This lesson explores the specific types of financial risks that organizations face and the techniques used to manage them.
5.1 Types of Financial Risks
Financial risks are uncertainties in financial markets that can affect an organization’s performance and value. Key types of financial risks identified in financial risk management curricula include :
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Market Risk:Â The risk of losses due to changes in market prices, including interest rates, stock prices, foreign exchange rates, and commodity prices .
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Credit Risk:Â The risk of loss from a counterparty failing to meet its obligations .
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Liquidity Risk:Â The risk that an organization will not be able to meet its short-term financial obligations .
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Operational Risk:Â The risk of loss from failed internal processes, people, systems, or external events .
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Interest Rate Risk:Â The risk to earnings and capital from adverse movements in interest rates .
5.2 Risk Measurement and Management
Once risks are identified, they must be measured. Value at Risk (VaR) is a widely used measure that estimates the maximum loss of a portfolio over a specific time horizon at a given confidence level . Expected Shortfall is another measure that captures the average loss in the worst-case tail of the distribution . Students learn to apply derivatives, such as forwards, futures, options, and swaps, to generate risk-mitigating plans and to critically analyze these concepts in local and global contexts .
5.3 Derivatives for Risk Management
Derivatives are powerful tools for hedging financial risk . Forwards and futures are contracts to buy or sell an asset at a future date for a set price. Options give the holder the right, but not the obligation, to buy or sell an asset. Swaps are agreements to exchange cash flows. These instruments are used to manage risks such as interest rate or foreign exchange exposure . The effective use of derivatives requires a deep understanding of the instruments and the underlying risks they are meant to hedge.