What is Financial Risk Management?
Financial Risk Management refers to the process of identification, analysing of risk and making important investment decisions, either by accepting or mitigating them. The financial risk can be qualitative or quantitative risks. It is the responsibility of the financial manager to make use of different financial instruments for the purpose of hedging so that the risk can be reduced. For an instance, the Basel Accords in banking, are the regulations that are adopted by the global banks for tracking, reporting and exposing the credit, operational and marketing risks.
The financial risk management is basically a practice of safeguarding the economic value of the organization through hedging in different financial instruments. As a specialization in risk management, it focuses on the method and timeliness of using hedge in making investment decisions. It is the process of understanding and managing the financial risks of the business in present as well as in future.
What Are The Risks In The Financial Management?
There are several types of risk in financial management such as credit risk, market risk, legal risk, liquidity risk and operational risk. Each type of risk are discussed in brief below:
Operational Risks: The operational risk is defined by the Basel II framework as the risk of direct or indirect loss that are caused by inadequate or failed internal system, people, processes or any other similar events. It may include risks such as legal risks, security risks, environmental risks, fraud and physical risks. The operational risks are not driven by the revenue of the form nor capable of being eliminated completely. This type of risks will always remain in an organization until the systems and processes remain inefficient or imperfect. In financial risk management, the operational risks may be acceptable up to a certain level of risk tolerance.
Credit Risks: It refers to the risks associated with the client’s or the borrowers. It may be possible that the clients’ default on their outstanding payments. In addition to the loss of capital, the company also had to incur losses in the form of loss of interest, increased collection costs and so on. All these types of costs must be considered while determining the extent of credit risk. Yield Spreads are often used by the financial analysts for determining the credit risks levels in the market. One of the easiest methods of mitigating credit risks is to perform a credit check on the borrowers at regular interval. Another method is hold assets as collateral or purchase an insurance. Some methods include payment on delivery, request for advance payments and payments on delivery before handling the product or line of credit to the clients.
Foreign Exchange Risks: This type of risk is also known as currency risk. The value of each currency fluctuates at every moment. It generally occurs when the transaction place in currency other than the operating currency. The operating currency of the organization is generally the domestic currency where the business is situated. The risk from foreign exchange rate arises when the value of transactional currency and operating currency changes unfavourably. Businesses that rely on goods from other countries for the purpose of carrying out its operation are open to this type of risk.
Inflationary Risks: In simple words, it is the risk of inflation. It occurs when the real value of return from investment is reduced by the inflation, which erodes the purchasing power of the funds.
What Are The Strategies Of Financial Risk Management?
The experts strategies for mitigating the financial risk should be developed in a manner so that it could safeguard any kind of assets owned by the firm. Generally, the financial risks can be mitigated using one of the three ways. Firstly, by off-loading the risk onto somebody else, Secondly, by hedging the risk, and thirdly, by doing nothing and accepting the risk as it is. Following are the strategies or tips that could be followed for effective financial risk management:
- Evaluation of whether the business is operating for efficiency or not. The first and foremost thing is to determine the efficiency of the business operations. It would help in mitigating the operational risks associated with the business.
- Carrying out proper amount of insurance: Insurances are often used to mitigate the losses that the company may incur in future. The risk from financial market can be reduced with the help of insurance. However, it requires the entity to pay certain amount of money as premium to the insurance company.
- Maintaining adequate emergency funds: The financial aspects of the business as the main reason for the existence of the business is to earn profit, except for not-for-profit organizations.
- Diversification of investment: It is essential to invest the available funds in different alternatives. This enables the investors to mitigate the losses from one type of investment with the gain from other type of investment.
How Do You Implement Financial Risk Control?
The steps for implementing the financial risk control are presented below:
- Identification of risks
- Measuring the extent of financial risks.
- Learning about investments in financial instruments.
- Looking towards insurance policies for mitigating risks.
- Building an emergency fund to meet the unexpected expenses.
- Reviewing the financial ratings of the company or financial institutions.
- Diversify the sources of income for the firm.
- Reassessing the risks associated with the investment on a regular basis.
- Being diligence towards the responsibility of the financial manager.
What Is The Purpose Of Financial Risk Management?
The main purpose of the financial risk management is to enable the firm to identify, measure, and manage the risks associated with the organizations. It enables the firm to understand its risk appetite and focus on earning high investment returns at the given level of risk. The financial risk manager or analysts often attempts to understand the quantify the extent of risk or losses from a particular investment. It facilitates better decision making within the organization. It is basically a function that aims at detecting, managing and hedging the organizational exposure to various types of risks and get right financing so that the firm can have more certainty in financing costs.