Reviews on Financial Risk Management Essay

The definition and types of m unitytary run a run a pretend III. take a chance perplexity and the suppositional giveation IV. The execute of monetary take chances watchfulness V. The challenges confront by the new-fangled monetary luck steering theories ?Abstract? pecuniary lay on the lines are exposures of uncertainties for those participants in pecuniary foodstuffplace. fiscal endangerments throw out be split into four-spot categories commercializeplace risk, credit risk, liquidity risk and operating(a) risk. Risk apportionment has dumbfound to a greater extent and more crucial for a market participant to survive in the highly competitive market.As the information of the global fiscal market, in that respect are m whatsoever phenomena that substructure non be explained by handed-down monetary risk forethought theories. These phenomena retain accelerated the ripening of behavioral finance and stinting physics. The monetary centering theorie s have already alterd a lot everywhere the past decades, save dumb facing near challenges. Therefore, this report testament review rough of the essence(p) issues in the financial risk management deliver some speculative foundation of financial risk management, and discuss the challenges faced by the new-fangled-day financial risk management.I. Introduction Financial risk is one of the basal characteristics of financial system and financial activities. And financial risk management has become an grievous component of the economic and financial system since the occurrence of financial in human society. Over the past few decades, economic globalisation spread across the world with the falling down of the Bretton Woods system. infra higher up background, the financial markets have become even more insecure due to some signifi tin stinkpott changes.Many events happened during the decades, including the Black Monday of the year 1987, the business crisis in Japan in 199 0, the European monetary crisis in 1992, the financial storm of Asia in 1997, the bankruptcy of Long-Term Capital Management in 1998, and the most recent global financial crisis triggered in the year 2008. whole these changes brought enormous destruction of the smooth tuition of the world economy and the financial market. At the same time, they as well helped people realise the necessity and goad of the financial risk management. Why did the crisis happened and how to avoid the risk as a lot as possible?These questions have been endowed more significant means for the further development of the economy. Therefore, this report will review some valuable issues in the financial risk management introduce some theoretical foundation of financial risk management, and discuss the challenges faced by the modern financial risk management. II. The Definition and Types of Financial Risk The word risk itself is neutral, which means we cannot define risk a good thing or bad. Risk is one o f the indispensable features of human behavior, and it comes from the uncertainty of the future results.Therefore, soon speaking, risk can be defined as the exposure to uncertainty. In the definition of risk, there are two extremely of the essence(predicate) factors world-class is uncertainty. Uncertainty can be considered as the dissemination of the possibility of one or more results. To deliberate risk, we imply to have a distinct description about the possibility of the risk. However, from the point view of a risk manager, the possible result in the future and the characteristic of the possibility distri only ifion are usually unknown, so subjective factors are frequently inevitable when making lasts.The second factor is the exposure to uncertainty. Different human activities were learnd at different take to the same uncertainty. For example, the future weather is uncertain to everyone, but the beguile it has over agriculture can be far deeper than that over finance industry or some other industry.Based on the above description about risk, we could have a clearer definition of financial risk. Financial risk is the exposure to uncertainty of the participants in the financial market activities. The participants in the first place refer to financial institutions and non-financial institutions, usually not including ndividual investors. Financial risk arises with countless transactions of a financial nature, including sales and purchases, investments and loans, and various other business activities. It can arise as a result of intelligent transactions, new projects, mergers and acquisitions, debt financial backing, the energy component of costs, or through the activities of management, stockholders, competitors, outside(prenominal) governments, or weather. (Karen A. Horcher). Financial risk can be divided into the following types fit in to the different sources of risk. A. Market risk.Market riskis theriskthat the valuate of a portfolio, ei ther an investment portfolio or a trading portfolio. It will fall due to the change in value of the market risk factors. The four commonplace market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices. The solve of these market factors have over the financial participants can be both direct and indirect, like through competitors, suppliers or customers. B. Credit risk. Credit riskis an investors risk of privation arising from a borrower who does not make payments as promised.Such an event is called adefault. near all the financial transactions have credit risk. Recent years, with the development of the internet financial market, the problem of internet finance credit risk likewise became prominent. C. Liquidity risk. Liquidity riskis the risk that a precondition security or asset cannot be traded quickly enough in the market to prevent a detriment. Liquidity risk arises from situations in which a party arouse in trading anassetcannot do it beca drop nada in themarketwants to trade that asset.Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their expertness to trade. D. Operational risk. Operational risk is the risk of loss resulting from inadequate or failed internal assistes, people and systems, or from external events. Nowadays, the employment and management of operational risk is getting more attention. The makeups are trying to perfect their internal control to minimize the possibility of risk. At the same time, the mature possible action of other subjects, much(prenominal)(prenominal) as operational research manners, are in any case introduced to the management of operational risk.Overall, financial risk management is a process to deal with the uncertainty resulting from financial markets. It involves assessing the financial risks facing an arrangement and beneathdeveloped management strategies consistent with internal pr iorities and policies. Addressing financial risks proactively may provide an organization with a competitive emolument. It also ensures that management, operational staff, stockholders, and the board of directors are in agreement on key issues. III. Risk Management and the Theoretical al-QaedaFinancial market participants attitude towards risk can be basically divided into the following categories. A. Avoid risk. It is irrational for some companies to think that they can avoid the financial risks though their careful management because of the following reasons. First of all, risk is the internal feature of human activities. purge though it doesnt have direct influence, it could generate indirect influence though the competitors, suppliers or customers. Moreover, sometimes it might be a go against choice for the manager of the alliance to accept risk.For example, when the profit margin of the companionship is higher than the market profit margin, the manager can increase the va lue of the gild by apply financial leverage principle. Obviously, it will be harder to increase the value of a company if the manager is al manners using the risk avoidance strategy. B. Ignore risk. Some participants tend to ignore the universe of discourse of risks in their financial activities, thus they will not take any steps to manage the risk. According to a research of Loderer and Pichler, almost all the Swedish multinational companies ignored the exchange rate risk that they are facing. C. substitute risk.Many companies and institutions choose to diversify risk by putting testicle into different baskets, which means reaching the purpose of lower risk by holding assets of different type and low correlation. And the cost is comparatively low. However, as to small corporations or individuals, diversifying risk is somehow unrealistic. Meanwhile, modern asset portfolio possible action also tells us that diversifying risk could only lower the unsystematic risk, but not syst ematic risk. D. Manage risk. Presently, most people have realized that financial risk cannot be eliminated, but it could get managed though the financial possibleness and tools.For instance, participants can break down the risk they are loose to by using financial engineering methods. After keeping some prerequisite risk, diversify the rest risk to others by using derivatives. plainly why do we need financial risk management? In other words, what is the theoretical foundation of the existence of financial risk management? The early financial theory argues that financial risk management is not obligatory. The Nobel Prize winner Miller amp Modigliani pointed out that in a perfect market, financial measures like hedging cannot influence the starchys value.Here the perfect market refers to a market without tax or bankruptcy cost, and the market participants own the round out information. Therefore, the managers do not need to worry about financial risk management. The similar the ory also says that even though there will be slight moves in the short run, in the long run, the economy will move relatively stable. So the risk management that is used to prevent the loss in short term is alone a waste of time and resource. Namely, there is no financial risk in the long run, so the financial risk management in the short run will just offset the unbendables profits, and therefore reduce the warms value.However, in reality, financial risk management has already roused more and more attention. The need for risk management theory and measures soar to unprecedented high gear for both the regulator and participants of the financial market. Those who think risk management is necessary argue that the need for risk management is mainly based on the imperfection of the market and the risk abuse manager. Since the real economy and the financial market are not perfect, the manager can increase a firms value by managing risk.The imperfection of the financial market is sh own in the following aspects. First, there are various types of tax alert in the real market. And these