Risk can be explained as an uncertainty and is usually associated with the unpredictability of an investment performance. All investments are subject to risk, but some have a greater degree of risk than others. Risk is often viewed as the potential for an investment to decrease in value. Though quantitative analysis plays a significant role, experience, market knowledge and judgment play a key role in proper risk management. As complexity of financial products increase, so do the sophistication of the risk manager's tools. We understand risk as a potential future loss. When we take an insurance cover, what we are hedging is the uncertainty associated with the future events. Financial risk can be easily stated as the potential for future cash flows (returns) to deviate from expected cash flows (returns).There are various factors that give raise to this risk. Return is measured as Wealth at T+1- Wealth at T divided by Wealth at T. Mathematically it can be denoted as (WT+1-WT)/WT. Every aspect of management impacting profitability and therefore cash flow or return, is a source of risk. Financial risk management Risk management is the process of measuring risk and then developing and implementing strategies to manage that risk. Financial risk management focuses on risks that can be managed ("hedged") using traded financial instruments (typically changes in commodity prices, interest rates, foreign exchange rates and stock prices). Financial risk management will also play an important role in cash management. This area is related to corporate finance in two ways. Firstly, firm exposure to business risk is a direct result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of creating, or enhancing, firm value. All large corporations have risk management teams, and small firms practice informal, if not formal, risk management.
[...] It is important for treasury personnel to know what benchmarks they are aiming for and it's important for senior management or the board to be confident that the risk of the business are being managed consistently and in accordance with overall corporate strategy Scenario Planning Making Rational Decisions The recognition of the financial risks associated with foreign exchange mean some decision needs to be made. The key to any good management is a rational approach to decision making. The most desirable method of management is the pre-planning of responses to movements in what are generally volatile markets so that emotions are dispensed with and previous careful planning is relied upon. [...]
[...] Examples are illustrations of bullish and bearish put spreads respectively Covering Exchange Risk with Options A currency option enables an enterprise to secure a desired exchange rate while retaining the possibility of benefiting from a favorable evolution of exchange rate. Effective exchange rate guaranteed through the use of options is a certain minimum rate for exporters and a certain maximum rate for importers. Exchange rates can be more profitable in case of their favorable evolution. Apart from covering exchange rate risk, Options are also used for speculation on the currency market Covering Receivables Denominated in Foreign Currency In order to cover receivables, generated from exports and denominated in foreign currency, the enterprise may buy put option as illustrated in Examples Example: The exporter Vikrayee knows that he would receive US $ 5,00,000 in three months. [...]
[...] Risk management must be focused on the areas of highest risk within the project, with continual monitoring of other areas of the project to identify any new or changing risks Managing risk - How to manage risks There are four ways of dealing with, or managing, each risk that you have identified. You can: Accept it Transfer it Reduce it Eliminate it For example, you may decide to accept a risk because the cost of eliminating it completely is too high. [...]
[...] Some of the significant reasons for entering into swap contracts are given below .1Hedging Exchange Risk Swapping one currency liability with another is a way of eliminating exchange rate risk. For example, if a company (in UK) expects certain inflows of deutschemarks, it can swap a sterling liability into deutschemark liability Differing Financial Norms The norms for judging credit-worthiness of companies differ from country t6 country. For example, Germany or Japanese companies may have much higher debt-equity ratios than what may be acceptable to US lenders. [...]
[...] Finally at the fourth and the highest level is the nation's central bank, which acts as the lender or buyer of last resort when the nation's total foreign exchange earnings and expenditure are unequal. The central then either draws down its foreign reserves or adds to them CUSTOMERS: The customers who are engaged in foreign trade participate in foreign exchange markets by availing of the services of banks. Exporters require converting the dollars into rupee and importers require converting rupee into the dollars as they have to pay in dollars for the goods / services they have imported. [...]
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