Understanding Financial Risk Management

Financial risk management, as opposed to “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.

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.

In addition to a program of avoiding unnecessary risk through controls, many firms attempt to minimize the necessary risks of doing business by hedging their financial risks in the financial futures markets. A company may choose to use one or all of the various derivative instruments available to them for this purpose. A derivative instrument, broadly defined, is a financial instrument that “derives” its value from the value of some commodity or financial instrument. Some of the simplest and most common forms of financial derivatives are futures, swaps and options.

A futures contract allows a firm to buy or sell a contract in a specific financial instrument for delivery at a future date. This would allow the company to protect against adverse rate and price movements. For example, in three months time, a company may have to finance a large order for about six months. Since they do not know what the six month interest rate will be in three months, they would consider selling a Treasury bill futures contract. If rates go up in the intervening period, the company will have to pay a higher rate, but this will be offset by the profit in buying back the T-bill contract, since rates move opposite prices. If the rate were to go down, the company would lose on the futures contract (have to pay more), but that loss would be offset by their lower interest cost. The idea is not to try to outguess the market, but to limit the risk of interest rates moving against the company.

A swap is a mechanism whereby fixed rate interest payments are swapped for floating rate payments. If a company, for instance, has financial assets that have a floating rate of interest, it may want to use a swap to match its exposure to changing interest rates with a loan that also has a changing rate of interest, instead of the fixed rate on a loan it has open.

Options offer the firm the possibility to buy a stock or a bond at a specific price, depending on whether the company exercises the option. It gives the company the right, but not the obligation, to buy a certain financial instrument at a specific price or rate on or before a specified date. This may be used to offset a position in that stock or bond since it would guarantee a buy or sell price in that stock or bond in exchange for a fee.

These markets have now become extremely complex, with many variations on these types of derivatives, and many more new derivatives being developed. A large company may have a department that deals only with this type of financial risk management. These instruments are also extremely attractive to speculators, who usually represent the other side of each transaction. They are willing to take the risks, (in order to make money) that the company is happy to hand off to them.

 

Information is for educational  purposes only and is not be interpreted as financial advice. This does not represent a recommendation to buy, sell, or hold any security. Consult your financial advisor.






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