taxes will influence the earning flow of the firm, and also the firms value. So the Modigliani amp Miller theory does not flex for the real economy. Secondly, there is transaction cost in the real market. And the small the transaction is, the higher the cost. Last but not least, the financial market participants cannot obtain the complete information. Therefore, firms can benefit from risk management.First, the firm can get stable cash flow, and thus avoid the external financing cost caused by the cash flow shortage, decrease the fluctuation frame of the stock and keep a good credit record of the company. Secondly, a stable cash flow can guarantee that a company can invest successfully when the opportunity occurs. And it gets some competitive return compared to those who dont have stable cash flow. Thirdly, since a firm possesses more resource and knowledge than an individual , which means it could have more complete information and manage financial risks more efficiently.If the manager of a firm is risk aversion, he can improve the managers utility through financial risk management. Many researches show that the financial risk management activities have close relation to the managers aversion to risk. For example, Tufano studied the risk management strategy of American gold industry, and found that the risk management of firms in that industry has close relation to the shove that the managers signed about reward and punishment contracts.The managers and employees are full of devotion about risk management is because that they put great amount of hidden capital in the firm. The invisible capital includes human capital and particularized skills. So the financial risk management of the firms became some natural chemical reaction to protect their devoted assets. In conclusion, although controversy is still going on about the financial risk management, there is no doubt that the theory and tools of financial risk management is adopted and used by market participants, and continue to be enriched and innovated.IV. The Process of Financial Risk Management The process of financial risk management comprises strategies that enable an organization to manage the risks associated with financial markets. Risk management is a dynamic process that should evolve with an organization and its business. It involves and impacts many parts of an organization including treasury, sales, marketing, tax, commodity, and corporate finance. Companys financial risk management can be divided into three major(ip) steps, namely identification or confirmation risk, measure risk and manage risk.Lets illustrate it using the market risk as an example. First, confirm the market risk factors that have a significant influence to the company, and then measure the risk factors. At present, the frequently used measure of market risk approach can be divided into the re lative measure and absolute measure. A. The relative measure method It mainly measures the aesthesia relationship between the market factors fluctuations and financial asset price changes, such as the duration and convexity. B. The absolute measure methodsIt includes variance or standard deviation and the absolute deviation indicator, mini max and value at risk (VaR). VaR originated in the 1980s, which is defined the maximum loss that may occur within a certain confidence aim. In mathematics, VaR is expressed as an investment vehicle or a combination of profit and loss distribution of ? -quantile, which stated as follows Pr ( ? p lt= VaR ) = ? , where, ? p said that the investment loss in the holding period within the confidence level (1 ? ). For example, if the VaR of a company is 100 million U. S. ollars in 95% confidence level of 10 days, which means in the next 10 days, the risk of loss that occurred more than 1 million U. S. dollars may of only 5%. done this quantitative me asure, company can clear its risks and thus have the major power to carry out the next step targeted quantitative risk management activities. (Guanghui Tian) The last step is management risk. Once the company identified the major risks and have a quantitative grasp of these risks through risk-measurement methods, those companies can use various tools to manage the risk quantitatively.There are different types of risk for different companies, even the same company at different stages of development. So it requires specific conditions for the optimization of different risk management strategies. In general, when the company considers its risk exposure more than it could bear, the following two methods can be used to manage the risk. The first way is changing the companys operating mode, to make the risk back to a sustainable level. This method is also known as Operation Hedge.Companies can alter the supply channels of raw materials, set up production plants in the sales directly or adjust the volume of inflow and springtime of foreign exchange and other methods to achieve above purpose. The second way is adjust the companys risk exposure through financial markets. Companies can take advantage of the financial markets. Companies can take advantage of the financial markets wide range of products and tools to hedge its risk, which means to offset the risk that the company may face through holding a depraved position.Now various financial derivative instruments provide a suitable and diverse selection of products. Derivative products are financial