Chapter 6

Financial Risk Management

1-What Is Risk?
2- How Does Financial Risk Arise?
3- main sources of financial risk.
4-What Is Financial Risk Management?
5- Strategies for risk management.
- Diversification strategy .
- Derivatives strategy .
6- Risk Management Process.
7-Factors that Impact Financial Rates and Prices .
 Risks faced by a firm
Unsuccessful product launch

Core Business
Labour problems
• Peculiar to a firm

Risks
Cyclical demand fluctuations

Material supply problems

And so forth..

Exchange rate fluctuations

Environmental

• All pervasive and affect Interest rate fluctuations

all firms in an industry
Risks

Sudden price rise of goods

• Financial risks are a
subset of environmental Shifts in government policies
risks
And so forth..
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What is FINANCIAL Credit risk
Concentration
risk

risk? Interest rate

risk

Currency risk

Market risk
A situation involving
RISK
exposure to danger. Equity risk

SOURCE: Oxford Dictionary Commodity

risk
Financial risk refers to the
Refinancing
chance that Liquidity risk
risk
an investment's
Financial Risk
actual return will be Legal risk
FINANCIAL
different than expected. It
RISK
basically is exposure to the
Model risk
danger of financial loss on Operational
investments made by risk
Political risk
investors.

Valuation risk

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 1-What Is Risk?
Financial risk means a state of uncertainty about the expected
results, and means deviation from the expected values ​of
return.
Risk refers to the probability of loss, When an organization has
financial market exposure, there is a possibility of loss but also an
opportunity for gain or profit.
Risk is the likelihood of losses resulting from events such as
changes in market prices.
Put another way, risk is the probable variability of returns.

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but that may result in a high loss, are particularly
troublesome because they are often not
anticipated. Put another way, risk is the probable
variability of returns.
Since it is not always possible or desirable to
eliminate risk, understanding it is an important
step in determining how to manage it.
Identifying risks forms the basis for an
appropriate financial risk management strategy.

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 2- How Does Financial Risk Arise?
•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, new projects,

mergers and acquisitions, debt financing, the energy
component of costs, or through the activities of management,
stakeholders, competitors, foreign governments, or weather.

•When financial prices change dramatically, it can increase costs,

reduce revenues, or otherwise adversely impact the profitability of
an organization.

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 3- main sources of financial risk
There are three main sources of financial risk
1- Financial risks arising from an organization’s exposure to
changes in market prices, such as interest rates, exchange
rates, and commodity prices .

2- Financial risks arising from the actions of, and

transactions with, other organizations such as vendors,
customers, and counterparties in derivatives transactions.

3- Financial risks resulting from internal actions or failures of

the organization, particularly people, processes, and systems.

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 4-What Is Financial Risk Management?

- Financial risk management is a process to deal with the

uncertainties resulting from financial markets , It involves
assessing the financial risks facing an organization and
developing management strategies consistent with internal
priorities and policies.
- Financial Risk Management is the process of identifying risks,
analyzing them and making investment decisions based on either
accepting, or mitigating them. These can be quantitative or
qualitative risks, and it is the job of a Finance manger to use the
available Financial instruments to hedge a business against them.
- Addressing financial risks proactively may provide an
organization with a competitive advantage.

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There are three broad alternatives for managing risk:
1. Do nothing and actively, or passively by default,
accept all risks.
2. Hedge a portion of exposures by determining which
exposures can and should be hedged.
3. Hedge all exposures possible.

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 5- Strategies for risk management
• A risk management strategy is a key part of the risk
management lifecycle. After identifying risks and assessing
the likelihood of them happening, as well as the impact they
could have, you will need to decide how to treat them. The
approach you decide to take is your risk management
strategy. This is also sometimes referred to as risk treatment.
• There are four main risk management strategies, or risk
treatment options:
• Risk acceptance.
• Risk transference.
• Risk avoidance.
• Risk reduction.
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r •
• Risk acceptance
A risk is accepted with no action taken to mitigate it.
• This approach will not reduce the impact of a risk or even
prevent it from happening, but that’s not necessarily a bad
thing. Sometimes the cost of mitigating risks can exceed the
cost of the risk itself, in which case it makes more sense to
simply accept the risk.
• it is best to accept risks only when the risk has a low chance
of occurring or will have minimal impact if it does occur.
• Risk transference
A risk is transferred via a contract to an external party who will
assume the risk on an organization's behalf.
• Choosing to transfer a risk does not entirely eradicate it. The
risk still exists, only the responsibility for it shifts from your
organization to another.
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• Risk avoidance
A risk is eliminated by not taking any action that would
mean the risk could occur.
• If you choose this approach, you are aiming to completely
eliminate the possibility of the risk occurring.
• Treating risks by avoiding them should be reserved for risks
that would have a major impact on your organization if they
were to occur. However, if you avoid every risk you come up
against, you may miss out on positive opportunities.
• Risk reduction
A risk becomes less severe through actions taken to prevent
or minimize its impact.
• Risk reduction is a common strategy when it comes to risk
treatment. It is sometimes known as lowering risk. By choosing this
approach, you will need to work out the measures or actions you can
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 - Diversification strategy
- For many years, the riskiness of an asset was assessed based
only on the variability of its returns. In contrast, modern
portfolio theory considers not only an asset’s riskiness, but
also its contribution to the overall riskiness of the portfolio to
which it is added. Organizations may have an opportunity to
reduce risk as a result of risk diversification.
- Diversification among investment assets reduces the
magnitude of loss if one issuer fails. Diversification of
customers, suppliers, and financing sources reduces the
possibility that an organization will have its business adversely
affected by changes outside management’s control. Although
the risk of loss still exists, diversification may reduce the
opportunity for large adverse outcomes

