
Policies and plans of action designed to deal with financial risks
Financial risk management strategies are a plan of action or policies that are designed to deal with various forms of financial risk. The strategies are important for any firm or individual to manage the inherent financial risks that come with operating within the economy and financial system.
Before we can propose financial risk management strategies, we need to first understand the nature of the financial risks faced by individuals, corporations, and financial institutions. In general, financial risks are events or occurrences which have undesirable or unpredictable financial outcomes or impacts.
Individuals face financial risks in many aspects of their lives. These risks come in the form of:
For corporations and financial institutions, there are additional types of risks faced, such as:
Managing financial risk for both individuals and corporations starts by working through a four-stage process that includes the following steps:
There are various risk management strategies available to both individuals, corporations, and financial institutions.
At the individual level, some risk management strategies include:
At the corporate level, the same risk management strategies may be applied, but in slightly different contexts:
Difficulty arises in deciding which strategy to utilize for a particular risk. It comes down to the nature of the risk and the individual’s or corporation’s current risk appetite. Risks should be fully understood before deciding on the appropriate strategy to remedy them.
Example 1 – Risk Transfer: many individuals with spouses and children purchase life insurance to protect against the risk of premature death. They want to insure against the loss of income and ensure there is an income safety net for surviving family members.
Example 2 – Risk Retention: lumber producers are able to hedge their exposure to lumber prices with the use of futures contracts. However, many choose to retain this risk and accept commodity price fluctuations. It is, in fact, the industry standard. If a lumber producer were to hedge their risk, they could place themselves at a disadvantage if the commodity price begins to move in a favorable direction.
Thank you for reading CFI’s guide to Financial Risk Management Strategies. To keep learning and developing your knowledge, we highly recommend the additional resources below: