Financial risk management is a method of producing or adding value to a company through utilizing financing mediums for handling vulnerability to risk, specifically market risk and credit risk. Financial risk management is an important form of risk management.
About Financial Risk Management
Financial risk management is a type of risk management, which tries to add value in a company through implementation of financing mediums (cash instruments and derivative instruments) to handle risk exposure, especially from market risk and credit risk.
With the help of financial risk management, a number of financial risks can be handled, which include the following:
- Shape risk
- Foreign exchange risk
- Sector risk
- Volatility risk
- Inflation risk
- Liquidity risk
The characteristics of financial risk management resemble the features of common risk management and the process of financial risk management involves identification of financial risk, evaluating the financial risk and strategies to deal with those risks.
Financial risk management concentrates on the appropriate time and manner for hedging implementation of cash instruments and derivative instruments to address pricey risk exposures.
In the banking industry all over the world, the Basel Accords are usually chosen by multinational or global banking institutions for identifying, describing and disclosing credit risk, operational risk and market risks.
Application of Financial Risk Management
Theories of financial economics suggest that a company should go for a project at the time it grows shareholder value. In addition, financial theory demonstrates that the management of the company is not able to produce shareholder (who are also known as the investors of the company) value through undertaking a project, which the shareholders are able to perform for themselves at equal expenses. At the time when this concept is implemented towards financial risk management, it denotes that management of a company should not go for hedging risks, which the shareholders are able to hedge on their own at similar expenses.
This idea is corroborated by the hedging irrelevance proposition, which says that in case of a perfect market, a company is not able to perform value creation through hedging a risk while the cost of carrying the risk within the company is equal to the cost of carrying it away from the company. In reality, no financial market is a perfect market. This indicates that the management of a company has a large number of options to generate value for the shareholders utilizing financial risk management.