Financial risk management

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Financial risk management is the practice of economic value in a firm by using financial instruments to manage exposure to risk: operational risk, credit risk and market risk, foreign exchange risk, shape risk, volatility risk, liquidity risk, inflation risk, business risk, legal risk, reputational risk, sector risk etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them. [1]

Business organization involved in commercial, industrial, or professional activity

Business is the activity of making one's living or making money by producing or buying and selling products. Simply put, it is "any activity or enterprise entered into for profit. It does not mean it is a company, a corporation, partnership, or have any such formal organization, but it can range from a street peddler to General Motors."

Risk is the possibility of losing something of value. Values can be gained or lost when taking risk resulting from a given action or inaction, foreseen or unforeseen. Risk can also be defined as the intentional interaction with uncertainty. Uncertainty is a potential, unpredictable, and uncontrollable outcome; risk is a consequence of action taken in spite of uncertainty.

Operational risk is "the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external events, differ from the expected losses". This definition, adopted by the European Solvency II Directive for insurers, is a variation from that adopted in the Basel II regulations for banks. In October 2014, the Basel Committee on Banking Supervision proposed a revision to its operational risk capital framework that sets out a new standardized approach to replace the basic indicator approach and the standardized approach for calculating operational risk capital.

Contents

Financial risk management can be qualitative and quantitative. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk. [2]

Hedge (finance)

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks. [3] [4]

The Basel Accords refer to the banking supervision Accords —Basel I, Basel II and Basel III—issued by the Basel Committee on Banking Supervision (BCBS). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the committee normally meets there. The Basel Accords is a set of recommendations for regulations in the banking industry.

Uses of financial risk management

Finance theory (i.e., financial economics) prescribes that a firm should take on a project if it increases shareholder value. Finance theory also shows that firm managers cannot create value for shareholders, also called its investors, by taking on projects that shareholders could do for themselves at the same cost. [5]

Financial economics is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a trade". Its concern is thus the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. It has two main areas of focus: asset pricing and corporate finance; the first being the perspective of providers of capital, i.e. investors, and the second of users of capital.

A shareholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders may be referred to as members of a corporation. Legally, a person is not a shareholder in a corporation until their name and other details are entered in the corporation‘s register of shareholders or members.

Management Coordinating the efforts of people

Management is the administration of an organization, whether it is a business, a not-for-profit organization, or government body. Management includes the activities of setting the strategy of an organization and coordinating the efforts of its employees to accomplish its objectives through the application of available resources, such as financial, natural, technological, and human resources. The term "management" may also refer to those people who manage an organization.

When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. This notion was captured by the so-called "hedging irrelevance proposition": [6] In a perfect market, the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm. In practice, financial markets are not likely to be perfect markets. [7] [8] [9] [10]

Price quantity of payment or compensation given by one party to another in return for goods or services

A price is the quantity of payment or compensation given by one party to another in return for one unit of goods or services.. A price is influenced by both production costs and demand for the product. A price may be determined by a monopolist or may be imposed on the firm by market conditions.

This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management, wherein they have to determine which risks are cheaper for the firm to manage than the shareholders. Market risks that result in unique risks for the firm are commonly the best candidates for financial risk management. [11]

Market risk is the risk of losses in positions arising from movements in market prices.:

The concepts of financial risk management change dramatically in the international realm. Multinational Corporations are faced with many different obstacles in overcoming these challenges. There has been some research on the risks firms must consider when operating in many countries, such as the three kinds of foreign exchange exposure for various future time horizons: transactions exposure, [12] accounting exposure, [13] and economic exposure. [14]

Financial risk manager

FRM® (Certified Financial Risk Manager Program) is an international professional certification offered by GARP (The Global Association of Risk Professionals). [15] [16] [17] FRM certificants are to be found in more than 190 countries and territories worldwide. [18] Successful candidates take an average of two years to earn their FRM Certification. [19] FRMs are employed at major banks (Bank of America, Bank of China, ICBC...) and corporates (Goldman Sachs, KPMG, Deloitte, PIMCO, JP Morgan, BlackRock..). [16] [20] [21] [22] [23] [24]

The FRM curriculum is updated annually by risk professionals employed internationally at major banks, asset management firms, hedge funds, consulting firms, and regulators.[ undue weight? ] [18] The Exam curriculum: [25] [18]

See also

Discussion

Institutions

Certifications

Bibliography

Related Research Articles

Finance Academic discipline studying businesses and investments

Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.

