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Reviews on pecuniary take a chance Management EssayThe definition and types of pecuniary chance III. Risk anxiety and the theoretical foundation IV. The dish up of monetary endangerment precaution V. The challenges confront by the innovative pecuniary chance steering theories ?Abstract? Financial adventures are exposures of uncertainties for those participants in monetary merchandise. Financial pretends crapper be divided into four categories commercialise gamble, credit stake, liquidity jeopardize and usable jeopardize. Risk charge has become to a greater extent and more crucial for a commercialize participant to survive in the highly competitive market. As the discipline of the world-wide pecuniary market, there are many phenomena that deal non be explained by traditional financial happen management theories. These phenomena hand over accelerated the development of styleal finance and frugal physics. The financial management theories apply alr eady improved a lot over the past decades, entirely still facing around challenges. Therefore, this report get out review more or less important issues in the financial risk management introduce some theoretical foundation of financial risk management, and discuss the challenges faced by the modern financial risk management.I. Introduction Financial risk is one of the basic characteristics of financial system and financial activities. And financial risk management has become an important component of the scotch and financial system since the elapserence of financial in human society. everywhere the past few decades, economic globalization spread across the world with the falling drop of the Bretton Woods system. Under supra background, the financial markets subscribe become even more unstable due to some signifi do-nothingt changes. legion(predicate) events happened during the decades, including the Black Monday of the division 1987, the stock crisis in Japan in 1990, the European monetary crisis in 1992, the financial storm of Asia in 1997, the bankruptcy of Long-Term Capital Management in 1998, and the most recent global financial crisis triggered in the year 2008. All these changes brought enormous destruction of the smooth development of the world economy and the financial market. At the same beat, they also assistanceed people sureized the necessity and urgency of the financial risk management. Why did the crisis happened and how to stave off the risk as much as possible?These questions form been endowed more signifi pott means for the further development of the economy. Therefore, this report will review some important issues in the financial risk management introduce some theoretical foundation of financial risk management, and discuss the challenges faced by the modern financial risk management. II. The Definition and Types of Financial Risk The word risk itself is neutral, which means we cannot see risk a good thing or bad. Risk is o ne of the intimate features of human sort, and it comes from the incertitude of the future results.Therefore, briefly speaking, risk can be defined as the exposure to uncertainty. In the definition of risk, there are two extremely important factors first is uncertainty. Uncertainty can be considered as the distribution of the possibility of one or more results. To ingest risk, we pauperization to prolong a on the button explanation well-nigh the possibility of the risk. However, from the assign view of a risk manager, the possible result in the future and the characteristic of the possibility distribution are unremarkably unknown, so subjective factors are frequently geted when making decisions.The second factor is the exposure to uncertainty. Different human activities were diverged at divergent direct to the same uncertainty. For example, the future weather is uncertain to everyone, but the influence it has over agriculture can be far deeper than that over finance i ndustry or other industry.Based on the above description about risk, we could have a lightener definition of financial risk. Financial risk is the exposure to uncertainty of the participants in the financial market activities. The participants mainly refer to financial institutions and non-financial institutions, usually not including ndividual investors. Financial risk switch offs by countless dealings of a financial nature, including sales and purchases, investments and loans, and various other business activities. It can arise as a result of legal transactions, innovative projects, mergers and acquisitions, debt pay, the energy component of costs, or with the activities of management, stockholders, competitors, unconnected governments, or weather. (Karen A. Horcher). Financial risk can be divided into the hobby types according to the different sources of risk. A. securities industry risk.Market riskis theriskthat the grade of a portfolio, either an investment portfolio or a commerce portfolio. It will decrease due to the change in value of the market risk factors. The four cadence market risk factors are stock prices, spare-time activity rates, foreign exchange rates, and commodity prices. The influence of these market factors have over the financial participants can be both direct and indirect, like through competitors, suppliers or customers. B. Credit risk. Credit riskis an investors risk of loss arising from a borrower who does not make payments as promised. much(prenominal) an event is called adefault. Almost all the financial transactions have credit risk. Recent years, with the development of the internet financial market, the problem of internet finance credit risk also became prominent. C. liquid risk. Liquidity riskis the risk that a given security or asset cannot be traded quickly abundant in the market to prevent a loss. Liquidity risk arises from situations in which a party c at oncerned in trading anassetcannot do it because no body in themarketwants to trade that asset.Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their skill to trade. D. running(a) risk. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from foreign events. Nowadays, the study and management of operational risk is getting more attention. The organizations are trying to perfect their internal control to minimize the possibility of risk. At the same time, the mature guess of other subjects, such(prenominal) as operational research methods, are also introduced to the management of operational risk.Overall, financial risk management is a process to deal with the uncertainty resulting from financial markets. It involves assessing the financial risks facing an organization and developing management strategies arranged with internal priorities and policies. Addressing financial risks proactively m ay provide an organization with a competitive advantage. It also ensures that management, operational staff, stockholders, and the jump on of directors are in agreement on key issues. III. Risk Management and the Theoretical FoundationFinancial market participants attitude towards risk can be basically divided into the following categories. A. Avoid risk. It is irrational for some companies to approximate that they can avoid the financial risks though their careful management because of the following reasons. First of all, risk is the internal feature of human activities. Even though it doesnt have direct influence, it could generate indirect influence though the competitors, suppliers or customers. Moreover, sometimes it might be a better choice for the manager of the company to accept risk.For example, when the profit margin of the company is higher than the market profit margin, the manager can increase the value of the company by using financial supplement principle. Obviousl y, it will be harder to increase the value of a company if the manager is always using the risk avoidance strategy. B. Ignore risk. Some participants tend to ignore the existence of risks in their financial activities, thus they will not take any measures to manage the risk. According to a research of Loderer and Pichler, almost all the Swedish multinational companies ignored the exchange rate risk that they are facing. C. Diversify risk.Many companies and institutions choose to convert risk by putting eggs into different baskets, which means reaching the purpose of overthrow risk by holding assets of different type and low correlation. And the cost is relatively low. However, as to small corporations or individuals, diversifying risk is somehow unrealistic. Meanwhile, modern asset portfolio theory also tells us that diversifying risk could only lower the unsystematic risk, but not systematic risk. D. Manage risk. Presently, most people have realized that financial risk cannot be eliminated, but it could get managed though the financial theory and tools.For instance, participants can break down the risk they are exposed to by using financial engineering methods. After keeping some necessary risk, diversify the rest risk to others by using derivatives. But why do we need financial risk management? In other words, what is the theoretical foundation of the existence of financial risk management? The early financial theory argues that financial risk management is not necessary. The Nobel Prize superior Miller amp Modigliani pointed out that in a perfect market, financial measures like hedging cannot influence the firms value.Here the perfect market refers to a market without tax or bankruptcy cost, and the market participants own the complete information. Therefore, the managers do not need to worry about financial risk management. The similar theory also says that even though there will be slight moves in the short run, in the long run, the economy will move r elatively stable. So the risk management that is used to prevent the loss in short term is just a waste of time and resource. Namely, there is no financial risk in the long run, so the financial risk management in the short run will just offset the firms profits, and therefore tame the firms value.However, in reality, financial risk management has already roused more and more attention. The need for risk management theory and measures soar to unprecedented heights for both the regulator and participants of the financial market. Those who think risk management is necessary argue that the need for risk management is mainly based on the imperfection of the market and the risk abuse manager. Since the real economy and the financial market are not perfect, the manager can increase a firms value by managing risk.The imperfection of the financial market is shown in the following aspects. First, there are various types of tax existing in the real market. And these taxes will influence the earning flow of the firm, and also the firms value. So the