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Home > Financial Risk Management Best Practice

Financial Risk Management Best Practice

Best Practice

Internationally renowned finance leaders, experts and educators distil and summarize the most important aspects of finance best practice. Each Best Practice essay has an Executive Summary for quick reference, outlining the main points. The Making It Happen feature illustrates practical applications, and where relevant authors have provided illustrative case studies and definitions.

  • A Holistic Approach to Business Risk Management
    by Terry Carroll
    After arguably the greatest credit crisis in history, it is unsurprising that lenders, borrowers, and investors alike have become preoccupied with financial risk. Its magnitude seems to have dwarfed all other business risk considerations. It can be hard to take a pragmatic view when the strictures in the financial markets may have put the corporation at risk, but the correct perspective is for all risk to be captured in a holistic...
  • A Total Balance Sheet Approach to Financial Risk
    by Terry Carroll
    We are living in some of the most volatile times in the history of the global financial markets. One of the reasons is exactly because they have become truly global. As banks seek to restore profitability, they may increase their offering of “treasury products” to customers. This article argues that these should be considered only in the context of a total balance sheet approach rather than transaction by transaction.
  • Dangers of Corporate Derivative Transactions
    by David Shimko
    It’s easy for managers to overlook risks. Financial risk managers may ignore nonfinancial risks. Business managers responsible for a particular line item (such as costs) may downplay risks unrelated to their particular line item. Firms often manage their risks compartmentally—for example: the treasury department for foreign exchange and interest rates; the procurement department for commodity purchases; and the insurance department for...
  • Factoring Problem Loan Assumptions into Asset–Liability Management (ALM) Modeling
    by Gary Deutsch
    An essential part of the interest rate risk (IRR) management process is the analysis and documentation of IRR assumptions. Since all methods used to analyze the rate sensitivity of financial instruments require estimates of the amount and timing of their cash flows, the embedded prepayment options found in many types of loans must also be estimated. These estimates must include the level and speed of prepayments for an expected rate environment....
  • Formulating a Contingency Funding Plan to Manage Liquidity Risks
    by Gary Deutsch
    Managing the funding activities of a financial institution has become quite challenging as the global economy continues to develop economic linkages that can lead to unexpected volatility and systemic problems. The European Union, the United States, Asia, and other world economies have become connected through trade and currencies, and changing cultures and demographics such that it is no longer possible to focus solely on local or regional...
  • Integrated Corporate Financial Risk Policy
    by David Shimko
    Risk can be described as the threat of an adverse outcome. Many firms take the benchmark strategy of doing nothing (i.e., investing in Treasury Bills), and measure their risk in absolute terms relative to the strategy of doing nothing. Others measure their risk-taking behavior relative to what might be considered risky benchmarks. Mutual funds, for example, do not focus on the absolute risk of their portfolios; rather, they determine how far...
  • Introduction to Islamic Financial Risk Management Products
    by Qudeer Latif, Susi Crawford
    To consider the basics of Islamic financial risk management products it is helpful to summarize the Islamic principles and jurisprudence on which Islamic finance is based.Speculation: contracts which involve speculation (maysir) are not permissible (haram) and are considered void. Islamic law does not prohibit general commercial speculation, but it does prohibit speculation which is akin to gambling, i.e. gaining something by chance rather than...
  • Investment Risk in Islamic Finance
    by Kamal Abdelkarim Hassan, Hassan Ahmed Yusuf
    At the inception of Islamic finance, Islamic economists advocated change and developed a policy for Islamic banking practice and process, arguing that the main aspect of conventional banking—riba (interest)—required immediate rectification if Islamic banking was to exist. To achieve this goal, profit and loss sharing methods were introduced, along with other products such as ijarah (lease) and murabahah (cost plus). The rest of the technical...
  • Managing Counterparty Credit Risk
    by David Shimko
    Counterparty risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations; it is otherwise known as default risk.Counterparty risk relates closely to performance risk. It arises whenever one entity depends on another to honor the terms of a contract. If a parts supplier fails to provide steering wheels to General Motors, GM will be damaged because of its inability to deliver complete cars....
  • Managing Interest Rate Risk
    by Will Spinney
    Almost all firms are exposed to interest rate risk, but it can manifest itself in different ways. A proper response to this risk can only come following a full understanding of the context of the firm and its strategy, along with a full evaluation of the risk. Firms should generate a well thought out key performance indicator (KPI) and then apply one or more of the many tools available in the market to transfer interest rate risk.
