Essentials of Financial Risk Management by Karen A. Horcher

Essentials of Financial Risk Management by Karen A. Horcher

CHAPTER 1
What Is Financial Risk
Management?

After reading this chapter you will be able to
• Describe the financial risk management process
• Identify key factors that affect interest rates, exchange rates,
and commodity prices
• Appreciate the impact of history on financial markets
Although financial risk has increased significantly in recent years,
risk and risk management are not contemporary issues. The result
of increasingly global markets is that risk may originate with events
thousands of miles away that have nothing to do with the domestic
market. Information is available instantaneously, which means that
change, and subsequent market reactions, occur very quickly.
The economic climate and markets can be affected very quickly by
changes in exchange rates,interest rates,and commodity prices.

Counterparties can rapidly become problematic. As a result, it is important to
ensure financial risks are identified and managed appropriately.

Preparation is a key component of risk management.
What Is Risk?
Risk provides the basis for opportunity.The terms risk and exposure have
subtle differences in their meaning. Risk refers to the probability of loss,

while exposure is the possibility of loss, although they are often used
interchangeably. Risk arises as a result of exposure.
Exposure to financial markets affects most organizations, either directly
or indirectly.When an organization has financial market exposure, there
is a possibility of loss but also an opportunity for gain or profit. Financial
market exposure may provide strategic or competitive benefits.
Risk is the likelihood of losses resulting from events such as changes
in market prices.Events with a low probability of occurring,but that may
result in a high loss, are particularly troublesome because they are often
not anticipated.Put another way,risk is the probable variability of returns.
Since it is not always possible or desirable to eliminate risk, understanding

it is an important step in determining how to manage it.
Identifying exposures and risks forms the basis for an appropriate financial

risk management strategy.
How Does Financial Risk Arise?
Financial risk arises through countless transactions of a financial nature,
including sales and purchases, investments and loans, and various other
business activities. It can arise as a result of legal transactions, new projects,

mergers and acquisitions, debt financing, the energy component of
costs, or through the activities of management, stakeholders, competitors,

foreign governments, or weather.
When financial prices change dramatically, it can increase costs,
reduce revenues, or otherwise adversely impact the profitability of an
organization. Financial fluctuations may make it more difficult to plan
and budget, price goods and services, and allocate capital.

Essentials of Financial Risk Management by Karen A. Horcher