Financial Risk Management - When To Use Financial Risk Management

When To Use Financial Risk Management

Finance theory (i.e., financial economics) prescribes that a firm should take on a project when it increases shareholder value. Finance theory also shows that firm managers cannot create value for shareholders, also called its investors, by taking on projects that shareholders could do for themselves at the same cost.

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 was captured by the 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, 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. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is that market risks that result in unique risks for the firm are the best candidates for financial risk management.

The concepts of financial risk management change dramatically in the international realm. Multinational Corporations are faced with many different obstacles in overcoming these challenges. There has been some research on the risks firms must consider when operating in many countries, such as the three kinds of foreign exchange exposure for various future time horizons: transactions exposure, accounting exposure, and economic exposure.

Megaprojects (sometimes also called "major programs") have been shown to be particularly risky in terms of finance. Financial risk management is therefore particularly pertinent for megaprojects and special methods have been developed for such risk management.