Risks are common to any thing we do regardless of the factors involved in what we do. In this note, we are trying to understand risks involved in the financial field and the ways of effectively managing them.
In financial risk management, the main objective is to minimize the exposure to the risk rather than mitigating if exposed to. When it comes to risks, financial risk management is particular about credit risks and markets risks. What do we mean by credit risk? Credit risk is the risk which occurs when a debtor does not payback payments of a loan or any other line of credit such as credit card payments and this include both the principle and the interest. A market risk is defined as the risk that the value of a certain investment would reduce due to the market movements and other factors. There are four main factors that influence market risk; they are equity risk, interest rate risk, currency risk and commodity risk.
Other than credit and markets risks there are a few other risks considered under financial risks: foreign exchange, shape, volatility, sector, liquidity and inflation risks. Yes, there is a number of other risks involved in financial risk management but above are considered the prominent and they carry more likelihood of occurring. When it comes to banking sector, Basel Accords are adopted internationally for tracking, reporting and exposing operational, credit and market risks. Basel Accords are a set of supervisory rules the bank can adopt for streamlining their risk management process.
When should the financial institutions use risk management? When it comes to the financial institutions, there are two main categories in terms of investment and the management point of view: shareholders and financial institution managers. Usually de facto is that, the financial institution managers should not manage risks that investors (shareholders) can manage for themselves at the same cost. So, risk management comes in to play at the places where the shareholders cannot manage risks at the same cost. The generally accepted concept is that market risks that result in unique risks for the financial institution are the best candidates for risk management.