Financial risk management

From ArticleWorld

Financial risk management is a specialist branch of risk management that aims to manage exposure to risk as economically as possible for investors, thus using risk to create value. Risk management identifies sources of risk and their potential cost, and uses financial instruments to hedge large risks.

Creating value

According to financial economics, any risk which can be managed within the firm for the same price as that of taking it outside does not create value, the ultimate goal of risk management. In finance theory this is called the hedging irrelevance proposition. Since there are no perfect markets, at any given time, there are unique risks open to firms alone, which can be hedged to create value.

Financial instruments

Swap, forward contracts and similar over-the-counter derivatives are ideal to manage exchange and interest rate risks because they can be engineered to exactly match particular predicted risks. Options and futures contracts are less secure to manage futures exchange risk because they are standardized, but they remain cheaper to track.