What is Financial Risk Management?

Malcolm Tatum

Financial risk management is a strategy that is aimed at generating value within a firm while also utilizing various types of financial instruments to keep the level of risk in balance with the projected return on investments. This type of risk management is similar to other forms of managing risk, in that the goal of protecting the interests of the firm is central to the specific strategies used to achieve the goal. As part of the corporate governance process, financial risk management often involves elements that both qualify financial transactions in terms of potential return versus risk, while also recognizing the necessity to manage the number of quantity of those transactions.

Man climbing a rope
Man climbing a rope

In many instances, financial risk management requires that financial officers and planners understand how to make use of different investment strategies to achieve the most lucrative end for the company. This means understanding market risk in general, based on what is happening in the market at the present time. It also involves knowing how to evaluate trends within that marketplace, and manage investments so that the return is enhanced while the risk or volatility is minimized. It is not unusual for the strategy of hedging to be employed by financial risk managers, along with any other investment approach that is relevant to current and projected market conditions.

Along with structuring investments so that potential return is high and risk is low, financial risk management also requires that managers monitor market activity on a continual basis. This aids in identifying emerging trends in the early stages, and determining if those trends are likely to affect currently held investments in any way. How the manager responds to those trends will vary. In some cases, the manager may feel an emerging trend will have no effect, or perhaps result in a short-term decrease on the value of one or more holdings, only to reverse and drive the value of those holdings above current levels. A manager may also determine that it is in the best interests of the company to sell certain holdings now, especially if there is indication of a long-term decrease in the value of those holdings.

With financial risk management, understanding the liquidity risk associated with investments, as well as properly assessing the risk adjusted return on capital that applies to those holdings, is key to success. For this reason, risk managers are often well versed in how markets function and how to interpret various events and their effects on markets in general. By properly interpreting market risk and accurately projecting market movements, a competent risk manager can save an employer or a client a great deal of time, money, and frustration.

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