Financial Risk Management

Exposure to financial risk is the result of an organization failing to have adequate risk management tools, processes and systems in place. Employees must be properly trained to use the tools and develop the processes that timely identify the organizations exposure to risk. Financial risk arises from exposure to changes in market prices or interest rates, or from transacting business with customers, suppliers, or a counterparty (the other party in a financial agreement).

Financial risk management is the process of evaluating and managing current and probable risk of an organization as a method of diminishing the organization's exposure to the identified risks. It is incumbent on risk managers to identify and evaluate the risks and then implement the processes and systems necessary to mitigate the risks. The key risks inherent to an organization are foreign exchange, interest rate, commodity, operational and credit risk.

Risk managers are required to know what tools mitigate what risks. The hedging instruments and tools available to a financial risk manager are forwards, options, futures, corporate governance, and diversification. 

A forward contract is an agreement between two parties to exchange at some fixed future date a given amount of currency or a given amount of a commodity at a fixed price. A forward contract mitigates the risk of a rise in price of a currency or a commodity in the future because the future price is fixed today.

Purchasing an option contract reduces the risk of adverse currency, interest rate or commodity price movements whilst at the same time maintaining the ability to profit from any favourable price movements. The buyer of an option has the right but not the obligation to purchase a given amount of a currency, debt or commodity at a certain rate at a certain time. At the agreed time if the price is favourable to the option buyer the option is allowed to lapse and the buyer takes advantage of favourable prices, other wise the buyer takes up the option to mitigate price risk.

A futures contract is an exchange traded contract that is used to reduce price risk. It requires that at a specific price on a specific date in the future a delivery of a commodity, currency or bond. Unlike an option holder the future contracts holder has an obligation to buy. A buyer of a futures contract anticipates a rise in the future price of an asset, whilst the seller anticipates a fall in the price of an asset in the future.

Corporate governance is the framework of rules and practices by which a board of directors manages operational risk. The rules and practices cover clear distribution of duties and roles, procedures for proper controls, supervision and information flows that form the systems of checks and balances that reduce operational risk.

Diversification is a risk management strategy designed to reduce credit risk by diversification of borrowers and counterparties to avoid over exposure within any industry, region or country. Implementation of industry and country borrowing and counterparty limits is another tool of the risk manager. 

A book could easily be written about each one of the above mentioned risk management tools and some have. There is one particular free downloadable e-book called The Essentials of Financial Risk Management that is worth a read. Otherwise read my other hubs on finance on hubpages.