Financial Risk Management
1. Introduction to Financial Risk Management
Financial Risk Management is the process of identifying,
analyzing, and controlling financial risks that can negatively affect an
organization’s income, cash flow, assets, or overall financial position.
In modern businesses, uncertainty arises due to market
fluctuations, credit defaults, liquidity shortages, and operational failures.
Financial risk management helps organizations reduce losses and ensure
financial stability.
Objectives of Financial Risk Management
- Protect
business assets
- Ensure
stable cash flows
- Reduce
uncertainty in earnings
- Improve
decision-making
- Enhance
investor and stakeholder confidence
2. Types of Financial Risks
Financial risks are broadly classified into the following
types:
2.1 Market Risk
Definition
Market risk is the risk of financial loss due to changes
in market prices, such as:
- Interest
rates
- Exchange
rates
- Share
prices
- Commodity
prices
Examples
- Loss
due to fall in stock prices
- Loss
due to increase in interest rates
- Loss
due to currency depreciation
Types of Market Risk
- Interest
Rate Risk
- Currency
(Foreign Exchange) Risk
- Equity
Price Risk
- Commodity
Price Risk
Solved Numerical Example – Market Risk
A company invests Rs. 500,000 in shares. Due to market
fluctuation, the value falls to Rs. 450,000.
Calculate market loss.
Solution:
Market Loss = Initial Value – Current Value
= 500,000 – 450,000
= Rs. 50,000
📌 Interpretation:
The company faces a market risk loss of Rs. 50,000 due to price
fluctuation.
2.2 Credit Risk
Definition
Credit risk is the risk that a borrower or customer fails
to repay loan or credit as agreed.
Examples
- Customer
fails to pay credit sales
- Borrower
defaults on loan
- Delay
in receivables
Sources of Credit Risk
- Poor
credit evaluation
- Economic
downturn
- Weak
customer financial position
Solved Numerical Example – Credit Risk
A firm sells goods worth Rs. 200,000 on credit. Expected
default rate is 5%.
Calculate expected credit loss.
Solution:
Expected Loss = Credit Sales × Default Rate
= 200,000 × 5%
= Rs. 10,000
📌 Interpretation:
The firm should expect a credit loss of Rs. 10,000.
2.3 Liquidity Risk
Definition
Liquidity risk is the risk that a firm cannot meet its
short-term obligations due to lack of cash or liquid assets.
Examples
- Unable
to pay salaries
- Unable
to pay suppliers
- Delay
in loan repayment
Causes
- Poor
cash management
- High
current liabilities
- Slow
receivables collection
Solved Numerical Example – Liquidity Risk
A company has:
- Current
Assets = Rs. 300,000
- Current
Liabilities = Rs. 450,000
Calculate current ratio and comment on liquidity risk.
Solution:
Current Ratio = Current Assets ÷ Current Liabilities
= 300,000 ÷ 450,000
= 0.67 : 1
📌 Interpretation:
Since current ratio is less than 1, the firm faces high liquidity
risk.
2.4 Operational Risk
Definition
Operational risk arises from failures in internal
processes, systems, human errors, or external events.
Examples
- Fraud
- System
failure
- Poor
management decisions
- Natural
disasters
Solved Numerical Example – Operational Risk
A firm suffers system failure causing production loss worth
Rs. 80,000 and repair cost Rs. 20,000.
Calculate total operational loss.
Solution:
Total Loss = Production Loss + Repair Cost
= 80,000 + 20,000
= Rs. 100,000
📌 Interpretation:
Operational risk resulted in a loss of Rs. 100,000.
3. Risk Mitigation Strategies
Risk mitigation refers to methods used to reduce or
control financial risks.
3.1 Hedging
Definition
Hedging is a technique used to reduce risk by taking an
opposite position in financial markets.
Instruments Used
- Futures
- Options
- Forwards
- Swaps
Example
An importer hedges foreign exchange risk using forward
contracts.
Solved Numerical Example – Hedging
An importer needs to pay USD 10,000 after 3 months.
Current exchange rate = Rs. 280/USD
Forward rate locked = Rs. 285/USD
Calculate amount payable under hedge.
Solution:
Payment = 10,000 × 285
= Rs. 2,850,000
📌 Interpretation:
Hedging protects the importer from adverse exchange rate changes.
3.2 Diversification
Definition
Diversification is the strategy of spreading investments
across different assets to reduce risk.
Principle
“Do not put all eggs in one basket.”
Solved Numerical Example – Diversification
An investor invests Rs. 100,000 equally in two assets.
- Asset
A loses 10%
- Asset
B gains 8%
Calculate net gain or loss.
Solution:
Investment in each = 50,000
Loss on A = 50,000 × 10% = 5,000
Gain on B = 50,000 × 8% = 4,000
Net Result = 4,000 – 5,000
= Loss of Rs. 1,000
📌 Interpretation:
Diversification reduced total loss.
3.3 Insurance
Definition
Insurance transfers risk to an insurance company in
exchange for premium.
Types
- Property
insurance
- Life
insurance
- Business
insurance
Solved Numerical Example – Insurance
Annual premium = Rs. 15,000
Loss due to fire = Rs. 200,000
Insurance coverage = 90%
Calculate compensation received.
Solution:
Compensation = 200,000 × 90%
= Rs. 180,000
📌 Interpretation:
Insurance significantly reduces financial loss.
4. Introduction to Financial Derivatives
Definition
Financial derivatives are financial instruments whose
value depends on an underlying asset, such as:
- Shares
- Bonds
- Interest
rates
- Currencies
Types of Financial Derivatives
- Forwards
- Futures
- Options
- Swaps
Purpose of Derivatives
- Hedging
risk
- Speculation
- Arbitrage
Solved Numerical Example – Derivatives
An investor buys a futures contract for wheat at Rs. 3,000
per unit.
Market price rises to Rs. 3,200.
Calculate profit per unit.
Solution:
Profit = Market Price – Futures Price
= 3,200 – 3,000
= Rs. 200 per unit
📌 Interpretation:
The investor earns profit through derivative trading.
5. Importance of Financial Risk Management
- Protects
firms from unexpected losses
- Stabilizes
cash flows
- Improves
creditworthiness
- Supports
long-term planning
- Essential
for banks, firms, and investors
6. Summary
Financial Risk Management is essential in today’s uncertain
business environment.
Understanding types of risks, risk mitigation strategies, and financial
derivatives helps students and managers make better financial decisions,
reduce losses, and ensure sustainable growth.
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