Risk can be explained as uncertainty and isusually associated with the unpredictability of an investment performance. Allinvestments are subject to risk, but some have a greater degree of risk thanothers.
Risk is often viewed as the potential for an investment to decrease invalue. Though quantitative analysis plays a significant role, experience,market knowledge and judgment play a key role in proper risk management. Ascomplexity of financial products increase, so do the sophistication of the riskmanager’s tools. We understand risk as a potential future loss. When we take aninsurance cover, what we are hedging is the uncertainty associated with thefuture events.
Financial risk can be easily stated as the potential for futurecash flows (returns) to deviate from expected cash flows (returns). There arevarious factors that give raise to this risk. Return is measured as Wealth atT+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 thereforecash flow or return, is a source of risk.
We can say the return is the functionof.· Prices· Productivity· Market Share· Technology· Competition Financial risk management focuses on risks thatcan be managed using traded financial instruments (changes in commodity prices,interest rates, foreign exchange rates and stock prices). Financial riskmanagement will play an important role in cash management. This area is relatedto corporate finance in two ways. Firstly firm exposure to business risk is adirect result of previous Investment and Financing decisions. Secondly, bothdisciplines share the goal of creating, or enhancing, firm value. All largecorporations have risk management teams, and small firms practice informal, ifnot formal, risk management. Derivatives are the instruments most commonly usedin financial risk management.
Because unique derivative contracts tend to becostly to create and monitor, the most cost-effective financial risk managementmethods usually involve derivatives that trade on well-established financialmarkets. These standard