Reviews on Financial Risk Management Essay

The definition and cases of pecuniary gamble of infection III. Risk steering and the suppositious posterior IV. The help of monetary venture humpment V. The ch whollyenges faced by the modern pecuniary jeopardy copement theories ?Abstract? monetary adventures argon mental pictures of uncertainties for those participants in monetary trade. fiscal fortunes throw out be divided into four categories market find, quote peril, liquidity risk and operational risk. Risk steering has become much and more crucial for a market participant to survive in the highly competitive market.As the development of the global pecuniary market, in that location atomic number 18 umpteen phenomena that lowlifenot be explained by traditional fiscal risk screwment theories. These phenomena deplete accele assessd the development of appearanceal finance and economic physics. The fiscal vigilance theories have already ameliorate a lot over the past decades, further still facin g some challenges. Therefore, this report give surveil some authorised issues in the fiscal risk management introduce some theoretical foundation of financial risk management, and discuss the challenges faced by the modern financial risk management.I. presentation Financial risk is one of the basic characteristics of financial dodge and financial activities. And financial risk management has become an important component of the economic and financial system since the occurrence of financial in adult male society. Over the past few decades, economic globalization spread across the world with the falling start of the Bretton Woods system. Under above background, the financial markets have become until now more unstable imputable to some signifi crowd outt changes.Many events happened during the decades, including the Black Monday of the year 1987, the caudex crisis in Japan in 1990, the European monetary crisis in 1992, the financial storm of Asia in 1997, the nonstarter of L ong-Term Capital Management in 1998, and the most recent global financial crisis triggered in the year 2008. All these changes brought enormous destruction of the undisturbed development of the world deliverance and the financial market. At the same time, they similarly helped people realized the urgency and urgency of the financial risk management. Why did the crisis happened and how to avoid the risk as much as accomplishable?These questions have been endowed more significant meaning for the further development of the economy. Therefore, this report lead re realize some important 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 of the versed features of human behavior, and it comes from the uncertai nty of the future results.Therefore, briefly speaking, risk can be defined as the exposure to uncertainty. In the definition of risk, in that location ar two extremely important factors first is uncertainty. Uncertainty can be considered as the distribution of the possibility of one or more results. To study risk, we need to have a precise description close the possibility of the risk. However, from the point view of a risk private instructor, the possible result in the future and the characteristic of the possibility distribution ar usually unknown, so subjective factors are much needed when making decisions.The second factor is the exposure to uncertainty. Different human activities were actd at different level to the same uncertainty. For example, the future weather is uncertain to everyone, but the influence it has over agriculture can be far deeper than that over finance industry or other industry.Based on the above description about risk, we could have a clearer definit ion of financial risk. Financial risk is the exposure to uncertainty of the participants in the financial market activities. The participants mainly refer to financial institutions and non-financial institutions, usually not including ndividual investors. Financial risk arises through 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 legal transactions, bleak projects, mergers and acquisitions, debt financing, the energy component of costs, or through the activities of management, stockholders, competitors, foreign governments, or weather. (Karen A. Horcher). Financial risk can be divided into the following types according to the different sources of risk. A. Market risk.Market riskis theriskthat the think of of a portfolio, either an investment portfolio or a trading portfolio. It exit decrease due to the change in value of the market risk factors. The four pre cedent market risk factors are stock prices, gratify rates, foreign exchange rates, and commodity prices. The influence 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 expiry arising from a borrower who does not make payments as promised.Such an event is called adefault. Almost all the financial transactions have credit risk. Recent years, with the development of the net receipts financial market, the problem of internet finance credit risk similarly became prominent. C. Liquidity risk. Liquidity riskis the risk that a prone aegis or addition cannot be traded quickly enough in the market to prevent a loss. Liquidity risk arises from situations in which a party interested in trading anas scorecannot do it beca engagement nobody in themarketwants to trade that asset.Liquidity risk becomes particularly important to parties who are ab out to hold or currently hold an asset, since it affects their top executive to trade. D. Operational risk. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Nowadays, the study and management of operational risk is fussting more attention. The boldnesss are trying to faultless their internal control to minimize the possibility of risk. At the same time, the mature theory of other subjects, such as operational research systems, are also 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 organization and developing management strategies consistent with internal priorities and policies. Addressing financial risks proactively may leave behind an organization with a competitive advantage. It also ensures that management, operational s taff, stockholders, and the board of directors are in agreement on key issues. III. Risk Management and the Theoretical FoundationFinancial market participants military position towards risk can be basically divided into the following categories. A. Avoid risk. It is irrational for some companies to hypothesise that they can avoid the financial risks though their careful management beca map of the following reasons. First of all, risk is the internal feature of human activities. Even though it doesnt have direct influence, it could generate indirect influence though the competitors, suppliers or customers. Moreover, sometimes it might be a better choice for the manager of the lodge to accept risk.For example, when the profit margin of the participation is higher than the market profit margin, the manager can enlarge the value of the fellowship by using financial leverage principle. Obviously, it will be harder to increase the value of a follow if the manager is al offices usi ng the risk avoidance system. B. Ignore risk. Some participants endure to ignore the existence of risks in their financial activities, thus they will not take any cards 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. Diversify risk.Many companies and institutions choose to diversify risk by putting pelt into different baskets, which means reaching the purpose of lower risk by holding assets of different type and low correlation. And the cost is relatively low. However, as to small corporations or individuals, diversifying risk is somehow unrealistic. Meanwhile, modern asset portfolio theory also tells us that diversifying risk could only lower the un opinionated risk, but not systematic risk. D. Manage risk. Presently, most people have realized that financial risk cannot be eliminated, but it could loll around managed though the financial theory and tools.F or instance, participants can break down the risk they are exposed to by using financial engineering methods. After keeping some necessary risk, diversify the rest risk to others by using derivative instruments. But 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 repugns that financial risk management is not necessary. The Nobel Prize winner Miller amp Modigliani pointed out that in a perfect market, financial measures like hedging cannot influence the firms value.Here the perfect market refers to a market without tax or bankruptcy cost, and the market participants own the complete information. Therefore, the managers do not need to worry about financial risk management. The similar theory 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 just 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 firms profits, and therefore reduce the firms 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 heights 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 annoyance 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 shown in the following aspects. First, there are various types of tax existing in the real market. And these taxes will influence the earning accrue of the firm, and also the firms value. So the Modigliani amp Miller theory does not work for the real economy. Secondly, there is transaction cost in the real market. And the smaller the transaction is, the higher the cost. Last but not least(prenominal), 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 range 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 advantage 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 ut ility 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 focus that the managers signed about reward and punishment contracts.The managers and employees are full of enthusiasm about risk management is because that they put great amount of invisible great in the firm. The invisible capital includes human capital and specific skills. So the financial risk management of the firms became some natural chemical reaction to protect their accustomed 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 keep to be enriched and innovated.IV. The Process o f 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 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 relative measure and absolute measure. A. The relative measure method It mainly measures the sensitivity 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 agency level. 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 nigh 10 days, the risk of loss that occurred more than 1 million U. S. dollars may of only 5%. done this quantitative measure, company can clear its risks and thus have the qualification to carry out the beside step targeted quantitative risk management activities. (Guanghui Tian) The last step is m anagement risk. Once the company set 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 adjust the supply channels of lancinating materials, set up production plants in the sales directly or adjust the volume of influx and outflow 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 contrary position.Now various financial derivative instruments provide a sufficient and diverse selection of products. Derivative products are financial instruments whose value is connect 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 Management Theory Over the recent years, as the focus of risk management hifts from a control function to one of global financial optimization, the concern shifts from modeling the behavior of engi neered contracts in selected markets to modeling the evolution of the entire economy. This change of focus calls for a vastly improved ability 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 reason to different assets.Though linear methods such as variance-covariance help to understand 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 focused on predicting 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 form ation, the emergence of bankruptcy chains, or patterns of boom-and-bust cycles. Lars Hansen, Homer J. Livingston professor of economics at the University of Chicago, remarks that these new paradigms will bring to asset determine and risk management at enhanced understanding once the implicit 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 Uni versity 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 later on an entire 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 explanation of economic reality.New theories are attempting to do so through models that reflect 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 tha t irrelevant in a physical 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 balanced 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 complicated 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 behavior study into the measurement of financial risk.