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In portfolio management terms, the addition of individual
components to a portfolio provides opportunities for
diversification..

A diversified portfolio contains assets whose returns are

dissimilar, in other words, weakly or negatively correlated with
one another.

Diversification is an important tool in managing financial

risks.

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 - Derivatives strategy
• “Derivatives are financial contracts whose
value is derived from some underlying asset.
These assets can include equities and equity
indices, bonds, loans, interest rates, exchange
rates, commodities, residential and commercial
mortgages, and even catastrophes like
earthquakes and hurricanes”. The contracts
come in many forms, but the more common
ones include options, forwards/futures and
swaps.
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• The benefits of derivatives are threefold:
(i) risk management,
(ii) price discovery, and
(iii) enhancement of liquidity.
• The Functions of Financial Derivatives
Financial derivatives have two important functions. They are:
Hedging.
Speculation

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 6- Risk Management Process
• 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, legal, tax, commodity, and
corporate finance.
• The risk management process involves both internal and
external analysis. The first part of the process involves
identifying and prioritizing the financial risks facing an
organization and understanding their relevance.

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22
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From the previous figures, it is clear that the risk
management process includes the following stages:
1- Defining risks.
2- Measuring and analyzing risks.
3- Assess risks and develop solutions.
4- Implementing solutions to treat risks.
5- Monitoring and reviewing the risk level.

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• Measurement and reporting of risks provides decision makers
with information to execute decisions and monitor outcomes,
both before and after strategies are taken to mitigate them.
Since the risk management process is ongoing, reporting and
feedback can be used to refine the system by modifying or
improving strategies.
• An active decision-making process is an important component
of risk management. Decisions about potential loss and risk
reduction provide a forum for discussion of important issues
and the varying perspectives of stakeholders.

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 7-Factors that Impact Financial Rates and Prices
• Financial rates and prices are affected by a number of factors.
It is essential to understand the factors that impact markets
because those factors, in turn, impact the potential risk of an
organization.
A-Factors that Affect Interest Rates
• Interest rates are a key component in many market prices and
an important economic barometer. They are comprised of the
real rate plus a component for expected inflation, since
inflation reduces the purchasing power of a lender’s assets.
Interest rates are also reflective of supply and demand for
funds and credit risk.

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Factors that influence the level of market interest rates
include:
• Expected levels of inflation.
• General economic conditions.
• Monetary policy and the stance of the central bank.
• Foreign exchange market activity.
• Foreign investor demand for debt securities.
• Levels of sovereign debt outstanding.
• Financial and political stability .

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 B-Factors that Affect Foreign Exchange Rates
Foreign exchange rates are determined by supply and demand for
currencies. Supply and demand, in turn, are influenced by factors
in the economy, foreign trade, and the activities of international
investors.
Capital flows, given their size and mobility, are of great
importance in determining exchange rates.
Factors that influence the level of interest rates also influence
exchange rates among floating or market-determined currencies.
Currencies are very sensitive to changes or anticipated changes in
interest rates and to sovereign risk factors.

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Some of the key drivers that affect exchange rates include:
• Interest rate differentials net of expected inflation.
• Trading activity in other currencies.
• International capital and trade flows.
• International institutional investor sentiment.
• Financial and political stability.
• Monetary policy and the central bank.
• Domestic debt levels (e.g., debt-to-GDP ratio).
• Economic fundamentals .

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 C. Factors that Affect Commodity Prices
Physical commodity prices are influenced by supply and demand.
Unlike financial assets, the value of commodities is also affected
by attributes such as physical quality and location.
Commodity supply is a function of production. Supply may be
reduced if problems with production or delivery occur, such as
crop failures or labor disputes. In some commodities, seasonal
variations of supply and demand are usual and shortages are not
uncommon. Demand for commodities may be affected if final
consumers are able to obtain substitutes at a lower cost. There
may also be major shifts in consumer taste over the long term if
there are supply or cost issues.

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Commodity prices may be affected by a number of factors,
including:
• Expected levels of inflation, particularly for precious metals.
• Interest rates.
• Exchange rates, depending on how prices are determined.
• General economic conditions.
• Costs of production and ability to deliver to buyers.
• Availability of substitutes and shifts in taste and consumption
patterns.
• Weather, particularly for agricultural commodities and energy.
• Political stability, particularly for energy and precious metals.

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