Financial Risk Management Components
Financial risk management usually covers the following subcategories:
• Market Risk. This refers to the risk that changes in the price of stocks or rates of interest led to a reduction in the value of an investment portfolio or security. There are four types of market risk:
Foreign exchange risk. The main sources of foreign exchange risk are came from currency movements and fluctuations in international interest rates. This is one of the biggest risks for multinationals, because it can generate huge operating losses.
Interest rate risk. That is the risk that the value of a fixed income security will decrease due to a change in market interest rates.
Commodity risks. Opposed to interest rate risk and currency risk, risks may arise from variations in supply and demand, such as coffee, which can increase volatility. The markets stage dramatic price developments, both upstream and downstream, which distinguishes also risks of other types of financial risks management.
Equity risk. This has two components: the risk of general market, which refers to the sensitivity of a financial instrument to all movements in stock indexes and specific risks that relate to the institution itself, its sector, management capability and so forth.
• Liquidity Risk. In that respect there are two parts to this. The first is the ability of a financial organization to raise the cash it needs to meet, among other things, the security requirements of its counterparts and its debt. The 2nd is the risk that an institution can’t execute a transaction at market prices because there is no appetite to temporarily treat. If it proves impossible to cancel the transaction and the institution may lose large amounts of money. It is not surprising that central banks pumping liquidity into the markets during the cut in 2000, when the risks associated with the loss of computers because of the millennium bug were significant threat.
• Credit Risk. That’s the risk that the counterparty default and the bank lose all of its market position or party which is unrecoverable. Credit risk management is complex and institutions rely on rating agencies such Standard & Poor’s and Moody, to provide the basis of the level of risk to which they are exposed and, consequently, the amount of interest they fee. Agencies such as Moody’s research will analyze the credit company before issuing their opinion with one. This includes an assessment analyze the structure of the company, its operations and economic condition, quality of management, and trends (market and industry) that affect May and all of the macroeconomic environment in which the company operates.
Once business transactions take place across international borders they involve additional risks beyond those that are managed in a national setting. This is known as country risk and it arises because of various business and economic policies that exist in the world. Even if some form of country risk has always been present between trading partners, globalization has highlighted the imbalances. This means that, for organizations that are transnational, risk management-country capacity is increasingly important. There are six main categories of country risk:
• Economic Risk. That’s the risk that the return on an investment held / introduced in a country is affected by changes in a country of economic structure and growth. These risks resulting from changes in fiscal and monetary policy, recessions, and the availability of resources.
• Transfer of risks. This stems from restrictions on capital movements imposed by foreign governments. These restrictions may occur during periods of economic or trading conditions, as during the Asian crisis of the late 1990s, when some Asian governments imposed fixed rates of exchange to minimize the impact of decrease the value of currencies.
• Currency Risk. This equals the risk that a sudden change in the value of a currency of the country. These changes are usually associated with the economic turmoil, war or attacks by speculative investors (as we saw when the United Kingdom and subsequently joined the left European Exchange Rate Mechanism in 1992). The risk may also occur when a country moves from a fixed to a floating rate of exchange.
• Location or Neighborhood Risk. This, essentially, that the problems of one country from spreading to another. This can occur in times of war (as during the first Gulf War and more recently in the Balkans) and regional economic difficulties (as we have seen in Latin America in the 1980s and Asia in 1990).
• Sovereign Risk. These are the risks associated with the failure of government to meet its loan obligations, as with the Russian default in 1998.
• Political Risk. Regarding political stability of the country which may change during regional wars, military coups and civil war (eg Zimbabwe).
How country risk is handled depends largely on the nature of the relationship the organization has with countries with which we trade. For example, if it’s located a factory in another country, the long-term risk and will require the organization to evaluate all aspects of risk in the country before the investment is made and for a long time after . Particularly, political risks must be carefully controlled in parts of the world who have a history of instability. The country risk also varies with the type and nature of the loans. Long-term loans to governments generally low economic risk, but rates of exchange, sovereign and political risks, while a short-term loan to a private entity is generally low risk - with the exception of transfer of risk.
The increasing sophistication and complexity of financial instruments led to higher risks. Particularly, the rapid expansion of the derivatives market is a source of concern. Derivative contracts involve a wide range of securities that typically involve a future payment which is directly linked to stock prices, currency values or rates of interest. The market for this type of financial product has dramatically increased the volatility in financial markets has increased.