  • Managing Liquidity Risk in a Financial Institution: The Dangers of Short-Term Liabilities
    by David Shimko
    The assets and liabilities of a firm can be segregated into their short-term and long-term components. Short-term assets include cash, cash equivalents, marketable securities, and marketable inventories—i.e., any asset that can be converted in a short period of time to cash. Long-term assets include assets that cannot easily be converted to cash, such as plant and equipment, reputation, good will, and the present value of future growth...
  • Modeling Market Risk
    by Marius Bochniak
    Every financial institution with a portfolio exposed to market risk should have a model in place which is designed to measure that risk. Such a model allows one to control and to limit the market risk taken by each desk or by the traders and to charge each portfolio position a cost of capital required to cover its market risk. Success in meeting these objectives serves the interests of the stakeholders in the firm.The measures of market risk...
  • Optimal Long-Term Property and Casualty ALM with Risk Capital Control
    by Giorgio Consigli, Massimo di Tria
    Increasing competition and record property and casualty (P&C) insurance claims reported by global players in recent years (Comité Européen des Assurances, 2010) have generated remarkable pressure on the financial stability of P&C divisions within insurance firms, leading to increased technical reserves and higher capital requirements. At the same time investment management divisions have expanded, reinforcing the role of insurers as...
  • Quantifying Corporate Financial Risk
    by David Shimko
    Consider the case of a company that has experienced six months of cash flows this year and wants to forecast the next six months. The usual way to do this is to predict a cash flow growth rate—expected, high, and low—and to base the analysis on these choices. A sample cash flow projection might be illustrated graphically in Figure 1.Figure 1. Deterministic cash flow forecast for last six months In reality, of course, several different cash flow...
  • Risk Management of Islamic Finance Instruments
    by Andreas Jobst
    Since only interest-free forms of finance are considered permissible in Islamic finance, financial relationships between financiers and borrowers are not governed by capital-based investment gains but by shared business risk (and returns) in lawful activities (halal). Any financial transaction under Islamic law implies direct participation in performance of the asset, which constitutes entrepreneurial investment that conveys clearly identifiable...
  • Small and Medium-Sized Enterprises and Risk in the Gulf Cooperation Council Countries: Managing Risk and Boosting Profit
    by Omar Fisher
    Small and medium-sized businesses (SMEs) across the Gulf Cooperation Council (GCC) region, many of which are family-owned enterprises, bear the same risks as Fortune 1000 companies. A common definition of a SME is a business with fewer than 250 employees and revenues below US$68 million (Dhs 250 million), whereas the real difference lies in scale and complexity. We have found in working with many types of business that most business owners in...
  • Stress-Testing in Asset and Liability Management: A Coherent Approach
    by Alex Canavezes, Mario Schlener
    In light of recent extreme events, such as the collapse of Lehman Brothers in 2008, both the financial services industry and its regulators have keenly felt the need to complement traditional percentile-based risk management tools (such as value-at-risk (VaR) or economic capital) with stress tests and scenario analyses.Following the logic of Dermine (2003), asset and liability management (ALM) can be interpreted as the main management tool for...
  • To Hedge or Not to Hedge
    by Steve Robinson
    Business has become increasingly international, and companies cannot ignore the impact of currency changes on cash flows, profitability, and their asset and liability position. No company is wholly immune—the cash received from exporting is affected by the relationship between the currency used by the customer to pay and the currency in which the cost of providing the product or service is denominated.Many commodity prices have been volatile,...
  • Tools for Measuring Interest Rate Risk
    by Steven V. Mann
    One can understand risk intuitively as the chance of an unpleasant surprise. Financial institutions must be able to manage their exposure to risk. To accomplish this task, they must be able to identify the risks to which they are exposed and measure that exposure. Numerous types of risk put a financial institution in harm’s way. One major exposure is to interest rate risk. Interest rate risk has two dimensions—level risk and curve risk. Level...
  • Understanding and Applying Funds Transfer Pricing
    by Hovik Tumasyan
    In its simplest form funds transfer pricing (FTP) is the process whereby the treasury of a bank (its funding center) aggregates funds centrally and then redistributes them throughout the business units, balancing funding resource excesses and shortages and thus creating an internal market for liquidity. If there is still a deficit for funds, the treasury raises more funds from the capital markets, and if there is an excess of funds, treasury...

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