A hedge fund is an investment fund that pools capital from accredited investors or institutional investors and invests in a variety of assets, often with complex portfolio-construction and risk management techniques. It is administered by a professional investment management firm, and often structured as a limited partnership, limited liability company, or similar vehicle. Hedge funds are generally distinct from mutual funds and regarded as alternative investments, as their use of leverage is not capped by regulators, and distinct from private equity funds, as the majority of hedge funds invest in relatively liquid assets. However, funds which operate similarly to hedge funds but are regulated similarly to mutual funds are available and known as liquid alternative investments.

An investment bank is a financial services company or corporate division that engages in advisory-based financial transactions on behalf of individuals, corporations, and governments. Traditionally associated with corporate finance, such a bank might assist in raising financial capital by underwriting or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions (M&A) and provide ancillary services such as market making, trading of derivatives and equity securities, and FICC services. Most investment banks maintain prime brokerage and asset management departments in conjunction with their investment research businesses. As an industry, it is broken up into the Bulge Bracket, Middle Market, and boutique market.

Society of Actuaries

The Society of Actuaries (SOA) is a global professional organization for actuaries. It was founded in 1949 as the merger of two major actuarial organizations in the United States: the Actuarial Society of America and the American Institute of Actuaries. It is a full member organization of the International Actuarial Association.

The Chartered Financial Analyst (CFA) Program is a professional credential offered internationally by the American-based CFA Institute to investment and financial professionals. The program covers a broad range of topics relating to investment management, financial analysis, quantitative analysis, equities, fixed income and derivatives, and provides a generalist knowledge of other areas of finance.

Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.

Investment management is the professional asset management of various securities and other assets in order to meet specified investment goals for the benefit of the investors. Investors may be institutions or private investors.

Prime brokerage is the generic name for a bundled package of services offered by investment banks, wealth management firms, and securities dealers to hedge funds which need the ability to borrow securities and cash in order to be able to invest on a netted basis and achieve an absolute return. The prime broker provides a centralized securities clearing facility for the hedge fund so the hedge fund's collateral requirements are netted across all deals handled by the prime broker. These two features are advantageous to their clients.

Chartered Alternative Investment Analyst (CAIA) is a professional designation offered by the CAIA Association to investment professionals who complete a course of study and pass two examinations. The "alternative investments" industry is characterized as dealing with asset classes and investments other than standard equity or fixed income products. Alternative investments can include hedge funds, private equity, real assets, commodities, and structured products. The CAIA curriculum is designed to provide finance professionals with a broad base of knowledge in alternative investments.

Enterprise risk management (ERM) in business includes the methods and processes used by organizations to manage risks and seize opportunities related to the achievement of their objectives. ERM provides a framework for risk management, which typically involves identifying particular events or circumstances relevant to the organization's objectives, assessing them in terms of likelihood and magnitude of impact, determining a response strategy, and monitoring process. By identifying and proactively addressing risks and opportunities, business enterprises protect and create value for their stakeholders, including owners, employees, customers, regulators, and society overall.

Financial risk Any of various types of risk associated with financing

Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.

Financial modeling is the task of building an abstract representation of a real world financial situation. This is a mathematical model designed to represent the performance of a financial asset or portfolio of a business, project, or any other investment.

Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company. The exchange risk arises when there is a risk of appreciation of the base currency in relation to the denominated currency or depreciation of the denominated currency in relation to the base currency. The risk is that there may be an adverse movement in the exchange rate of the denomination currency in relation to the base currency before the date when the transaction is completed.

Certified Risk Analyst (CRA) is a risk management professional designation offered by the Academy of Finance & Management. CRA risk management training and certification is available in New York, California, Asia, the Middle East and other locations.

Goethe Business School gGmbH (GBS) is a subsidiary of Goethe University Frankfurt. Goethe Business School was founded 2004 and offers, in close cooperation with the Faculty of Economics and Business Administration, a wide range of education for executives and young professionals.

Aaron C. Brown is an American finance practitioner, well known as an author on risk management and gambling-related issues. He also speaks frequently at professional and academic conferences. He was Chief Risk Manager at AQR Capital Management. He was one of the original developers of value at risk and one of its strongest proponents.

Institute and Faculty of Actuaries

The Institute and Faculty of Actuaries is the professional body which represents and regulates actuaries in the United Kingdom.

Corporate finance area of finance dealing with the sources of funding and the capital structure of corporations

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

Riccardo Rebonato is Professor of Finance at EDHEC Business School and EDHEC-Risk Institute, and author of journal articles and books on Mathematical Finance, covering derivatives pricing, risk management and asset allocation. Prior to this, he was Global Head of Rates and FX Analytics at PIMCO.

