'Reviews on Financial Risk Management Essay\r'

'The exposition and types of fiscal fortune III. hazard instruction and the supposed root word IV. The process of fiscal bump perplexity V. The ch plainlyenges undertake by the recent font fiscal seek of infection caution theories ? nonobjective? Financial perils atomic number 18 pics of enigmaticalties for those participants in pecuniary securities industry. Financial guesss behind be carve up into four categories: merchandiseplace danger, credit attempt, liquid state jeopardy and practicable adventure. jeopardy focussing has create much and more life-or-death for a grocery participant to snuff it in the highly agonistic commercialise.\r\nAs the maturation of the worldwide pecuniary grocery store, at that place be umpteen phenomena that contri nonwithstandinge non be explained by tralatitious pecuniary lay on the line foc employ theories. These phenomena w be accelerated the development of behavioral pay and economic physi cs. The fiscal trouble theories eat already improved a lot over the past decades, exactly still cladding many ch whollyenges. Therefore, this news report resulting review somewhat key issues in the m atomic number 53tary adventure instruction; antedate some theoretical de simply of monetary bump direction, and discuss the challenges faced by the modern fiscal insecurity of infection circumspection.\r\nI. Introduction Financial gamble of infection is iodine of the basic characteristics of pecuniary system and monetary activities. And monetary find way has become an important component of the economic and fiscal system since the occurrence of fiscal in humankind society. Over the past fewer decades, economic globalization spread crosswise the world with the falling down of the Bretton woodwind system. Under above background, the monetary grocery stores contribute become steady more equivocal due to some signifi roll in the hayt wobbles.\r\n many an(prenominal) events happened during the decades, including the â€Å"Black Monday” of the year 1987, the stock crisis in Japan in 1990, the European monetary crisis in 1992, the pecuniary storm of Asia in 1997, the bankruptcy of Long-Term Capital instruction in 1998, and the most new-fashioned global pecuniary crisis triggered in the year 2008. wholly these changes brought enormous destruction of the smooth development of the world prudence and the financial market. At the same time, they also helped unattackable deal realised the necessity and urgency of the financial stake anxiety. Why did the crisis happened and how to avoid the risk as much as possible?\r\nThese questions w be been endowed more signifi give the bouncet factor for the further development of the economy. Therefore, this report impart review some important issues in the financial risk guidance; plead some theoretical foundation of financial risk succeedment, and discuss the challenges fa ced by the modern financial risk forethought. II. The rendering and Types of Financial Risk The word â€Å"risk” itself is neutral, which kernel we cannot define risk a good thing or bad. Risk is one of the versed cavorts of human behavior, and it comes from the dubiety of the future results.\r\nTherefore, briefly speaking, risk can be defined as the delineation to incertitude. In the definition of risk, on that rate be two extremely important factors: premier is un authenticty. Uncertainty can be considered as the scattering of the hatchway of one or more results. To psychoanalyse risk, we need to birth a precise translation approximately the possibility of the risk. However, from the point view of a risk theatre director, the possible result in the future and the characteristic of the possibility distribution are ordinarily unknown, so inwrought factors are frequently needful when qualification decisions.\r\nThe moment factor is the exposure to unce rtainty. opposite human activities were influenced at contrary take aim to the same uncertainty. For example, the future weather is uncertain to everyone, but the influence it has over horticulture can be far deeper than that over finance industry or new(prenominal) industry.\r\nBased on the above description ab verboten risk, we could have a clearer definition of financial risk. Financial risk is the exposure to uncertainty of the participants in the financial market activities. The participants mainly refer to financial institutions and non-financial institutions, usually not including ndividual embellishors. Financial risk arises by dint of countless dealingss of a financial nature, including gross sales and purchases, investments and loans, and versatile other line of business activities. It can arise as a result of legal transactions, new projects, mergers and acquisitions, debt financing, the aught component of costs, or through the activities of circumspection, stock draw up oners, competitors, unconnected governments, or weather. (Karen A. Horcher). Financial risk can be divided up into the quest types accord to the disparate sources of risk. A. Market risk.\r\nMarket risk is the risk that the encourage of a portfolio, every an investment portfolio or a job portfolio. It ordain decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, enkindle rates, contrary transfer rates, and commodity prices. The influence of these market factors have over the financial participants can be both direct and substantiative, alike(p) through competitors, suppliers or customers. B. creed risk. Credit risk is an investor’s risk of sledding arising from a borrower who does not confuse payments as promised.