Financial risk management involves the use of financial instruments to examine as well as manage a firm’s exposure to market and credit risks. Financial risk management is a very important practice with economic value for any firm. Financial risk management includes management of other factors such as a firm’s shape, volatility, liquidity, foreign exchange, inflation and sector risks. It requires specific expertise to identify the sources of risks, measuring the risks as well as setting up plans on how to manage them. There are two distinct types of financial risk management. These are quantitative management and qualitative management. The two types focus on how and when the managers should utilize financial instruments to manage and mitigate costs arising from the risks. Financial instruments are any tradable assets whether cash, contractual right and ownership interests. They are important in risk management.
With newer trends in the market after the global financial crisis, managers are finding it harder to manage risks. This is because the prices of stocks in the market are high with little knowledge on future expectations of prices as well as returns. This makes it more difficult for investors to set their objectives and achieve them in the set period. Investors are no longer sure which investments to fund because financial risk management has become harder. This is an opportunity for financial risk managers to come up with new methods of risk assessment to accommodate market changes. The market requires innovation more than ever due to uncertainties both in local and international trade. There are new products and services for clients. This calls for smarter and better strategies to mitigate market as well s credit risks. These will increase the investment outcomes and at the same time cut the investors’ exposure to costs arising from risks.
According to Merril Lynch from the Bank of America, for example, investments in equity as well as money markets have become unpredictable since the financial crisis of 2008. This is because there is a higher correlation between stock and investing dominated by the macro-economic forces. It has become harder for stock advisers to predict the markets. In the recent year, the equity market has seen investment funds perform poorly with less than a third making the expected returns. There are many concerns why there are lower returns on equity. Some of them include the funding status for investments. Investors fear that markets might collapse with uncertainties. Governments are more involved in market control, making it difficult to venture into new markets. There are also more risks as well as return drawbacks. This makes it difficult for investments to have more returns. Overhead as well as running costs for all industries are higher due to such factors as environmental sustainability requirements for industries. Investors also demand more transparency especially in the banking industry to prevent the repeat of the global financial crisis. Thus, new financial risk managers have new areas of focus to enable effective investment advice. They must focus on allocation of assets in different sectors of the economy to ensure the balance. Flooding in one area of investment will lead to fewer returns. The risk managers must also reassess risk management tools. This will lead to deployment of strategies which are income-oriented (Hampton, 2011).
According to financial economics, every firm should engage in investments that increase the financial value of its stakeholders. This theory also suggests that managers in different firms cannot create or increase its stakeholders’ or investors’ value if the stakeholders can increase their value at similar or even fewer costs. This suggests that an investor does not get into a venture with high costs and low returns if he has other options with less cost. This theory is applicable in financial risk management. It implies that managers in different firms cannot use the investor’s funds to hedge risks that the investors can hedge without the firm’s help. This means that one cannot invest in a firm which faces certain risks when the same risks are available without the firm’s help. One would get more returns without the firm’s help. This is the scenario in perfect markets. Financial markets are perfect markets whereby the theory of hedging irrelevance proposition applies. This states that a firm does not create value by hedging risks when the cost of bearing that risk outside the firm is less or equal to the cost inside the firm. Thus, financial risk managers have to come up with tools to manage risks and reduce those that are not available outside the company. This will encourage investment.
Financial risk management presents great opportunities for managers since investors cannot venture into a risky enterprise when there is a firm which can assist in the risk mitigation. Therefore, the firms’ managers must identify the risk which would be cheaper to manage more effectively than the investor’s ability outside the firm. The best risks for a firm to manage are market risks because they are unique and identifiable. The international market is changing dramatically which requires effective financial risk management. Multinational corporations such as commercial banks as well as local industries are finding it more difficult to manage risks effectively (Jorda?o, 2010). Such corporations as Toyota Company have reported losses for the better part of the last half of the decade after the financial crisis of 2008. For such firms to recover, they should use financial risk management tools to cut costs. They should identify their exposure to risks arising from foreign exchange, competition, transactions, accounting, economics as well as uncertainty in future trends.
Effective financial risk management involves three distinct steps. These are risk identification, risk assessment and risk prioritization. After taking these steps, the firm can coordinate strategies as well as economically apply resources to monitor, control and minimize the impact or probability of future uncertainties. This will enhance the maximization of opportunities in the future. Uncertainties in the financial markets are the main sources of risks. Other sources include the legal abilities, accidents, credit risks, and natural disasters, threats from failures of the project, deliberate attacks or other unpredictable causes. These risks threaten the firm’s financial position with a possibility to increase costs. Different firms have developed risk management standards with universal standards from international organizations. These organizations are the ISO standards, National Institute of Standards and Technology, Project Management Institute and the Global Actuarial Societies. Risk management tools involve different methods according to the contexts which include the industrial processes, security engineering, project management, public safety and health as well as actuarial assessments. This presents different strategies that managers can apply to manage financial risks according to their types (Sun, 2013).
There are methods that every firm should follow in financial risk management. The first one involves the identification and characterization of threats. This gives the actual risks surrounding the firm’s operation. The second method involves assessing the vulnerability of the company as far as the risk is concerned. This involves the consequences of specific threats to critical assets in the firm. The third method is to determine which risks are more likely to occur than the others. The firm should value different risks according to the consequences they will have on different assets as well as the likelihood of occurrence. The companies should then come up with the most effective ways to reduce these risks. Finally, the firm’s managers should prioritize on the measures to reduce certain risks. They should deploy the most effective strategies to ensure that they reduce the risks significantly. This will reduce the firm’s probability of exposure thus reduce operation uncertainties and at the same time costs arising from risk occurrence.
