• S. Banik

Risk management techniques used in financial management

Techniques for Financial Risk Management: Financial risk management is the process of evaluating and managing the various financial risks associated with financial products. For instance, currency risk, credit risk, market risk, inflation risk, liquidity risk, business risk, and volatility risk are all examples of risks.

Today, every investment carries a degree of risk. Additionally, these risks increase the likelihood of failing to meet financial objectives. Numerous financial risks that may affect an economic or financial activity of the business. It is associated with the likelihood of experiencing a decrease in Return on Investment.

1. Interest Rate Risk – That when an investor invests in bonds or mutual funds that pay a fixed rate of return, the possibility exists that interest rates will rise, depreciating the value of the bond.

2. Business Risk – This type of risk is also referred to as irrational risk. Typically, this risk pertains to individual securities. For example, an issuer of a bond, stock, or other short-term asset could run out of cash and declare bankruptcy.

3. Credit Risk – This risk refers to an issuer's inability to make anticipated principal, interest, or both payments.

4. Taxability Risk – Municipal bond products are subject to a specific risk. A tax-exempt security may lose its tax-exempt status before it matures. As a result of municipal bonds' low interest rates, the investor will receive lower returns than expected.

Financial Risk Management is classified into the following subcategories:

Each economic activity involves some level of risk, which is the fundamental concept of financial risk. For instance, credit risk, market risk, currency risk, shape risk, volatility risk, sector risk, liquidity risk, and inflation risk are just a few examples. Risk is classified broadly into three types in financial management.

Risks associated with the market - The dangers of equity, APRs, Rates of exchange, Market prices for commodities.

Risks associated with Credit - Customer Risks, Threats to the supplier, Risks associated with partners.

Risks Associated with Financing/Liquidity – Financing, Cash flows, Liquidity on the market

These risks are frequently interdependent, putting the business at greater risk. For example, interest rates and currency exchange rates are inextricably linked. When structuring the framework for Investment and Financial Risk Management, it is important to consider the interdependence of these risks.

By utilising a variety of financial instruments, financial risk management aims to protect the business from these risks. It is possible for it to be quantitative as well as qualitative. The subject of Investment and Financial Risk Management entails managing the relationship between the internal workings of financial institutions and the external factors that affect investment. Additionally, it transacts business on contemporary financial markets. Investment and Financial Risk Management provides a solid foundation for modern investment and risk management techniques.

Methods and Techniques for Financial Risk Management:

A business must be aware of the magnitude and nature of the risks to which it is exposed. Finance managers are responsible for conducting an in-depth analysis of the situation and selecting the most appropriate approach, process, or method for mitigating that financial risk.

1. Regression Analysis – This technique is used to determine the effect that a change in one variable has on another. Consider the changes that will occur in cash inflows as a result of an increase or decrease in interest rates.

2. Value at Risk (VaR) Analysis – VaR analysis is another popular technique for assessing and monitoring financial risk. VaR is calculated in terms of the potential loss amount, the probability of that loss amount, and the time horizon. For instance, a financial firm is exposed to a risk of AUD 50,000 if its monthly value falls by 5%. This means that the firm has a 5% chance of incurring a monthly loss of AUD 50,000. Consider another example to help you grasp this concept. Assume another firm owns an investment portfolio for which the VaR is determined to be AUD 100,000 over a 40-day holding period with a 50% confidence level. Now, if no investments are made or sold within 40 days, the firm faces a 50% chance of losing AUD 100,000. VaR is a probability distribution function that estimates the maximum loss that could occur. Actual losses may exceed or fall short of the estimate.

3. Security Analysis – Security analysis is the examination of tradable financial instruments such as debt (money borrowed from the market), equity (owner's fund), a combination of the two, and company warrants. Occasionally, futures and tradable credit derivatives are included as well. Security analysis is further divided into fundamental analysis, which is concerned with a variety of essential business factors such as economic statements, and technical analysis, which is concerned with price trends and momentum.

4. Scenario Analysis – Another useful technique for quantifying risks is scenario analysis. Additionally, stress tests, sensitivity tests, and 'what if?' analyses are used to refer to it. Financial managers develop multiple scenarios and consider the 'what if' scenario. As an illustration

What would happen if the stock market fell 38%?

How about a 100-basis-point increase in interest rates?

How about a 40% increase in the exchange rate?

What would happen if a significant client left the firm?

Now, the findings of these theoretical scenario evaluations are converted to a risk measure by assuming the calculated risk exposure and the maximum loss predicted are the worst case scenarios. Financial risk management methodologies should protect any type of asset, from our personal funds to those of an entire business. Otherwise, uncontrolled expenses may spiral out of control. No matter how large a budget is, there is always a risk of compromising the financial balance if no plan is in place. Therefore, let us examine the following ten financial risk management suggestions and how they can be implemented.