Modigliani amp Miller theory does not work for the real economy. Secondly, there is transaction cost in the real market. And the smaller the transaction is, the higher the cost. Last but not least, the financial market participants cannot obtain the complete information. Therefore, firms can pull in from risk management.First, the firm can get stable cash flow, and thus avoid the external financing cost caused by the cash flow shortage, decrease the fluctuation range of the stock and keep a good credit record of the company. Secondly, a stable cash flow can guarantee that a company can invest success plentifuly when the opportunity occurs. And it gets some competitive advantage compared to those who dont have stable cash flow. Thirdly, since a firm possesses more resource and knowledge than an individual, which means it could have more complete information and manage financial risks more efficiently.If the manager of a fir m is risk aversion, he can improve the managers utility through financial risk management. Many researches show that the financial risk management activities have close relation to the managers aversion to risk. For example, Tufano studied the risk management strategy of American gold industry, and found that the risk management of firms in that industry has close relation to the contract that the managers signed about reward and punishment contracts.The managers and employees are full of enthusiasm about risk management is because that they put great amount of invisible capital in the firm. The invisible capital allows human capital and specific skills. So the financial risk management of the firms became some natural reaction to protect their devoted assets. In conclusion, although controversy is still going on about the financial risk management, there is no doubt that the theory and tools of financial risk management is adopt and used by market participants, and continue to be enriched and innovated.IV. The Process of Financial Risk Management The process of financial risk management comprises strategies that enable an organization to manage the risks associated with financial markets. Risk management is a dynamic process that should evolve with an organization and its business. It involves and impacts many parts of an organization including treasury, sales, marketing, tax, commodity, and corporate finance. Companys financial risk management can be divided into three major ill-uses, namely realisation or confirmation risk, measure risk and manage risk.Lets illustrate it using the market risk as an example. First, confirm the market risk factors that have a significant influence to the company, and hence measure the risk factors. At present, the frequently used measure of market risk approach can be divided into the relative measure and sheer(a) measure. A. The relative measure method It mainly measures the sensitiveness relationship amidst the mark et factors fluctuations and financial asset price changes, such as the duration and convexity. B. The absolute measure methodsIt includes variance or standard deviation and the absolute deviation indicator, mini max and value at risk (VaR). VaR originated in the 1980s, which is defined the maximum loss that may occur within a certain office aim. In mathematics, VaR is expressed as an investment vehicle or a combination of profit and loss distribution of ? -quantile, which stated as follows Pr ( ? p lt= VaR ) = ? , where, ? p said that the investment loss in the holding period within the confidence level (1 ? ). For example, if the VaR of a company is 100 jillion U. S. ollars in 95% confidence level of 10 days, which means in the next 10 days, the risk of loss that occurred more than 1 million U. S. dollars may of only 5%.Through this quantitative measure, company can clear its risks and thus have the ability to carry out the next step targeted quantitative risk management activ ities. (Guanghui Tian) The last step is management risk. Once the company identified the major risks and have a quantitative grasp of these risks through risk-measurement methods, those companies can use various tools to manage the risk quantitatively.There are different types of risk for different companies, even the same company at different stages of development. So it requires specific conditions for the optimization of different risk management strategies. In general, when the company considers its risk exposure more than it could bear, the following two methods can be used to manage the risk. The first way is changing the companys operating mode, to make the risk back to a sustainable level. This method is also known as Operation Hedge.Companies can adjust the supply channels of raw materials, set up production plants in the sales outright or adjust the volume of inflow and outflow of foreign exchange and other methods to achieve above purpose. The second way is adjust the c ompanys risk exposure through financial markets. Companies can take advantage of the financial markets. Companies can take advantage of the financial markets wide range of products and tools to misrepresent its risk, which means to offset the risk that the company may face through holding a reverse gear position.Now various financial derivative instruments provide a commensurate and diverse selection of products. first derivative products are financial instruments whose value is attached to some other