What is Financial Risk Management? Definition, Analysis and Approaches

Financial Risk Management Definition:

Financial risk management refers to the process of financially viable value in any organization. Financial instruments are put in use to assist the management team to manage disclosure to risk, principally credit risk and market risk. Other risks include equity risks, supplier risks, customer risks, partner risks, financing risks, liquidity risks and risks related to interest rates, exchange rates and commodity prices. The algorithm of financial risk management is similar to that of general risk management, the process is sub divided in three phases broadly – the first one being identification of risks’ sources, its assessment, and construction of the plans to address them.

Qualitative and quantitative, both the approaches are feasible in financial risk management and use of either of the approaches will depend on the type of risk the management team is dealing with. As a particular branch of risk management, financial risk management aims to prioritize the use of hedge with the help of financial instruments to manage costly exposures to risk.

The inter-dependency of the risks makes them more hazardous and the company or the investment is exposed to more vulnerability. For instance, exchange rates and interest rates are strongly associated to each other. Their co-dependency must be considered while structuring the framework of Financial Risk Management.

Financial risk management is designed and carried out to safeguard the company from these risks by using efficient financial instruments. Owing to its demand, Financial Risk Management is also taught as a subject. The curriculum entails managing the relationship between internal aspects of financial institutions and the external factors that influences the investment. Also, it deals in modern financial markets. Financial Risk Management provides foundation understanding about underpin modern risk management techniques.

Financial Risk Management Analysis:

A company or the financial management team (for their clients) is supposed to compute the intensity and types of potential risks it is prone to. The team must then, thoroughly analyze the situation and come up with the most feasible technique or approaches or method to either avoid that risk or minimize its impact. Here we will understand financial risk management methods and approaches with examples:

Consideration Clauses of Financial Risk Management Analysis:

Value at Risk (VaR) – One of the most prominent approaches or steps for financial risk management is VaR analysis. VaR is calculated on the basis of degree of potential losses, the likelihood of the intensity of loss, and the time frame. To give you a better understanding suppose there is a hypothetical project run by a financial firm and the exposed one month value at risk is of 7 for the total capital of INR 20,000. This means that in any given month during the lifecycle of the project there is 7 per cent chance that it will incur the loss of INR 20,000. Another example is of any typical investment portfolio of a firm or an individual. If INR 10000 is the determined measure of VaR, at the rate of 38 per cent confidence level over a holding period of 29 days and theirs is no investment or sale till the 29^th day, then there’s a 38 per cent chance that the portfolio holder will lose out INR 10000. VaR is approximation of the likely utmost loss. Actual losses may be above or below the estimated value.

Regression Analysis – Another famous financial risk management method or approach is called regression analysis. It is practiced to study the consequence on one variable when the other one is exposed to any sort of change. It will determine what magnitude of changes will cash inflow encounter when rate of interest increases or decreases.

Scenario Analysis – Scenario analysis is another robust method of financial risk management. It is sometime called as one of the techniques of financial risk management. It is also known by stress tests, sensitivity tests, or ‘what if?’ analyses. Financial managers and there team sit down, discuss and create several hypothetical yet relevant scenarios and ask ‘what if’ this situation were to occur? Some of the questions can be developed like this – What if the there’s a downfall of 48 per cent in the stock market? What if there’s a rise of 29 basis points in interest rates by RBI? What if the exchange rates were to show a decrease by 30 per cent or increase by 29? What if an important client were to leave the firm? Once evaluated, the outcomes of these hypothetical scenario analyses are converted into a risk quantify by assuming the risk disclosure based on the computations and utmost loss forecasted is treated as the worst case scenario.

Conclusion:

Here we have learned and understand about methods and techniques involved in financial risk management. Also steps involved in various approaches to mitigate the financial risk management. Hope this tutorial was very useful in your personal and professional life. Best of Luck !