Corporate Finance Theory and Practice, Third Edition

Chapter 49

MANAGING FINANCIAL RISKS

Forbidden, but useful, tools…

In recent years investors, regulators and management have increasingly focused their attention on risk management. We have thus seen:

• tighter regulatory frameworks (e.g. with the Sarbanes–Oxley Act in the US in 2002) that impose communication on risk identification and risk management;
• greater pressure from the market for increased transparency. In this context, the recommendation for good corporate governance suggests a reinforced role for directors, in particular through risk and audit committees;
• management awareness of risk management issues has led to the creation or the increased role of risk management departments (internal audit, risk managers, …).

A recent trend in risk management consisted in splitting up the risks and managing them with products that allow finer and more flexible hedging.

Section 49.1

INTRODUCTION TO RISK MANAGEMENT

1/ DEFINITION OF RISK

The key features of risk are:

• intensity of the possible loss on the amount of the exposure;
• frequency, which is the likelihood of this loss occurring (insurers talk about loss probability).

Risk can be classified into four major categories:

• Risk fundamentally linked to market changes (interest and exchange rates, raw material prices). The likelihood of occurrence of fundamental risk, i.e. the probability that the market will move against the interests of the company, is mechanically close to 50%. The intensity of the loss will depend on the volatility ...