Financial Risk Management
Financial risk management is the activity of
monitoring financial risks and managing their
It is a sub-discipline of the wider task of
managing risk, that is, controlling the effects of
uncertain and generally adverse external
developments (or events) on the firm’s activities
It is a practical application of modern finance
theories, models and methods.
What is Risk?
Risk is the chance (or probability) of a
deviation from an anticipated outcome.
It is not limited to consideration of losses, but
looks at the extent and probability of all of the
It is a function of objectives. Without an objective
or intended outcome, there is only uncertainty.
Bryan Wynne (1992) proposed a four level
Risk: where probabilities are known
Uncertainty: where the main parameters are
known, but quantification is suspect
Indeterminacy: where the causation or risk
interactions are unknown
Ignorance: risks have escaped detection or have
not manifested themselves
Risk can be quantified; whereas uncertainty cannot.
Risk Management Approach
If we use the term risk factor to refer to a particular
risk, then the total risk will be made up of one or
more risk factors.
A risk profile is a graphical representation of the payoffs associated with changes in the risk factor.
Rather than focusing on risk elimination, the firm
typically considers the trade-off between risk taken and
the expectation of reward.
Liquidity risk arises when there may not be a counterparty willing to transact at a price close to the previously
recorded transaction, within a reasonable time.
Strategic Impact of Price Volatility
The currencies in which a firm earns its
revenues or incurs its production costs have a
direct impact on their competitiveness and
profitability, even if they participate only in
Volatility in interest rates may mean that a
company increases the hurdle rate on an
investment or a requires faster payback.
The oil price shocks demonstrate the same
factor in commodity markets.
Risk Management Objectives
Two criteria typically predominate decisions:
The costs of reducing risks
Setting risks at an acceptable level
When there is an actual or prospective major loss, the
focus shifts to stability or even survival.
Firms will want to arrive at an acceptable level of
exposure in order to allow managers to focus on the
core activity of value creation, and not be
preoccupied with the nature, extent and
consequences of risks in the business.
Steps to Risk Identification
Awareness: (1) risks that are unknown, (2) risks that
are known but not measurable, and (3) risks that are
known and measurable.
Measurement: the task is to model the risk in order
to measure its impact, thus allowing decisions to be
made on a course of action.
Adjustment: changing the nature, probability or
impact of the risk. These include behavior change,
insurance (transfer), operational hedging and
2. Management of the Firm
A firm may be risk averse, be risk neutral or be a risk
As a general rule, firms will be risk takers in areas where they have some comparative advantage, but seek to hedge
or eliminate risks where they do not.
Most firms will manage core business risks internally.
They may seek to reduce exposures to changes in
economic variables (like interest rates, inflation,
currencies and commodity prices) through operational and
Altering operational procedures as a risk
management tool can be costly and firms are
generally disinclined to use this (operational or
‘strategic’ risk management) as their primary means
of controlling market exposures.
Firms resort to financial hedging:
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