Introduction – Essentials of Financial Risk Management

Introduction

Why a New Book on Financial Risk Management?

There are lots of books on financial risk management—why the need for this one? It is a very fair question. The reason we are writing this book is that we believe there is a need for a book on financial risk management for the rest of us; those of us who are not quantitative geeks, those of us who do not want to wade through a large number of formulas, those of us who do not want to deal with abstractions that take away from the real-world applicability of much of the world of risk management. In other words, a concise, yet thorough book on what one needs to know to be effective (rather than just knowledgeable) about risk management.

Financial risk management is managing the volatility and uncertainty of financial prices. In our ever-increasingly connected and global business landscape, managing the financial risks of a firm is more important than ever and perhaps more difficult to do properly. The good news is that there are lots of tools, tactics, and techniques for doing so. The not-so-good news is that many of these techniques are being developed for the quantitatively inclined, rather than for the practical business manager. This is the gap that this book aims to narrow significantly by providing a no-nonsense guide to the essentials of financial risk management.

Financial risk management has been an important aspect of corporate management probably since financial transactions replaced bartering as a mechanism for trade. There is evidence that early form of derivative contracts existed in biblical times, and in more or less continuous use since then. Financial risk management has continued to evolve, but a modern transformation took place when Fischer Black, Myron Scholes, and Robert Merton developed the Black-Scholes Merton option pricing model in the 1970s. Financial risk management exploded into the public conscience for all the wrong reasons as derivative debacles of the late 1990s led famed investor Warren Buffet to call derivatives “weapons of financial mass destruction”. Of course, derivatives, or more specifically Collateralized Debt Obligations and Credit Derivatives, again became front page buzz words during the financial crisis of 2008 as risk management techniques again seemingly not only failed but backfired.

This is, however, not a book about financial derivatives—although derivatives and derivative concepts frequently do play a role in financial risk management. This book is a common-sense approach for managing the day-to-day financial risks that come about from operating in our ever-increasingly connected and global world. At a time when focus on implementing a competitive strategy is as important as ever, no firm is safe from having their well-thought-out plans derailed by unexpected volatility in financial prices. Failure to properly manage financial risks generally leads to failure or at least a damaged reputation of the managers and the directors. That being so, it is incumbent upon managers and directors to have a firm grasp of risk management principles and to effectively develop and implement an appropriate risk management strategy.

The aim of this book is to cut through the clutter and get to the essence of best practices in financial risk management. It is a book based in theory but focused on practice and being practical in its approach. It is a book for those who need to practice financial risk management, rather than theorize about financial risk management. It is not a “Dummies” book. It is a book for the intelligent and thoughtful manager who wants to as efficiently as possible gain the financial risk management knowledge and know-how necessary so they can get on to their foremost job of managing their department or even the firm.

Who This Book Is Intended For

This book is first and foremost for practitioners. It is intended for those managers who understand the importance of financial risk management for the achievement of their goals. While the manager may not actually be implementing the financial risk management tactics themselves, they realize the importance of knowledge of the principles so they can intelligently integrate their operational strategies with the financial risk management strategy. Knowledge of risk management strategies allows one to implement strategies with a higher degree of confidence with a lower probability of derailment due to unforeseen financial events.

The book is also a useful primer for the general manager who wants to expand their skill set. Financial risk management knowledge is increasingly necessary for senior managers. If one aspires to senior management, then financial risk management is a key piece of the skill and knowledge set needed.

The original impetus for this book was the increasing demand for training for Boards of Directors that we encountered. Financial risk management expertise is not a nice-to-have feature, but instead it is a necessity for Board members. In recognition of this, Chapter 10 on Risk Governance has a section dedicated to the specific issues that Board members need to pay attention to.

This book is also a practical guide for the investor who wishes to learn more about financial risk management in the goal of making better investment decisions. An understanding of a firm’s financial risk management practices can certainly help an investor build a much better risk adjusted and performing portfolio. Understanding a firm’s risk management strategies not only helps identify when a firm may be exposed to unwanted adverse moves, but also provides insight into economic situations where a firm may be particularly well positioned competitively.

This book, particularly when combined with its sister books (Rethinking Risk Management: Critically Examining Old Ideas and New Concepts,1 and Essentials of Enterprise Risk Management2), forms the basis for a comprehensive course in risk management. We have used the materials for this series of books in MBA-level courses and Executive training seminars and corporate training programs for several years. Students appreciate the practical yet rigorous approach as contrasted with the dry academic style of many other financial risk management texts.

Finally, the book is also suitable for other stakeholders such as regulators, lawyers, or accountants who need a concise yet comprehensive practical understanding of financial risk management.

A Few Central Tenets

Before concluding this Introduction, we would like to mention the six central tenets of this book that will be covered in depth in Chapter 1 and which form the basis of our philosophy of financial risk management. These tenets are: (1) firms (with the exception of financial institutions) are not in business to take financial risk, (2) deciding not to hedge a financial risk is still a hedging decision, (3) hope is not a prudent financial risk management strategy, (4) the appropriate definition of risk is that risk is the possibility that bad or good things may happen, (5) the only perfect hedge is in a Japanese Garden, and (6) financial risk management is a value-added activity.

Perhaps the most significant tenet of this book is that financial risk management is a value-added activity. It is our aim to have you, the reader, believe that taking the time to go through this book was indeed a value-added activity.

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1R. Nason. 2017. Rethinking Risk Management: Critically Examining Old Ideas and New Concepts (New York, NY: Business Experts Press).

2R. Nason and L. Frade. 2018. Essentials of Enterprise Risk Management. (New York, NY: Business Experts Press).