For financial services firms, risk management is the process of managing exposure and mitigating losses that can come via financial transactions. Risk management practices involve identifying and analyzing the potential losses of an investment and developing strategies that are consistent with an organization’s objectives to eliminate or minimize potential risks.
Risk exposure can arise from a variety of factors. In general, there are three main sources for risk: from transactions with trading partners; from an organization’s exposure to rapid changes in market prices; or from the internal actions of an organization.
The risk management process involves both internal and external analysis in order to obtain a solid understanding of an organization’s risk standing. Put simply, risk management can be divided into two parts: determining the risks in an investment; and then handling those risks based on investors’ tolerance levels and goals.
Overall, an organization has three alternatives for managing risk. An organization can opt to do nothing and accept all potential risk; hedge a portion of risk by determining those areas that should be hedged; or provide a comprehensive hedging strategy in an attempt to cover all risk exposure.
Strategies for risk management often involve the use of derivatives that allow an organization to pass risk along to third-party providers.
Large corporations may choose from a variety of strategies to mitigate risk, depending on the situation. For instance, a company may choose to diversify its portfolio, buy insurance to cover losses, or establish other hedging methods to minimize risk exposure.
Addressing financial risk ensures that an organization is taking proactive steps to prevent losses and to find agreement among those involved in a transaction on the strategies and practices that forestall disaster.