| Financial risk management is the practice of creating value in a
firm by using financial
instruments to manage exposure to risk. Similar to general risk management, financial risk management requires identifying the sources
of risk, measuring risk, and plans to address them. 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.
When to use financial risk management
Finance theory (i.e. financial economics) prescribes that
a firm should take on a project when it increases shareholder value. Finance
theory also shows that firm managers cannot create value for shareholders, also
call its investors, by taking on projects that shareholders could do for
themselves at the same cost. 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 is captured by the hedging
irrelevance proposition: 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. This suggests that firm managers likely have many opportunities to create value for shareholders using financial
risk management. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. A general rule
of thumb, however, is that market risks that result in unique risks for the firm are the best
candidates for financial risk management.
Important financial instruments
Because of their ability to offset specific risks, derivative securities (also called derivatives) are commonly used in financial risk management. The
most commonly traded derivatives include options, futures, forwards, and swaps. Market risk factors that derivatives are commonly based on include
stock prices, stock
indices, commodity prices, interest rates, and foreign exchange rates. Because
unique derivative contracts tend to be costly to create and monitor, the most
cost-effective financial risk management methods usually involve derivative that trade on well-established financial markets.
References
Stulz, René M. (2003). Risk Management & Derivatives (1st ed.). Mason, Ohio: Thomson South-Western. ISBN:
0-538-86101-0.
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