Over the last twenty years, the consensus view of financial risk in the financial system that emerged in response to the banking crises of the 1930s and before has lost much of its relevance. A new consensus has yet to emerge, but financial institutions and regulators have considerably broadened their assessment of the risks facing financial institutions. This passage mainly talked about the definition and types of financial risk. It also explains reasons to manage financial risk and gives some guidelines to companies.
Define financial risk
Should a company attempt to manage its exposure to financial risk? Finance theory generally judges policies whether they increase firm or shareholder value. If we apply this yardstick to corporate risk management activities, we must be able to identify how these activities create value.
Financial risk is the amount of chance that is present with any type of financial investment. Typically, the goal is to secure investments that appear to have a low amount of risk since these are more likely to earn a return. Both individual and corporate investors access the degree of risk present before executing an order to buy shares on any investment market.
Shareholders usually investigate the degree of financial risk present in any investment deal by exploring both the current and past performance of the stock option. The shareholder will also consider any changes in the current financial climate that could either cause the option to increase dramatically in value or cause the option to drop. Knowing this detail will help the investor determine how owning the option will affect his or her overall financial stability.
Corporations also engage in the process of assessing financial risk. In terms of property purchases, there is attention given to the ability to build up equity in the acquisitions, or how to make the most of equity financing strategies. The company will also want to maintain an adequate cash flow, so that even if the acquisition does not appreciate as quickly as projected, the finances of the business remain stable.
Financial risk can be defined as the exposure of a company’s earnings, cash flow, or market value to external factors such as interest rates, exchange rates or commodity prices. There are good risks and bad risks. What we are going to do is not eliminating all of the risks but to control them. So a better definition of risk is: Risk is the exposure to an event in which the outcomes are uncertain and at least one of the outcomes is undesirable relative to at least one other outcome.
Before discussing the potential value-maximizing rationales behind risk management, however, it is important to understand that there are various types of ways to mitigate risk; Hedging completely eliminates an exposure, eliminating both upside and downside. Insurance, as the name suggests, provides protection against the financial effects of unfavorable events, but leaves the exposed party with the potential to benefit from favorable event. Finally, one can mitigate certain types of risk through diversification. By holding a large collection of imperfectly-correlated assets, all exposures except those common to the pool can be “averaged-out”.
Types of risks
Participants in both clearing systems and typical financial markets are exposed to several types of financial risk.
1. Credit Risk
Credit risk, also called default risk, is the risk associated with a borrower going into default. Investor losses include lost principal and interest, decreased cash flow, and increased collection costs. This is the risk that a counterparty will not meet an obligation when due, and will never be able to meet that obligation for full value. An investor can also assume credit risk through direct or indirect use of leverage. For example, an investor may purchase an investment using margin. Or an investment may directly...