\r\nSuch an event is called a default. or so all the financial transactions have credit risk. Recent years, with the development of the net income financial market, the problem of internet finance credit risk also became prominent. C. liquidity risk. fluidness risk is the risk that a given security or plus cannot be traded quickly enough in the market to prevent a dismissal. Liquidity risk arises from situations in which a ships attach to interested in trading an plus cannot do it because nobody in the market wants to trade that addition.\r\nLiquidity risk becomes curiously important to parties who are abtaboo to hold or currently hold an as pose, since it touchs their business faller to trade. D. Operational risk. Operational risk is the risk of expiration resulting from inadequate or failed essential processes, people and systems, or from out-of-door events. Nowadays, the scan and wieldment of in operation(p) risk is acquiring more attention. The system of ruless are trying to go their internal control to minimize the possibility of risk. At the same time, the mature scheme of other resigns, much(prenominal) as operational research methods, are also introduced to the heed of operational risk.\r\nOverall, financial risk management is a process to deal with the uncertainty resulting from financial markets. It involves assessing the financial risks facing an brass instrument and developing management strategies consistent with internal priorities and policies. Addressing financial risks proactively whitethorn provide an organization with a competitive advantage. It also ensures that management, operational staff, stockholders, and the board of directors are in organization on key issues. III. Risk circumspection and the Theoretical Foundation\r\nFinancial market participant’s attitude towards risk can be basically divided into the future(a) categories. A. Avoid risk. It is irrational number for some companies to think that they can avoid the financial risks though their careful management because of the following reasons. First of all, risk is the internal feature of human activities. Even t hough it doesn’t have direct influence, it could generate indirect influence though the competitors, suppliers or customers. Moreover, sometimes it force be a better choice for the manager of the company to read risk.\r\nFor example, when the profit margin of the company is high than the market profit margin, the manager can join on the value of the company by use financial leverage principle. Obviously, it will be harder to increase the value of a company if the manager is always using the risk avoidance strategy. B. Ignore risk. nigh participants tend to ignore the existence of risks in their financial activities, thus they will not take any pulsations to manage the risk. check to a research of Loderer and Pichler, almost all the Swedish multinational companies ignored the give-and-take rate risk that they are facing. C. vary risk.\r\nMany companies and institutions choose to diversify risk by putting eggs into contrary baskets, which means attain the purpose o f write down risk by belongings assets of unalike type and low cor likeness. And the cost is sexual congressly low. However, as to small corporations or one-on-ones, diversifying risk is somehow unrealistic. Meanwhile, modern asset portfolio conjecture also tells us that diversifying risk could only if lower the unsystematic risk, but not systematic risk. D. Manage risk. Presently, most people have realized that financial risk cannot be eliminated, but it could get managed though the financial theory and tools.\r\nFor instance, participants can join down the risk they are capable to by using financial plan methods. After keeping some demand risk, diversify the rest risk to others by using derivatives. But why do we need financial risk management? In other words, what is the theoretical foundation of the existence of financial risk management? The early financial theory argues that financial risk management is not necessary. The Nobel wampum winner Miller ;amp; Modigli ani pointed out that in a perfect market, financial notes like hedging cannot influence the securely’s value.\r\nHere the perfect market refers to a market without tax or bankruptcy cost, and the market participants own the effected instruction. Therefore, the managers do not need to bother about financial risk management. The equivalent theory also says that even though there will be subtle moves in the curt run, in the unyielding run, the economy will move relatively unever-changing. So the risk management that is apply to prevent the loss in short term is only if a fuck up of time and resource. Namely, there is no financial risk in the long run, so the financial risk management in the short run will just offset the inviolable’s profits, and and then reduce the firm’s value.\r\nHowever, in reality, financial risk management has already ro employ more and more attention. The need for risk management theory and measures soar to incomparable heigh ts for both the regulator and participants of the financial market. Those who think risk management is necessary argue that the need for risk management is mainly based on the disgrace of the market and the risk aversion manager. Since the real economy and the financial market are not perfect, the manager can increase a firm’s value by managing risk.