Considerable factors of financial risk management
Financial risk management is a practice of asses and dealing with various financial risk related to financial products. As an example: risk towards foreign exchange, credit risk, marketplace risk, inflation risk, liquidity risk, business risk, volatility risk, and so on. Nowadays each investment occurs with risk. These risks, in addition, create the possibility of failure for achieving the desired goals. Different kinds of financial risks which have the different type of ability to affect a financial activity. Visit Wikipedia for details.
Every economic activity is suffering to one or more than one risk. These risks are categories in three major types in financial risk management.
- Market Risk
- Credit Risk
- Liquidity Risk
Market risk is the situation when an organization losing its position due to the arising movement in market price. The market risk is categories are some other types.
- Equity Risk
- Currency Rate Risk
- Exchange Rate Risk
- Commodity Price Risk
Equity risk is “the financial risk concerned in maintaining equity in a particular investment”. Equity risk often refers to equity in organizations via the purchase of stocks and does no longer usually refer to the risk of paying into real estate or building equity in properties.
Currency Rate Risk
Currency risk (also known as FX risk, exchange rate risk) is a financial risk that exists when a financial transaction is done in a currency other than that of the bottom foreign money of the organization. Foreign exchange risk also exists when the overseas subsidiary of a company maintains financial statements in a currency other than the reporting currency of the merged entity.
Interest rate risk occurs for the bonds holders due to up and down in the market price. How much interest rate risk a bond has depends on how sensitive its price is to interest price adjustments inside the market. The sensitivity relies upon on two things, the bonds time to maturity, and the coupon rate of the bond.
Commodity Price Risk
Commodity risk refers to the uncertainties of future market values and of the scale of the future income, caused by the fluctuation inside the prices of commodities. These commodities can be grains, metals, fuel, and electricity and so on. A commodity company needs to cope with the following forms of risk.
- Price Risk
- Quality Risk
- Cost Risk
A credit risk is the risk of default on a debt which can rise up from a borrower failing to make required payments. Inside the first motel, the risk is that of the lender and consists of lost principal and interest, disruption to cash flows, and extended collection costs. The loss may be whole or partial. In an active market, higher stages of credit risk can be related to higher borrowing costs. Due to this, measures of borrowing expenses which includes yield spreads may be used to deduce credit risk levels based on checks through market members.
Some examples of Credit Risk
- A patron may also fail to make a price due on a mortgage loan, credit card, line of credit, or another loan.
- An organization is not able to pay off asset-secured fixed or floating charge debt.
- A business or client does no longer pay a trade bill whilst due.
Liquidity risk is a financial risk that for a certain time period a given financial asset, security or commodity can’t be traded speedy enough inside the market without impacting the market price. The liquidity risk is further classified in two other types.
- Financing Risk
- Market liquidity
Market liquidity is the condition when the assets cannot be sold due to lack of cash or liquidity in the market. At this point, the cash ha in limited hands and market is out of cash.
Those risks are often interdependent on every other which makes the company greater vulnerable. At this point financial risk management goals to defend the firm from those risks through the use of several financial instruments. It can be quantitative and qualitative each. Investment and financial risk management problem involves handling the relationship between inner factors of financial institutions and the external elements that impact the investment. Also, it offers in current financial markets.
Financial Risk Management Techniques
A company desires to understand the depth and kinds of potential risks it’s far liable to. At this point Finance, managers are presupposed to very well analyze the condition and that they’ve to choose the maximum apt technique or method to check that risk. Some method is here.
- Regression Analysis
- Value at Risk
- Security Analysis
- Scenario Analysis
This method is used to study the effect on one variable when the opposite one changes. Let’s say as an example what changes will cash influx encounter when rate of interest increases or decreases.
Value at Risk
Another method of measuring risk is VAR (value at risk). Value at risk measure the amount of potential loss and the time frame. For example, a financial firm is bare to 10 cents one-month value at risk of INR 100,000. This implies that there is a 10 cents chance that the firm has to bear a loss of INR 100,000 in any given month.
Analysis of tradable economic instruments like debts (cash borrowed from the marketplace), equities (owner’s fund), a mixture of those and warrants of the organization is called security analysis. From time to time futures contracts and tradable credit derivatives also are included. At this point, security analysis is further sub-classified into a fundamental analysis, which goes according to different fundamental business elements inclusive of financial statements, and technical analysis, which focuses upon price trends and momentum.
However, scenario analysis is some other useful method for measure risks. It also defines via stress tests, sensitivity tests, or ‘what if?’ analyses. Financial managers create multiple conditions and ask ‘what if’ this condition were to occur?
What if the stock market crashed by way of 20 cents?
What if interest rates have been to rise by way of 50 basis factors?
What if an important client were to go away from the firm?
What if the exchange rate were to upward push by means of 50 cents?
At this point, the effects of these hypothetical condition analyses are converted right into a risk measure by assuming the risk publicity primarily based at the calculations and most loss guess is believed to be the worst case condition.