situation. Some of these tools include VaR (value at risk), Monte Carlo simulation and stress testing. These tools are designed to identify risk to limit losses in financial transactions.
(Codjia, n.d) Credit risk is the loss expectation originating from a counterpart’s inability to repay a loan on time or fulfill other financial promises when they become due. In most cases, corporate credit officers will require business partners with a rating of high or medium to provide collateral, or financial guarantees, before engaging in further transactions as a means of mitigating the risk of doing business with them.

(Codjia, n.d) It is common for department heads and section managers to regularly review corporate procedures and prepare "risk and control self-assessment," or RCSA, reports in financial risk systems. An RCSA is a report where lower level managers list controls and related risks and rank them as "high," "medium" and "low" based on potential losses. (Codjia, n.d) Senior managers tend to focus on the high and medium risks so they can develop corrective measures for those and allow the lower risks to be mitigated by business unit level managers. RCSA reports are often required to be included in reports for the Securities and Exchange Commission and the Public Company Oversight Board (Codjia, n.d)

There are other non-quantitative ways to approach risk as well, such as brainstorming, event inventories and losses, interviews and self-assessment, facilitated workshops, SWOT (strengths, weaknesses,...
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