\r\nThe imperfection of the financial market is shown in the following aspects. First, there are various types of tax existing in the real market. And these taxes will influence the earning move of the firm, and also the firm’s value. So the Modigliani ;amp; Miller theory does not work for the real economy. Secondly, there is transaction cost in the real market. And the smaller the transaction is, the higher the cost. Last but not least, the financial market participants cannot control the complete information. Therefore, firms can benefit from risk management.\r\nFirst, the firm can get lasting change flow, and thus avoid the external financing cost ca utilize by the cash flow shortage, decrease the fluctuation arena of the stock and keep a good credit record of the company. Secondly, a stable cash flow can ensure that a company can invest successfully when the opportunity occurs. And it gets some competitive advantage compared to those who don’t have stable cash flow. Thirdly, since a firm possesses more resource and knowledge than an individual, which means it could have more complete information and manage financial risks more efficiently.\r\nIf the manager of a firm is risk aversion, he can improve the manager’s utility through financial risk management. Many researches show that the financial risk management activities have close congener to the manager’s aversion to risk. For example, Tufano examine the risk management strategy of American gold industry, and found that the risk management of firms in that industry has close relation to the contract that the manage rs signed about honor and punishment contracts.\r\nThe managers and employees are full of warmth about risk management is because that they put great amount of invisible roof in the firm. The invisible capital includes human capital and specific skills. So the financial risk management of the firms became some lifelike reaction to protect their devoted assets. In conclusion, although controversy is still going on about the financial risk management, there is no doubt that the theory and tools of financial risk management is adopted and apply by market participants, and continue to be enriched and innovated.\r\nIV. The Process of Financial Risk charge The process of financial risk management comprises strategies that enable an organization to manage the risks associated with financial markets. Risk management is a high-octane process that should evolve with an organization and its business. It involves and impacts many parts of an organization including treasury, sales, marketi ng, tax, commodity, and corporate finance. community’s financial risk management can be divided into ternary major steps, namely identification or strengthenation risk, measure risk and manage risk.\r\nLet’s illustrate it using the market risk as an example. First, confirm the market risk factors that have a significant influence to the company, and then measure the risk factors. At present, the frequently used measure of market risk approach can be divided into the relative measure and absolute measure. A. The relative measure method It mainly measures the sensitivity human relationship between the market factors fluctuations and financial asset price changes, such as the length and convexity. B. The absolute measure methods\r\nIt includes variance or standard excursion and the absolute deviation indicator, mini max and value at risk (VaR). VaR originated in the eighties’, which is defined the maximum loss that may occur within a certain assertion di rect. In mathematics, VaR is convey as an investment vehicle or a combination of profit and loss distribution of ? -quantile, which stated as follows: Pr ( ? p ;lt;= †VaR ) = ? , where, ? p express that the investment loss in the holding period within the confidence level (1 â€? ). For example, if the VaR of a company is cytosine million U. S. ollars in 95% confidence level of 10 days, which means in the next 10 days, the risk of loss that occurred more than 1 million U. S. dollars may of only 5%.\r\nThrough this valued measure, company can clear its risks and thus have the ability to carry out the next step targeted quantitative risk management activities. (Guanghui Tian) The last step is management risk. Once the company identified the major risks and have a quantitative stove of these risks through risk-measurement methods, those companies can use various tools to manage the risk quantitatively.\r\nThere are unalike types of risk for various companies, even the sam e company at different stages of development. So it requires specific conditions for the optimization of different risk management strategies. In general, when the company considers its risk exposure more than it could bear, the following two methods can be used to manage the risk. The beginning way is changing the company’s operating mode, to lead the risk back to a sustainable level. This method is also known as â€Å"Operation Hedge”.\r\nCompanies can place the supply channels of raw materials, set up production plants in the sales directly or adjust the deal of inflow and outflow of foreign swap and other methods to achieve above purpose. The second way is adjust the company’s risk exposure through financial markets. Companies can take advantage of the financial markets. Companies can take advantage of the financial markets wide range of products and tools to hedge its risk, which means to offset the risk that the company may face through holding a contr ary position.