1. Recognize the Risks

Entering a battle unaware of our adversary may seem counterintuitive. We must understand exactly what we are up against in order to choose our weapons appropriately. Even if the assets we wish to safeguard are personal or corporate, they are not immune to human error. This means that we must be truthful to ourselves in order for this initial step to work. Our finances may be jeopardised if we occasionally succumb to products that we do not require but only desire. Additionally, we should be aware of other types of risks. These risks can include those associated with asset-backed securities, credit, foreign investment, liquidity, market, operational, and model risk. Additionally, there may be external hazards that we are unable to control or predict, including cyber attacks or even theft. Make a list of the sources that are robbing us of our funds and be as candid as possible.

2. Quantify Financial Risks

To regain control of our risk management efforts, we must quantify each liability on our list. Because these measurements are based entirely on statistical models, we may require professional assistance or a collection of sophisticated financial tools to calculate the numbers. Financial risk assessment can be one of the most challenging steps in our management plan. However, it is critical for the long-term health of our assets that this stage is handled properly. As a result, you'll be able to make more informed decisions about future expenses.

3. Educate ourselves on investments

A complex financial risk management strategy should also incorporate the concept of investments. However, ignorance can be concealed by greed, and people are prone to fall for sounds-too-good-to-be-true scams. Even in the trading market, individuals can use a risk management strategy to avoid significant losses after opening a forex practise account. However, if we devote sufficient time to learning and comprehending the investment market, we will discover that it results in robust and fruitful returns. Therefore, we should begin reading reputable investment websites, books, and articles to familiarise ourselves with all of the concepts that govern this world.

4. Investigate Insurance Policies

Nobody enjoys contemplating worst-case scenarios, but they are an integral part of a well-structured risk management plan. It's difficult to imagine how many different ways our car could be damaged or how many theft crimes have occurred in our neighbourhood, but insurance has become a necessity in our society. Additionally, even if we are in excellent health at the moment, we should consider health insurance. Regrettably, these can be prohibitively expensive for many people. We should, however, conduct research and attempt to sign at least a basic type of insurance.

5. Establish an Emergencies Fund

Even if we are having a prosperous financial period, taking some precautions never hurts anyone. We can decide how much of our monthly profit should go into a savings account. These emergency funds will eventually prove to be a life-saving answer to some of the financial risks you'll encounter.

6. Conduct a review of our bank's financial ratings.

Following the global recession of 2008, the public has learned an invaluable lesson. We could have the world's largest savings account, but if our bank has poor financial ratings, we could end up with nothing in our pocket. As a result, we should factor into our risk management strategy the liability associated with entrusting our funds to a particular bank. If something happens to our bank, we could lose all of our money in an instant.

7. Invest in Our Competencies

As our finances are highly dependent on a daily job, we should devote as much time as possible to our professional career. Nobody is indispensable in today's competitive workforce, and the majority of people recognise that others can take their place if they become irrelevant. As a result, we should avoid becoming complacent in our job and seek out opportunities to develop our professional skills. This will ensure recognition and will also help maintain our mental acuity.

8. Diversify Our Sources of Income

The likelihood is that our primary source of income will face financial difficulties. However, the likelihood of this occurring simultaneously with multiple sources of income is slim. At some point in the future, geopolitical events may have an effect on financial fluctuations caused by a decline in demand. However, if we have multiple sources of income, our finances may not suffer significantly. Diversification of financial assets is one of the most dependable risk management strategies. It is always on our side when a risk becomes a reality. The negative consequences can be distributed evenly among our various sources of income to the extent that we are unlikely to suffer drastic consequences.

9. Re-evaluate our risks Frequently

Risk management is highly dependent on a variety of external factors. These are the outcomes of the market's volatile rules, which cause risks to fluctuate in intensity. As a result, we should consider global financial events before making a significant investment. A risk management strategy that is effective will evaluate liabilities on an ongoing basis, as circumstances may change since our last assessment. Whether purchasing a new home or business, individuals should consider the external factors that could jeopardise the investment.

10. Conduct Due Diligence

Finally, but certainly not least, we should exercise caution when working with documents. Whenever we are required to part with our hard-earned money, we owe it to ourselves to exercise caution and thoroughly read the contracts and documents pertaining to our purchasing conditions. This type of thorough examination can be time consuming and even inconvenient. However, it can protect us from a variety of risks that could have a negative impact on we in the long run.