How Does Risk Management Apply to Financial Decisions?

A very specific type of risk management relates to financial decisions taken in a business. In this context, risk management is not about eliminating risk but rather about controlling the way to take risks. It’s different from some other types of risk management.

What Is Risk Management?

Risk management is a process for mitigating or eliminating risk in a variety of different areas that may impact the operation of a business. Different strategies are used to manage risk depending on the business and the type of risk. In the case of financial risk management, this means making sure the financial risks that are taken are sound risks. This usually means codifying how the company makes these decisions as well as what constitutes a good financial risk.

Financial Risk Management

When companies make financial decisions, they always assume some degree of risk, especially when they’re making decisions about investments. Financial risk management is a set of practices that allow a company to optimize the way it takes financial risk. A financial risk management plan may include things like how the company monitors risky activities and applies the risk process. The company’s board or senior management decides the plan to guide how financial decisions are made.

Market Risks

As with other types of risk management, in financial risk management there are a variety of different types of risks the risk managers must take into account and evaluate. Market risk, the exposure to financial loss because of the uncertain future value of stocks, is a key component of financial risk. This type of risk is managed by avoiding day-to-day losses on the stock market. Risk management procedures might impose a level of acceptable risk in investing to mitigate market risk.

Credit Risks

Credit risk is a type of risk that comes into play when a company is making loans, issuing credit cards, insuring, or investing in the debt of other companies. In these cases, the risk they’re assuming is that the other party will default, in which case they’ll lose the investment. A risk management plan for credit risks would apply a procedure for determining how much of a risk a particular investment is. It would also detail how much risk is too much and how much is acceptable.

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Operational Risks

An operation risk is slightly different from market risk and credit risk because it concerns the internal operation of a company, rather than an exterior source of risk. Operational risk is the risk of a loss because of the failure of internal systems or processes or the errors of people working for a company. These may include system errors like computer failures, or losses to physical assets like fire, floods, or earthquakes. It may also include employee-caused problems like errors, fraud, theft, or other criminal activities.

Financial risk management involves protecting a company against financial loss due to a variety of factors. While this type of risk management only provides guidelines by which financial decisions should be made, it is still an important safeguard against loss.

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