Financial risk management

Financial risk management is the practice of protecting economic value in a firm by managing exposure to financial risk - principally credit risk and market risk, with more specific variants as listed aside - as well as some aspects of operational risk. As for risk management more generally, financial risk management requires identifying the sources of risk, measuring these, and crafting plans to mitigate them. See Finance § Risk management for an overview.

Financial risk management as a "science" can be said to have been born with modern portfolio theory, particularly as initiated by Professor Harry Markowitz in 1952 with his article, "Portfolio Selection"; see Mathematical finance § Risk and portfolio management: the P world.

The discipline can be qualitative and quantitative; as a specialization of risk management, however, financial risk management focuses more on when and how to hedge, often using financial instruments to manage costly exposures to risk.

In all cases, the last "line of defence" against risk is capital, "as it ensures that a firm can continue as a going concern even if substantial and unexpected losses are incurred".

Neoclassical finance theory prescribes that (1) a firm should take on a project only if it increases shareholder value. Further, the theory suggests that (2) firm managers cannot create value for shareholders or investors by taking on projects that shareholders could do for themselves at the same cost; see Theory of the firm and Fisher separation theorem.

Given these, there is therefore a fundamental debate relating to "Risk Management" and shareholder value. The discussion essentially weighs the value of risk management in a market versus the cost of bankruptcy in that market: per the Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the probability of financial distress.

When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. This notion is captured in the so-called "hedging irrelevance proposition": "In a perfect market, the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm."

In practice, however, financial markets are not likely to be perfect markets. This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management, wherein they are able to determine which risks are cheaper for the firm to manage than for shareholders. Here, market risks that result in unique risks for the firm are commonly the best candidates for financial risk management.