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.
Financial risk management strategies are plans of action or policies designed to deal with financial risks.
Financial risks are events or occurrences that have an undesirable financial outcome or impact. These risks are faced by both individuals and corporations alike.
The main financial risk management strategies include risk avoidance, risk reduction, risk transfer, and risk retention.
Examples of Financial Risks
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:
Risk of unemployment or loss of income: this includes unemployment, underemployment, health issues, disability, and premature death.
Risk of higher or unexpected expenses: this includes incurring higher expenses than budgeted or having to deal with unforeseen emergency expenses.
Risk related to assets/investments: this includes potential declines in the value of assets/investments, as well as potential damage and theft of assets.
Risks related to debt or credit financing: this includes being unable to service credit card debt, asset loans, mortgages, and so on.
For corporations and financial institutions, there are additional types of risks faced, such as:
Market Risk: the risk that losses may occur to financial assets based on the dynamics of the overall financial markets, for example, an equity security losing a substantial portion of its value.
Credit Risk: the risk that a counterparty may default on their contractual obligations, for example, an individual defaulting on their personal loan.
Liquidity Risk: the risk that funding obligations may not be met due to cash constraints, for example, a bank not having enough cash on hand to meet deposit withdrawal demand.
Operational Risk: the risk that losses occur as a result of failed internal processes, people, and systems. For example, an employee making a mistake on a transaction that results in a monetary loss.
Financial Risk Management Strategies
Managing financial risk for both individuals and corporations starts by working through a four-stage process that includes the following steps:
Identifying potential financial risks
Analyzing and quantifying the severity of these risks
Deciding on a strategy to manage these risks
Monitoring the success of the strategy
There are various risk management strategies available to both individuals, corporations, and financial institutions.
At the individual level, some risk management strategies include:
Risk avoidance: elimination of activities that can expose the individual to risk; for example, an individual can avoid credit/debt financing risk by avoiding the usage of credit to make purchases.
Risk reduction: mitigating potential losses or the severity of potential losses; for example, an individual can diversify their investment portfolio to reduce the risk that their investment portfolio experiences a severe negative drawdown.
Risk transfer: the process of transferring risk to a third party; for example, an individual may purchase a life insurance policy to offload the risk of premature death to the insurer.
Risk retention: the process of accepting responsibility for a particular risk, for example, an individual deliberately not insuring their property.
At the corporate level, the same risk management strategies may be applied, but in slightly different contexts:
Risk avoidance: elimination of activities that can expose the corporation to risk; for example, the corporation can avoid expanding operations to a geographical area that has high political and regulatory uncertainty.
Risk reduction: mitigating potential losses or the severity of potential losses; for example, a corporation may use hedging on foreign currency transactions to reduce their exposure to currency fluctuations.
Risk transfer: the process of transferring risk to a third party; for example, a corporation may purchase insurance on their property, plant, and equipment to transfer the risk of damage and theft to the insurer.
Risk retention: the process of accepting responsibility for a particular risk; for example, a corporation may accept risks of volatile input costs without using any hedging or insurance.
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: