Understanding Financial Risk Management | national news
Financial risk, which is the probability of financial loss, can arise in many business and investment scenarios. For example, a company cannot launch a product or service without taking a risk. However, risk also opens up opportunities in other areas of a given space. In portfolio management, there is usually a direct correlation between risk and rewards.
Consider working with a financial advisor to assess your own risk tolerance and the risks of specific financial movements.
The basics of financial risk management
Financial risk management is not necessarily about avoiding all risks. Rather, it is to assess the risk of any proposed investment or business venture and weigh it against the prospects of a proposal’s success. This often involves the use of hedging and other strategies to help reduce the effect of risk and maximize company value for stakeholders.
For example, the financial risk faced by a business stems from the various financial transactions of a business. Examples include sales and purchases, investments, debt financing, energy, management and stakeholder actions and more.
Broadly speaking, financial risk can be categorized into six types. These include interest rate risk, market risk, credit risk, currency risk, commodity risk and liquidity risk.
Interest rate risk
Changes in interest rates and the resulting interest rate risk can significantly affect businesses. If a business borrows money and the loan has an adjustable interest rate when interest rates are low, their interest payments will increase if the Federal Reserve raises interest rates. If interest rates are high and fall, even a business with a fixed interest rate loan may be at a competitive disadvantage. Higher interest rates make it harder to borrow money. In the case of a company holding bonds, the value of the underlying investment is lower as interest rates rise.
Financial risk managers help mitigate these risks by using a variety of hedging strategies. Smoothing is a hedging strategy. Companies that borrow from commercial banks can spread the loan in disbursements with variable and fixed interest rates. If interest rates fall, fixed rate loans are affected. If they increase, only variable rate loans are affected.
Derivative securities are generally used to manage interest rate risk (as well as to manage currency risk and commodity risk). Matching is another strategy that financial risk managers can use. If a company borrows from a bank and has a given interest rate on its loan, it can also deposit with the same bank at a similar interest rate and thus hedge part of its risk.
Interest rate swaps are particularly effective in hedging interest rate risk in the bond market. A company can use a derivative security to convert floating rate bonds into fixed rate bonds.
Market risk includes the risk associated with changes in the market in which a business competes. This is sometimes also called systematic risk.
A first example of market risk has gradually occurred in the energy sector of the US economy. Companies that extract fossil fuels and use fossil fuels to generate energy have seen the introduction of green energy companies in their market. Even though the fossil fuel industry still dominates in this sector, it is seeing its market share decline due to hybrid and electric cars, wind power, solar power and a general move towards more energy. own. They must find a new way to compete.
Usually, this involves changing their business model and finding a way to offer their value-added products that persuade customers to patronize their businesses. If they don’t change, they will eventually fall by the wayside with declining profit margins. This is what happens in the case of coal mines and coal-fired power plants.
If companies engage in financial risk management as their market experiences change, they will be in a better position. Some traditional car manufacturers, for example, are moving into electric and hybrid vehicles.
Credit risk refers to the possibility that a business will default on or honor its commitments. Banks and other credit institutions bear credit risk when they lend to businesses. Businesses bear credit risk when they allow customers to pay on credit.
The best way to avoid credit risk is through diversification. If a lending firm has a wide variety of customers and loans of different interest rates and maturities, that mitigates some of the loss in the event of a customer default. Using collateral and offsetting balances to secure a loan is often effective.
Lenders may also use credit default swaps to manage credit risk. Credit derivatives are agreements between creditor and debtor to transfer a large part of the risk to a third party as in the case of secured debt securities.
Risk of change
Currency risk is the possibility that exchange rates will change before a transaction is completed. Companies exposed to foreign exchange risk sometimes hedge against changes in exchange rates by using forward currency swap contracts as part of their financial risk management. These are derivative securities that allow the company to lock in exchange rates for a given period. A simple, non-derivative strategy is to simply charge and transact in US dollars only.
An example of hedging against the evolution of the price of a product is visible in the agricultural sector. Farmers operate on an extremely thin profit margin. If a farmer’s product is to be ready for market in three months, the farmer knows from his production costs what he has to do on each unit of the product. The farmer is worried that the price of the product will drop in three months due to unforeseen circumstances, such as the weather.
This farmer can sell a futures contract on the commodity which will lock in the future selling price. This also works if the price exceeds the price expected by the farmer. The downside in this case is that the farmer will not reap the benefits of the price increase.
Liquidity refers to the ease with which a company can convert its assets into cash. If a business is seasonal or cyclical, it may face greater liquidity risk than businesses with more sales. Seasonal or cyclical businesses generally face a much higher liquidity risk, as the business might not have cash flow to pay the bills.
Financial risk management looks to metrics such as the company’s free cash flow to monitor liquidity risk at all times. Quick ratio and inventory turnover ratios can be useful. In addition, the price/cash ratio helps to indicate to what extent the liquidity risk affects the value of the company.
Financial risk management serves to minimize risk to a business. Businesses are subject to many different types of risk. Using derivatives to quantitatively manage risk is one strategy. Other strategies come from the specific type of risk and may be particular to each type of risk. There are also hedging strategies that can be effective with most types of risk.
Risk Management Tips
- A potential course of action when trying to assess the risk of a specific move, whether in business or investing, is to consult a financial advisor. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
- Inflation risk is a type of risk that you may face on an individual level. SmartAsset’s free inflation calculator helps you determine the impact of inflation on your purchasing power.
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