underlying assets. These basic subject matters may be interest rates, exchange rates, bonds, stocks, stock index and commodity prices, but also can be a credit, the weather and even a snowfall in some ski showplace. Common derivatives include forward contracts, swaps, futures and options and so on. V.The Challenges Faced by the Modern Financial Risk Management Theory Over the recent years, as the sharpen of risk management hifts from a control function to one of global financial o ptimization, the concern shifts from modeling the behavior of engineered contracts in selected markets to modeling the evolution of the entire economy. This change of focus calls for a vastly improved ability to model the time evolution of economic quantities. (Sergio Focardi). While those who do risk management are interested in predicting if assets will go up or down, the over-riding interest is in the relationship in movement to different assets.Though linear methods such as variance-covariance help to understand the co-movements of markets, a different set of tools is necessary to better manage risk. (Jose Scheinkman). Paradigms such as learning, nonlinear dynamics and statistical mechanics will affect how risk from market and credit risk to operational risk is managed. While the first attempts to use some of these tools were focused on predicting market movements, it is now clear that these methodologies might positively influence many other aspects of economics.For instance, they could be useful in taking into custody phenomena such as price formation, the emergence of bankruptcy chains, or patterns of boom-and-bust cycles. Lars Hansen, Homer J. Livingston professor of economics at the University of Chicago, remarks that these in the altogether paradigms will bring to asset pricing and risk management at enhanced understanding once the implicit underlying fundamentals are better understood. He says What needed is a formal judicial admission of the market structure, the microeconomic uncertainty, and the investor preferences that is consistent with the posited nonlinear models.Commenting on the need to bring together the pricing of financial assets and the real economy, he notes that an understanding of whats behind pricing sensations to a better understanding of how assets behave. For risk management decisions that entail long-run commitments, he observes, it is particularly important to understand, beyond a purely statistical model, what is govern ing the underlying movements in security prices. Blake LeBaron, professor of economics at the University of Wisconsin-Medison, observes that there is now more interest in macro moves than in individual markets.But traditional macroeconomics typically provides only point forecasts of macro aggregates. In the risk management context, a simple point forecast is not sufficient a complete validated probabilistic framework is needed to perform operations such as hedging or optimization. One is after an entire statistical decision-making process. The big issue is the distinction between forecasts and decisions. (Blake LeBaron) Arriving at an entire statistical decision-making process implies reaching a better scientific explanation of economic reality.New theories are attempting to do so through models that reflect empirical selective information more consummate than traditional models. These models will improve our ability to forecast economic and financial phenomena. The endeavor is no t without its challenges. Our ability to model the evolution of the economy is limited. Prof. Scheinkman notes that unlike in a physical system where better data and more computing power can lead to better predictions, in social systems when a new level of understanding is gained, agents start to use new methods. Prof. Scheinkman says Less ambitious goals have to be set.Gaining an understanding of the broad features of how the structure of an economic system evolves or of relationships between parts of the system might be all that can be achieved. Prof. Scheinkman remarks that we might have to concentrate on finding those patterns of economic behavior that are not destroyed, at least not in the short-run, by the agent learning process. VI. evidence The theory foundation of modern financial risk management is the Efficient Markets Hypothesis, which notes that financial market is a linear balanced system.In this system, investors are rational, and they make their investment decision with rational expectations. This hypothesis shows that the changing of the future price of financial assets has no relation with the history information, and the return on assets should obey familiar distribution. However, the study of economic physics shows that financial market is a very complicated nonlinear system. At the same time, behavioral finance tells us that investors are not all rational when making decisions. They usually cannot completely understand the situation they are facing unlike hypothesized.And most times they will have cognitive bias, when they use experience or intuition as the basis of making decisions. It will lead to irrational phenomena like overreaction and under reaction when reflected on investment behaviors. Therefore, it will be meaningful to study how to improve the existing financial risk management tools, especially how to introduce the nonlinear science and behavior study into the measurement of financial risk.