FRM 2. How Do Firms Manage Financial Risk?

Introduction

In this chapter, we will explore the strategies used by firms to handle their risk exposures, the influence of risk appetite on risk management decisions, and the practical methods for hedging risks. Additionally, we will assess the impact of risk management tools and instruments, such as derivatives and risk limits, on a firm’s financial stability and risk profile. Keys topics covered include:

• Comparing Risk Management Strategies: Firm have four strategies at their disposal to manage their risk exposures, including risk retention, risk avoidance, risk mitigation (reducation) and risk transfer. Risk managers must pay special attention to understand the specific circumstances under which each strategy would be most effective.

• Risk Appetite and Decision Making: The risk appetite of a firm influences its risk management strategies and decision-making processes, ensuring alignment with overall business objectives and stakeholder expectations.

• Advantages and Disadvantages of Hedging: Hedging is a common technique used to mitigate risk exposures. There are several benefits and potential drawbacks of hedging, along with the challenges firms may face in implementing effective hedging strategies, such as costs, complexity, and market conditions.

• Hedging Operational and Financial Risks: Practical methods for hedging various types of risks include hedging of pricing, foreign currency, and interest rate risks. Hedging can be used to safeguard a firm’s operational and financial stability against market fluctuations and other uncertainties.

• Risk Management Tools: Various risk management tools, such as risk limits and derivatives, can be used to manage and mitigate risk effectively. These tools impact the overall risk profile and financial health of a firm.