instruments whose value is machine-accessible to some other underlying assets. These basic subject matters may be interest rates, exchange rates, bonds, stocks, stock index and commodity prices, but also can be a credit, the weather and even a snowfall in some ski showplace. Common derivatives include forward contracts, swaps, futures and options and so on. V.The Challenges Faced by the Modern Financial Risk Managem ent guess Over the recent years, as the stress of risk management hifts from a control function to one of global financial optimization, the concern shifts from fashion model the behavior of engineered contracts in selected markets to modeling the phylogenesis of the perfect economy. This change of focus calls for a vastly improved capability to model the time evolution of economic quantities. (Sergio Focardi). While those who do risk management are interested in predicting if assets will go up or down, the over-riding interest is in the relationship in movement to different assets.Though linear methods such as variance-covariance help to run across the co-movements of markets, a different set of tools is necessary to better manage risk. (Jose Scheinkman). Paradigms such as learning, nonlinear dynamics and statistical mechanics will affect how risk from market and credit risk to operational risk is managed. While the first attempts to use some of these tools were think on p redicting market movements, it is now clear that these methodologies might positively influence many other aspects of economics.For instance, they could be useful in understanding phenomena such as price formation, the emergence of bankruptcy chains, or patterns of boom-and-bust cycles. Lars Hansen, Homer J. Livingston prof of economics at the University of Chicago, remarks that these new paradigms will bring to asset price and risk management at enhanced understanding once the inexplicit underlying fundamentals are better understood. He says What needed is a formal specification of the market structure, the microeconomic uncertainty, and the investor preferences that is consistent with the posited nonlinear models.Commenting on the need to bring together the pricing of financial assets and the real economy, he notes that an understanding of whats behind pricing leads to a better understanding of how assets behave. For risk management decisions that entail long-run commitments, he observes, it is particularly important to understand, beyond a purely statistical model, what is governing the underlying movements in security prices. Blake LeBaron, professor of economics at the University of Wisconsin-Medison, observes that there is now more interest in macro moves than in individual markets.But traditional macroeconomics typically provides only point forecasts of macro aggregates. In the risk management context, a simple point forecast is not sufficient a complete validated probabilistic framework is needed to perform operations such as hedging or optimization. One is after an faultless statistical decision-making process. The big issue is the distinction between forecasts and decisions. (Blake LeBaron) Arriving at an entire statistical decision-making process implies reaching a better scientific definition of economic reality.New theories are attempting to do so through models that consider empirical data more accurate than traditional models. These models will improve our ability to forecast economic and financial phenomena. The endeavor is not without its challenges. Our ability to model the evolution of the economy is limited. Prof. Scheinkman notes that unlike in a visible system where better data and more computing power can lead to better predictions, in social systems when a new level of understanding is gained, agents start to use new methods. Prof. Scheinkman says Less ambitious goals have to be set.Gaining an understanding of the broad features of how the structure of an economic system evolves or of relationships between parts of the system might be all that can be achieved. Prof. Scheinkman remarks that we might have to concentrate on finding those patterns of economic behavior that are not destroyed, at least not in the short-run, by the agent learning process. VI. Conclusion The theory foundation of modern financial risk management is the Efficient Markets Hypothesis, which notes that financial market is a linear balan ced system.In this system, investors are rational, and they make their investment decision with rational expectations. This hypothesis shows that the changing of the future price of financial assets has no relation with the history information, and the return on assets should obey normal distribution. However, the study of economic physics shows that financial market is a very intricate nonlinear system. At the same time, behavioral finance tells us that investors are not all rational when making decisions. They usually cannot completely understand the situation they are facing unlike hypothesized.And most times they will have cognitive bias, when they use experience or intuition as the basis of making decisions. It will lead to irrational phenomena like overreaction and under reaction when reflected on investment behaviors. Therefore, it will be meaningful to study how to improve the existing financial risk management tools, especially how to introduce the nonlinear science and be havior study into the measurement of financial risk.