Professional Risk Managers International Association

The Professional Risk Managers' International Association (PRMIA) is a professional organization focused on the "promotion of sound risk management standards and practices globally", and "the integration of practice and theory"; it was founded in 2002 as a non-profit. It provides certification and credentialing for professional risk managers, as well as other educational programs and resources.

References

  1. Peter F. Christoffersen (22 November 2011). Elements of Financial Risk Management. Academic Press. ISBN   978-0-12-374448-7.
  2. Allan M. Malz (13 September 2011). Financial Risk Management: Models, History, and Institutions. John Wiley & Sons. ISBN   978-1-118-02291-7.
  3. Van Deventer, Donald R., and Kenji Imai. Credit risk models and the Basel Accords. Singapore: John Wiley & Sons (Asia), 2003.
  4. Drumond, Ines. "Bank capital requirements, business cycle fluctuations and the Basel Accords: a synthesis." Journal of Economic Surveys 23.5 (2009): 798-830.
  5. EMMANUEL ATTAH KUMAH. COST OF CAPITAL (A FINANCIAL TOOL TO CREATE AND MAXIMIZE SHAREHOLDER VALUE). Lulu.com. pp. 39–. ISBN   978-1-304-26045-1.
  6. KRISHNAMURTI CHANDRASEKHAR; Krishnamurti & Viswanath (eds.) "; Vishwanath S. R. Advanced Corporate Finance. PHI Learning Pvt. Ltd. pp. 178–. ISBN   978-81-203-3611-7.
  7. John J. Hampton (1982). Modern Financial Theory: Perfect and Imperfect Markets. Reston Publishing Company. ISBN   978-0-8359-4553-0.
  8. Zahirul Hoque (2005). Handbook of Cost and Management Accounting. Spiramus Press Ltd. pp. 201–. ISBN   978-1-904905-01-1.
  9. Kirt C. Butler (28 August 2012). Multinational Finance: Evaluating Opportunities, Costs, and Risks of Operations. John Wiley & Sons. pp. 37–. ISBN   978-1-118-28276-2.
  10. Dietmar Franzen (6 December 2012). Design of Master Agreements for OTC Derivatives. Springer Science & Business Media. pp. 7–. ISBN   978-3-642-56932-6.
  11. Corporate Finance: Part I. Bookboon. pp. 32–. ISBN   978-87-7681-568-4.
  12. http://www.emeraldinsight.com/Insight/viewContentItem.do;jsessionid=EFA8D4FB63329F2C94F48279646551BF?contentType=Article&contentId=1649008 (contrary to conventional wisdom it may be rational to hedge translation exposure. Empirical evidence of agency costs and the managerial tendency to report higher levels of translated income, based on the early adoption of Financial Accounting Standard No. 52).
  13. Aggarwal, Raj, "The Translation Problem in International Accounting: Insights for Financial Management." Management International Review 15 (Nos. 2-3, 1975): 67-79. (Proposed accounting framework for evaluating and developing translation procedures for multinational corporations).
  14. http://www.iijournals.com/doi/abs/10.3905/jpm.1997.409611 (Discusses the benefits for hedging in foreign currencies for MNCs).
  15. SEC(Securities and Exchange Commission), https://www.sec.gov/comments/s7-16-15/s71615-33.pdf
  16. 1 2 The Global Association of Risk Professionals, http://garp.org/#!/frm/
  17. Linkedin, https://www.linkedin.com/company/global-association-of-risk-professionals
  18. 1 2 3 Official Candidate Guide, http://storage.pardot.com/39542/121486/FRM_2017_CandidateGuide_V8.2_AG.pdf
  19. GARP Frequently-Asked-Questions -EXAM regulations-, http://www.garp.org/#!/frm/frequently-asked-questions
  20. Wallstreetmojo official FRM salary, http://www.wallstreetmojo.com/frm-salary/
  21. Chen, Liyan. "2015 Global 2000: The World's Largest Banks", Forbes Magazine. https://www.forbes.com/sites/liyanchen/2015/05/06/2015-global-2000-the-worlds-largest-banks/
  22. The Benefits of Professional Certification, William May William May Senior Vice President, http://www.garp.org/newmedia/presentations/frmerprecognitionceremony_williammay_021014.pdf
  23. iactglobal(2010. 5.) http://www.iactglobal.in/images/FRM_Companies.pdf
  24. 2012 Financial RiskManager Roadshow, http://sem.tongji.edu.cn/semen_data/attachments/month_1206/201265155126.pdf
  25. GARP Buy Side Risk Managers Forum – Risk Principles for Asset Managers(2015.6.11) http://www.ermsymposium.org/2015/presentations/C-19.pdf