Tools of Financial Risk Management

What are Tools of Financial Risk Management?

Tools of financial risk management are the set of systems and processes in place to identify and assess various financial risks, as well as formulate, implement, and monitor appropriate risk responses.

Financial risk is present in some form in every business large and small. That being said, financial institutions, such as banks, insurers, and investment managers are often the most exposed to financial risk. 

Types of Financial Risks

In order to fully understand how tools of financial risk management work, it is important to understand the underlying types of financial risks. These include:

1. Credit Risk: The failure of a counterparty such as a customer, supplier, or investor to meet their contractual obligation such as defaulting on the repayment of a loan.
2. Liquidity Risk: The ability or inability of an organization to meet immediate and or short-term obligations.
3. Market Risk: Systemic risks such as equity market risk, interest rate risk, exchange rate risk, and commodity risk.
4. Operational Risk: The failure of internal processes, people, or systems.

Importance of Financial Risk Management

Financial risk management is incredibly important for financial institutions that typically have thousands of customers and counterparties and are systemically important to the overall functioning of an economy. 

Banks, for example, not only take thousands of personal and business deposits but also support the growth of the economy through personal and business loans. If a bank defaults on its obligations as a consequence of financial risk, the impact on the economy can be significant. 

Insurance companies provide policies to a wide range of individual and corporate counterparties. An insurance company default caused by financial risk would potentially impact thousands of policyholders.

Lastly, investment managers manage money on behalf of their investors. They need to be able to take on enough financial risk to deliver the returns that investors are expecting while at the same time not taking on too much financial risk.

Strategies and Tools for Financial Risk Management

Financial institutions typically implement robust systems and processes to identify and manage financial risk. Elements of these systems and processes include how to:

1. Identify risks
2. Assess risks
3. Prioritize and quantify risks
4. Formulate risk responses
5. Implement risk responses
6. Monitor risk responses

There are various methods of responding to risks. These include:

1. Acceptance of risk 
2. Removal of risk
3. Risk sharing
4. Risk transfer

Acceptance of risk includes acknowledging and accepting risk. For example, a commodity producer may be willing to accept the price swings associated with the commodity they produce.

Removal of risk involves hedging a risk. Organizations can often do this by offsetting one internal risk against another. For example, when a bank trades a security with one counterparty in order to make a market in this security, they can hedge out their risk by taking the opposite side of the trade with another counterparty.

Risk sharing includes using derivatives such as forwards, futures, swaps, or entering into joint ventures. For example, a company looking to expand into a new market might enter into a joint venture with a local company that understands that market better – sharing the risk between themselves.

Risk transfer includes using options, insurance, and securitization. For example, a company can transfer the risk of suffering a monetary loss by purchasing insurance against this risk.

Tools for Quantifying Financial Risk

Financial risks can be quantified using various statistical methods. These include:

1. Regression Analysis – This involves understanding how one variable is affected by changes in other variables. Typically, regression analysis is used to explain the impacts of a range of factors on one important metric.
2. Value-at-Risk (VaR) – VaR defines the maximum potential loss in a position or portfolio over a specified time horizon. Typically, organizations use VaR to estimate potential losses at a certain confidence level.
3. Scenario Analysis – This involves quantifying risks in a model if and when certain stress-events were to occur. For example, estimating the impact on a company’s cash flows if interest rates were to rise by two hundred basis points.

Related Readings

Thank you for reading CFI’s guide to Tools of Financial Risk Management. In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Market Risk
• Regression Analysis
• Value-at-Risk (VaR)
• Scenario Analysis
• See all risk management resources