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Financial risk management is used to protect against financial market exposures. Traditional risk management tries to protect against loss of physical assets through loss control programs and commercial insurance products. Firms that hold financial assets or liabilities are likely to try to protect themselves against loss in the value of the financial asset, or increases in the cost and decreases in the return (interest rate) of those assets and liabilities.
When a firm makes an investment decision, it exposes itself to a number of financial risks. The significance of such risks depends on the type of financial instrument. These financial risks might be in the form of high inflation, volatility in capital markets, recession, bankruptcy, etc.
So, in order to minimize and control the exposure of investment to such risks, fund managers and investors practice risk management. Not giving due importance to risk management while making investment decisions might wreak havoc on investment in times of financial turmoil in an economy. Different levels of risk come attached with different categories of asset classes.
Businesses will need to identify the risk mitigation strategies that it will adapt to manage the financial risks it is facing or could be facing. The choice of mitigation strategies largely depends on the specific risk that is being managed and the available resources to implement them.
A number methods and instruments, which are becoming more and more sophisticated, are now used to protect against financial risk. First and foremost, they include the monitoring and control of all risk taking activities by developing relevant policies and procedures, and assuring that they are followed. A simple policy of limiting types of investments that a firm may invest in (for example, all bonds in the company’s portfolio must have a credit rating of triple-B or better), designating “caps” on any one type of exposure or in any one company or instrument and monitoring credit, foreign exchange or other exposures can protect a company as the first line of defense.
Correctly implemented and followed, risk management policies are one of the most powerful tools of financial risk management.
Interested in a FRM course but not sure which financial risk management training to look into? Why not find out more about the financial risk management courses at London TFE.
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