Financial risk management is the practice of protecting economic value in a firm by managing exposure to financial risk - principally operational risk, credit risk and market risk, with more specific variants as listed aside. As for risk management more generally, financial risk management requires identifying its sources, measuring it, and the plans to address them.[1]See Finance Risk management for an overview.
Financial risk management can be qualitative and quantitative. 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.[4]
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There is therefore a fundamental debate[11] relating to "Risk Management" and shareholder value. The discussion essentially weighs the value of risk management in a market versus the cost of bankruptcy in that market: per the Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the probability of financial distress.
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 in the so-called "hedging irrelevance proposition":[12]"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, however, financial markets are not likely to be perfect markets.[13][14][15][16]This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management, wherein they have to determine which risks are cheaper for the firm to manage than the shareholders. Here, market risks that result in unique risks for the firm are commonly the best candidates for financial risk management.[17]
As outlined, businesses are exposed, in the main, to market, credit and operational risk.A broad distinction [9] exists though, between financial institutions and non-financial firms - and correspondingly, the application of risk management will differ. Respectively:[9]For Banks and Fund Managers, "credit and market risks are taken intentionally with the objective of earning returns, while operational risks are a byproduct to be controlled". For non-financial firms, the priorities are reversed, as "the focus is on the risks associated with the business" - ie the production and marketing of the services and products in which expertise is held - and their impact on revenue, costs and cash flow, "while market and credit risks are usually of secondary importance as they are a byproduct of the main business agenda". (See related discussion re valuing financial services firms as compared to other firms.)In all cases, as above, risk capital is the last "line of defence".
The major focus here is on credit and market risk, and especially through regulatory capital, includes operational risk.Credit risk is inherent in the business of banking, but additionally, these institutions are exposed to counterparty credit risk. Both are to some extent offset by margining and collateral; and the management is of the net-position.Large banks are also exposed to Macroeconomic systematic risk - risks related to the aggregate economy the bank is operating in[20](see Too big to fail). 2ff7e9595c
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