Recently, financial management experts have come up with new portfolios to calculate risks and manage their reduction. These portfolios give a firm more control over a combination of risks. This implies that a company is able to determine what impacts a combination of various risks will have on its financial position as well as maintain its risk levels. The two portfolios are the alpha and beta portfolios. The managers can maintain the risk levels that they desire by regulating their average aggregate portfolio levels. The alpha portfolio bases its calculation on idiosyncratic risks. On the other hand, the beta portfolio is based on the overall market returns. This implies that the firm’s exposure to the risks in the market is equal to the systematic risk of the firm. The difference between the alpha and the beta portfolio is that alpha does not depend on market returns. Systematic risk refers to risks which arise from investing in financial securities in the market. This is the risk that an investor has, and it is dependent on the correlation with the overall market. Its representation is the beta portfolio (Sweeting, 2011). On the other hand, idiosyncratic risk refers to risk arising from investing in a single investment class. This level of risk depends on the specific characteristics of the investment represented by the alpha portfolio. There can be different idiosyncratic risks in the market which the alpha portfolio represents collectively.
In financial risk management, experts construct the beta exposure from several equities. This is not a fixed value in an investor’s security over the investment period. Rather, it represents the systematic risks that the managers cannot hold at any steady value. Every investor maintains his beta exposure according to its risk tolerance. The investor’s returns, therefore, are consistent depending on the portfolio. Financial managers always use the S&P 500 index to represent the market and assist in choosing the appropriate level of beta exposure for investors. However, this is not the only index available. There are other indexes which represent the whole market that an investor can choose from with financial expert’s advice. The advantage of the S&P 500 index is that it allows a wider variety of options for investors than other indexes. The choice of beta exposure is dependent on many factors in the financial markets, especially for the S&P 500 index. Higher beta exposure levels are efficient for market indexes with a certain benchmark. On the other hand, lower beta exposure levels are efficient for an investor whose objective is to achieve an absolute return. An investor determines beta exposure using three different ways. These are through purchase of index fund, futures contract or a combination of both the futures contract and index fund. Such an exposure is important in investment decisions in stock markets such as the New York Stock Exchange (NYSE). Index funds involve large sums of money and at the same time have bigger time horizons. Futures contracts have less time horizons of purchase but higher turnover rates which may lead to more transaction costs (Jorda?o, 2010).
Alpha content, on the other hand, deals with investments whose returns are independent from other beta returns. Pure alpha depends on factors like sale of liquidity premiums, statistical arbitrage and equity neutral strategies among others. Some financial risk managers use different portfolios to purchase equities in stock markets. This is not a pure alpha exposure but shows expertise in selection of equity. One can combine alpha with beta exposure such as in buying equities for better investment returns. In combining of the two portfolios, it is possible to come up with effective risk management decisions. One might say that pure alpha portfolios present better investments due to the fact that they only expose the investor to returns with no market correlation. However, the beta exposure has long-term benefits as seen in different stock and financial markets such as the NYSE. For maximum returns, one must decide on the most appropriate beta exposure levels that would present most advantages with the advice of an investment consultant. Then, he should invest the excess capital in a different alpha portfolio. This will give an appropriate alpha-beta framework for investors with minimum risks.
There are both qualitative and quantitative methods to assess risks, such as use of the alpha and beta portfolios. With increasing risk assessment methods, different financial risk management experts have identified principles to guide them. This is to ensure that with increasing need for investment in the dynamic market, one is able to make informed investment decisions. Financial risk management should create value through risk mitigation. Organizational processes also require financial risk managers as an integral part. Such organizations as Coca Cola, who deal with an international market, have financial risk managers in different regions of operation to determine the most effective risk mitigation tools. Recovering companies such as banks in the country under receivership also require financial risk managers to perform well in money, stock as well as open markets (Wu, 2011).According to the report by the Federal Reserve Bank in 2012, the decline in relative returns is a result of several factors. The correlation between macro-dominated investments and the stocks in the country has become unpredictable. This means that experts in financial and stock markets find it hard to show their skills. The global financial crisis has affected the markets in such a way that it is difficult for funds to have returns. Investors have also changed their needs, which raise concerns for the risk managers. Asset allocation is also making it difficult for alpha-beta portfolio balance. Experts need to become more innovative for qualitative and quantitative analysis before giving investment advice.
Financial risk managers are part of decision makers in each organization to reassess the risks in the constantly changing environment. The managers ensure that each company releases the relevant information for risk assessment and valuation to enable selection of the best portfolios. The information is available in stock and securities exchange databases such as the NYSE to ensure that investors make the right decisions. The companies must be transparent in their periodical records to guarantee that any decision to invest is not outdated. This is important in addressing market assumptions and uncertainties to ensure that one is able to deploy effective strategies for investment. This way, investors will recover from the global financial crisis to become successful in their operations (Wu, 2011).
In conclusion, financial markets around the world have changed since the financial crisis of 2008. Managers are struggling to mitigate market and credit risks. Investors are also seeking for new opportunities with more returns than the existing ones. This has led to innovation and creativity in asset and risk management as well as resource allocation. In investment, enterprises across the world are struggling to come up with investments with less cost, more returns and positive after-fee outcomes. The companies are now applying smart-beta portfolios which allow them to rotate among risks to come up with the most appropriate beta strategies. However, this does not imply that there are no risks as far as alpha-beta portfolios are concerned. Rather, it is an opportunity for financial risk managers to deploy better risk management strategies which will diversify alpha-beta portfolios. This will potentially deliver more returns in local as well as global markets.