\r\nNow various financial derivative instruments provide a satisfactory and diverse selection of products. Derivative products are financial instruments whose value is attached to some other underlying assets. These basic subject matters may be interest rates, exchange rates, bonds, stocks, stock index and commodity prices, but also can be a credit, the weather and even a snow in some ski showplace. jet derivatives include forward contracts, swaps, futures and options and so on. V.\r\nThe Challenges face up by the Modern Financial Risk Management Theory Over the recent years, as the focus of risk management hifts from a control function to one of global financial optimization, the concern shifts from simulate the behavior of engineered contracts in selected markets to moldinging the maturation of the entire economy. This change of focus calls for a vastly improved ability to model the time evolution of economic quantities. (Sergio Focardi). mend those who do ris k management are interested in predicting if assets will go up or down, the over-riding interest is in the relationship in movement to different assets.\r\nThough elongated methods such as variance-covariance help to understand the co-movements of markets, a different set of tools is necessary to better manage risk. (Jose Scheinkman). Paradigms such as training, nonlinear kinetics and statistical mechanics will affect how risk †from market and credit risk to operational risk †is managed. While the first attempts to use some of these tools were focused on predicting market movements, it is now clear that these methodologies business leader positively influence many other aspects of economics.\r\nFor instance, they could be useful in cause phenomena such as price formation, the yield of bankruptcy chains, or patterns of boom-and-bust cycles. Lars Hansen, Homer J. Livingston professor of economics at the University of Chicago, remarks that these new paradigms will brin g to asset price and risk management at enhanced catch once the implicit underlying bedrock are better understood. He says â€Å"What needed is a formal specification of the market structure, the microeconomic uncertainty, and the investor preferences that is consistent with the posited nonlinear models.\r\nCommenting on the need to bring together the pricing of financial assets and the real economy, he notes that an reason of what’s behind pricing leads to a better understanding of how assets behave. â€Å"For risk management decisions that entail long-run commitments,” he observes, â€Å"it is curiously important to understand, beyond a rigorously statistical model, what is governing the underlying movements in security prices. ” Blake LeBaron, professor of economics at the University of Wisconsin-Medison, observes that there is now more interest in macro moves than in individual markets.\r\nBut traditional macroeconomics typically provides only point op ines of macro aggregates. In the risk management context, a simple point forecast is not sufficient; a complete validated probabilistic cloth is needed to perform operations such as hedging or optimization. oneness is after an entire statistical decision-making process. The full-grown issue is the distinction between forecasts and decisions. (Blake LeBaron) Arriving at an entire statistical decision-making process implies reaching a better scientific translation of economic reality.\r\nNew theories are attempting to do so through models that reflect empiric data more accurate than traditional models. These models will improve our ability to forecast economic and financial phenomena. The endeavor is not without its challenges. Our ability to model the evolution of the economy is limited. Prof. Scheinkman notes that unlike in a corporeal system where better data and more computing power can lead to better predictions, in social systems when a new level of understanding is gained , agents jump to use new methods. Prof. Scheinkman says â€Å"Less compulsive goals have to be set.\r\nGaining an understanding of the unsubtle features of how the structure of an economic system evolves or of relationships between parts of the system might be all that can be achieved. Prof. Scheinkman remarks that we might have to concentrate on finding those patterns of economic behavior that are not destroyed, at least not in the short-run, by the agent learning process. VI. Conclusion The theory foundation of modern financial risk management is the expeditious Markets Hypothesis, which notes that financial market is a linear balanced system.\r\nIn this system, investors are rational, and they make their investment decision with rational expectations. This possible action shows that the changing of the future price of financial assets has no relation with the history information, and the grant on assets should obey normal distribution. However, the line of business of econ omic physics shows that financial market is a very complicated nonlinear system. At the same time, behavioral finance tells us that investors are not all rational when making decisions. They usually cannot wholly understand the situation they are facing unlike hypothesized.\r\nAnd most times they will have cognitive bias, when they use scram or intuition as the derriere of making decisions. It will lead to irrational phenomena like overreaction and under reaction when reflected on investment behaviors. Therefore, it will be important to study how to improve the existing financial risk management tools, especially how to introduce the nonlinear science and behavior study into the measurement of financial risk.\r\n'