Financial Risk Management and Risk Projection

FINANCIAL RISK MANAGEMENT:
Financial risk management involves identifying the potential downsides in any investment
decision and deciding whether to accept the risks or take measures to mitigate them.
Financial risk management is a continuing process as risks can change over time.
There are risks in all investments. Successful financial risk management requires a balance
between potential risks and potential rewards.
• An investor may choose virtually risk-free U.S. Treasury bonds over riskier lower-
rated corporate bonds
• A fund manager who identifies currency price changes as a risk may hedge that risk
with currency derivatives
• A bank checks the credit rating of applicants for personal lines of credit and grants or
denies the applicant based on the results
• A stockbroker uses financial instruments like options and futures to offset potential
losses in other investments
• A money manager uses strategies like portfolio diversification to mitigate the risk of
losses in specific stocks.
Techniques to avoid risk:
Avoidance: The most obvious way to manage risk is to avoid it. Some investors make their
investment decisions by cutting out volatility and risk completely. This means choosing the
safest assets with little to no risks.
Retention: This strategy involves accepting any risks as the price to be paid for the chance
of high returns.
Sharing: Risk can be shared among two or more parties. For instance, insurance companies
pay reinsurers to cover potential losses above specified levels.
Transferring: Risks can be passed on from one party to another. Health insurance allows
consumers to transfer the risk of expensive medical costs to an insurance company in return
for payment of regular premiums.
Loss prevention and reduction: Rather than eliminating risk, many investors mitigate it by
balancing volatile investments, such as growth stocks, with more conservative choices.
1. Market Risk: Market risk is one of the most common types of financial risk and directly
affects anyone participating in the financial markets.
This risk arises from changes in market prices, such as interest rates, stock prices, or
currency exchange rates.
2. Credit Risk: Credit risk refers to the possibility that a borrower will fail to repay a loan
or meet contractual obligations.
For instance, if a company extends credit to a customer and that customer fails to pay, it can
cause financial strain on the company.
3. Liquidity Risk: Liquidity risk occurs when an individual or business can’t easily convert
assets into cash without losing value. This type of risk is particularly relevant in times of
financial stress.
For instance, during the COVID-19 pandemic, many businesses faced liquidity issues due to
a sudden drop in sales, making it challenging to cover short-term expenses.
4. Operational Risk: Operational risk is the chance of loss resulting from failed internal
processes, people, or systems.
For example, if a bank’s IT system fails, it could disrupt services and lead to financial
losses.
Human errors, like processing mistakes or poor management decisions, are also sources of
operational risk.
5. Legal and Regulatory Risk: Legal and regulatory risk arises when a company fails to
comply with laws, rules, or regulations, potentially facing fines, penalties, or legal actions.
Businesses operating in finance need to keep up with changing regulations to avoid costly
legal consequences.
6. Political Risk: Political risk refers to the possibility that political changes or instability in
a country could affect a business or investment.
This risk includes factors like government policies, tax laws, or international relations.
FINANCIAL PROJECTIONS:
Financial projections are forecasts of a company's future financial performance, including
revenue, expenses, cash flow, profit and loss, and balance sheet. These projections serve as a
roadmap for businesses to chart their financial course and make informed decisions
When evaluating financial projections for risk assessment, it is essential to understand the
key components that make up these projections. Here are the key components of
financial projections to consider:
1. Revenue Projections:
Expenses and cost projections estimate the amount of money a company expects to spend to
support its revenue-generating activities. When evaluating expenses and cost projections for
risk assessment, it is crucial to consider factors such as inflation, cost of goods sold, variable
and fixed costs, and efficiency in operations.
3. Cash Flow Projections:
cash flow projections forecast the amount of cash flowing into and out of a company over a
specific period. When evaluating cash flow projections for risk assessment, it is important to
analyze factors such as timing of cash inflows and outflows, working capital
requirements, debt service obligations, and potential cash flow bottlenecks.
4. Profit and Loss Projections:
Profit and loss projections estimate a company's net income or loss over a specific period.
When evaluating profit and loss projections for risk assessment, it is crucial to analyze
factors such as gross margin, operating expenses, tax obligations, and potential risks that
may impact profitability.
5. Balance Sheet Projections:
Balance sheet projections provide a snapshot of a company's financial position at a specific
point in time. When evaluating balance sheet projections for risk assessment, it is important
to analyze factors such as assets, liabilities, equity, working capital, debt levels, and liquidity.

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FINANCIAL RISK MANAGEMENT:

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