Financial Risk Management

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A SEMINAR PAPER ON FINANCIAL RISK MANAGEMENT

CHAPTER ONE
Introduction
Risk means the possibility of loss due to exposure to certain circumstances. In any financial investment, there is a chance that the actual return will be much lesser than expected. This chance is referred to as Financial Risk. Managing this risk to minimize financial losses is the best practice known as Financial Risk Management. Managers with a finance responsibility are expected to have a working knowledge of the principles and practices of financial risk management. Whereas in the past such managers devoted their time to financial reporting, this is now seen as less important than skill in financial decision making. The rationale financial risk management is straightforward: In today’s environment the observed volatility in financial and commodity markets is testimony to the inherent risks firms face. Financial risk management is the discipline that aims to analyse, control, and if necessary reduce those risks to an acceptable level. Therefore, financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them. Financial risk management can be qualitative and quantitative. 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. The optimal level of ex-post investment risk, from the shareholders’ perspective, is determined by a trade-off between the costs of financial distress and value associated with the limited liability of the firm’s equity. Unlike the risk-shifting models such as Jensen and Meckling (1976), equity-value is not always an increasing function of firm risk in my model. While a high risk project increases the value of equity’s limited liability, it also imposes a cost on the shareholders by increasing the expected cost of financial distress. Due to these losses, the shareholders find it optimal to implement a risk-management strategy ex-post even in the absence of an explicit pre-commitment to do so. The optimal investment risk in the model depends on firm leverage, the financial distress boundary, the time horizon of the project and the costs of financial distress. As in the extant models (Smith and Stulz (1985), a firm with high leverage (financial distress) has a higher incentive to engage in hedging activities.

However, by explicitly modelling the shareholders’ risk-shifting incentives, my model shows that risk-management incentives disappear for firms with extremely high leverage. The model predicts stronger hedging incentive for highly leveraged firms in industries with higher incidence of predatory behavior by the competitors such as high concentration industries as shown by the empirical results of Opler and Titman (1994). The model shows that hedging incentives increase with project maturity. Financial risk management motivation in the model arises from costs incurred by the firm in states where it hits the financial distress barrier but remains solvent on the maturity date. If there are no financial distress costs, risk-management incentives disappear. On the other hand, when these costs are very high, the distinction between financial distress and insolvency diminishes along with any ex-post risk-management motivations. Intermediate levels of deadweight losses create financial risk-management incentives within the firm.

Historical Developments
Financial risks the risks to a corporation which emerge from the price fluctuations directly or indirectly influence the value of a company. A combination of greater deregulation, international competition, interest rates...
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