Financial Risk Management Research Paper

Pages: 10 (2853 words)  ·  Bibliography Sources: 8  ·  File: .docx  ·  Level: Master's  ·  Topic: Economics

Risk Management Analysis: Essential Tools and Perspectives in a Treasury Management Context

The recent (and arguably ongoing) global recession triggered in large part by the sudden economic crisis and collapse of the United States' banking industry and capital sourcing network has given businesses and governments the world over major grounds for pause and reflection about their operations and situations. Obviously, there is something wrong with a global financial system that can be sent into a near-total tailspin by a single country's lack of regulatory oversight and questionable lending practices. The debate over exactly what was wrong with the system however, both within the United States and in a global context, is far from reaching a point of agreement and a solid recommendation.

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The complexities of the global economy, which is becoming increasingly interconnected as technologies for information transference and the shipping of real goods become more efficient and more prevalent and as emerging markets begin to take a more active role in shaping the world's industries and trading framework, make it almost certain that the problems that created the global recession will never be fully understood or agreed upon. There are simply too many factors, identified and examined by too many disparate theories and trains of though, for a true objective consensus and understanding to be reached. Yet despite this lack of full understanding and agreement in regards to the causes of economic collapse, and indeed largely because of the continued uncertainties that exist in the global economic community, there are a number of tools that can themselves be understood and implemented to mitigate future damages.

TOPIC: Research Paper on Financial Risk Management Assignment

The theories and practices of Risk Management are not, of course, recent developments in reaction to the current (or recently passed) worldwide economic situation, but rather have existed both explicitly and implicitly through less-than-conscious practice for centuries, at least since the rise of the mercantile period. These tools and practices have been granted a renewed emphasis due to recent economic events, however, warranting a reexamination of some of the basic principles behind them as well as the practicalities and necessities of the risk management tools themselves. Through an increased understanding of risk management tools and their operations, issues such as the recent global recession can certainly be mitigated if not entirely avoided, enabling greater security and long-term prosperity for all major economic entities within the global community.

Both businesses and governments benefit from similar usages of risk management tools and principles, and though this paper will focus primarily on the use of these tools and practices in a treasury management context there will necessarily be some overlap in the discussion and the literature referred to. Essentially, however, the analysis of risk management contained herein will focus on the use of hedging tools and other methods of risk management from the perspective of government entities attempting to limit volatility and reduce exposure to shocks such as that which occurred as a result of the home mortgage/banking collapse that triggered the wider economic woes of the banking industry and the world economy at large. This will provide a solid ground upon which to build suggestions for sound long-term fiscal practices that ensure responsibility and security.

Risk Management: An Overview

Before examining the tools, principles, and practices that can be utilized to mitigate risks and manage them in a way that ensures continued growth and success while limiting exposure and increasing security, the major forces that create such risks must be identified. Risks are an inherent part of the market system, and will never be eradicated, nor would it be advantageous in a given industry or interconnected economy for such an elimination to take place -- risk is also a large driver of opportunity, and in many (perhaps most) instances is the automatic underbelly of opportunity.

This still does not fully capture a clear definition of what is meant by the concept of risk itself, however.

Essentially, risk can be understood as "the potential for future returns to vary from the expected returns."

From this broad yet accurate definition, it can be seen that risk is an inherent element to any endeavor, both financially based and otherwise. A variation in return is a high probability for most activities, and can include losses and even the complete dissolution of an organization or enterprise. Variations can also occur in a positive direction, of course, and though this is not traditionally perceived as "risk" it helps to illustrate the truism that the greater the risk, the greater the opportunity. Volatility in market forces, then, creates greater uncertainty and thus is a driver of risk; mitigating and/or limiting the effects of such volatility -- or even the existence of the volatility itself -- is the essential goal of risk management in both businesses and governments.

This is one area in which the risk management needs of a business organization differ significantly from the risk management goals of a treasury department or other governmental agency. Though both governments and business entities utilize the same (or similar) risk management tools, they do so with different aims. It is a business entity's desire to predict and capitalize on volatility, either through expansion efforts that turn volatility into profitability or through protective and conservative measures in response to modeled volatility that will allow the entity to maintain the bulk of its assets and continue to operate efficiently during volatile situations.

For governments and treasury departments or central banks, however, the goal is not to capitalize on predicted volatility but rather to limit the very existence of volatility in an effort to provide security for sustained growth.

The setting of acceptable risk levels and the monitoring of various business sectors has become an essential -- arguably the primary -- goal of government finance offices and/or departments.

It is through the use of risk management tools that volatility is controlled, or at least through which control of volatility is attempted, and this generally involves a host of activities and policies undergoing near-constant adjustment by the governmental office or agency as market situations and external environments change. An relatively brief examination of specific tools and practices utilized for this purpose occurs below, but it is essential to keep in mind the overall aim of such practices and procedures from a treasury management perspective is to simply limit, not make direct use of, volatility.

Hedging

A major aspect of risk management is hedging, the general meaning of which is demonstrated in the rather cliched (and now passe) idiomatic phrase "hedging one's bets." Essentially, hedging refers to any practices or methods that spread risk around, limiting exposure to risk in any one area and thus reducing the likelihood that a single environmental factor or internal change will have an equally negative impact on all facets of an organization or the economic market as a whole. In the realm of financial risk management, hedging is a much more specific and specialized term that refers to the use of statistical and financial tools to rearrange a company's assets in the face of predicted risks and changes to the financial environment.

Hedging tools are essential for mitigating or neutralizing risks brought on by changes to price and/or cash flow, making them of special interest to government agencies attempting to instill strong treasury management practices.

Many hedging practices that would be pertinent to business organizations, such as semi-annual yield payments, are less applicable to governments, but treasury bonds and other means of government funding that require a direct payout to private citizens require the same types of controls and adjustments.

Most government issued bonds are paid out at fixed growth rates at specific times, however, which is in itself a form of a hedging tool -- it is inherently and unequivocally stable, and this resists volatility and changes to price and cash flow. At the same time, the fixed nature of these bond payouts leaves them susceptible to fluctuations in the overall value of currency due to inflation, which is why the fixed nature of the yield of most government bonds is only one tool of many that is used to provide stability and resists volatility, hedging the government's financial position and the overall market.

The control of interest rates through central bank lending, a practice that has grown to new extremes in the past two years, is another example of a hedging practice that will be explored in greater detail below. There are a host of other treasury management techniques involving the money supply and the extent of government investment that fall under the umbrella of hedging practices, all of which are necessary to provide overall and long-term stability to a nation's (and the world's) economy. Without such hedging measures, the full volatility of market forces would create great volatility and instabilities in the overall economy, leaving all industries and individual consumers susceptible to price shocks and sudden changes to the money supply and available capital.

Spot and Forward Exchange Rates

Managing exposure to foreign exchange risks is another specific form of hedging… [END OF PREVIEW] . . . READ MORE

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