Financial risk management involves controlling risk by identifying sources and determining the degree of exposure to them. In practice, financial risk management can help businesses adapt to changing market conditions. However, the strategies used to mitigate such risks vary from one firm to the next. Identifying risks requires understanding their sources, and they are usually determined by reviewing an organization’s annual balance sheet.
Financial risk management is a demanding career that requires an analytical and strategic mindset. It involves spotting risks and opportunities, as well as using technology to make sound decisions. People who are working in this field should have a solid understanding of how the financial system works, and they should also have excellent communication skills. A bachelor’s degree in finance, economics, statistics, physics, or a similar field is required. A graduate degree is also beneficial for those who would like to work in the field.
The financial sector has a high degree of complexity, which makes risk assessment and management difficult. Complex financial products are notoriously hard to evaluate, and the 2008 financial crisis was a textbook example of the ineffective risk management of complex financial innovations. The complexity of these products and services also provides an avenue for the industry to hide risks and pass them onto unaware financial market participants. Furthermore, financial providers are often motivated by performance incentives, which reward short-term success, but encourage them to obtain market products with intransparent risks.
Financial risk management requires an in-depth understanding of a firm’s assets, liabilities, and cash flow records. Financial risk managers can also use risk measurement tools to estimate the probability of loss. In addition to cash flow records, they also need to know a firm’s exposure to interest rate risk, foreign exchange risk, and commodity price risk. These risk measures help financial risk managers make sound decisions and improve the performance of their organizations.
Financial risk can be categorized into three types: market risk, credit risk, and operational risk. Credit risk occurs when a firm is unable to meet its financial obligations. Market risk is a threat to the value of assets. Liquidity risk, on the other hand, is a risk related to the availability of liquid cash. Liquidity risk is a risk that arises when the company can’t convert assets into liquid cash. Finally, operational risk is the result of daily business activities.
Many financial holding companies have multiple subsidiaries. For example, Wells Fargo has a commercial banking division and a finance company that makes loans to consumers. While these are similar in function, finance company loans are deemed more risky than those of commercial banks because they are based on public debt whereas commercial banks rely largely on deposits.
A key strategy for financial risk management is to diversify your assets. While financial risk can be attributed to macroeconomic factors such as interest rates, defaults, and other large organizations, it can also be attributed to individual decisions made by business owners. For instance, building a business is an expensive endeavor and companies often have to seek funding from outside sources to finance their venture. This creates financial risk for the company as well as for the investors.