Risk Management

There are numerous risks in investment and financing decisions involving foreign currencies.  Some risks (such as exchange rate risk) affect all cross border currency movements, while others are limited to investment decisions or financing decisions.  Risk management requires that these risks be identified, quantified and monitored.  Systems and procedures ought to be enunciated to articulate top management response to, and awareness of, enterprise risk management.  Managing risk can involve risk sharing, risk transfer or risk mitigation through hedging.  Risk elimination is the ideal situation, but not all risks can be eliminated in spite of the best attempts.  This is because the response to risk is ex ante, while the impact of the risk and the effectiveness of the response can be assessed only ex post. 

Adequacy of response is judged by the ability to enforce contractual terms.  Response adequacy varies with the credit standing of the parties to the contract, agreement or guarantee.  It is also affected by the enforceability of the contractual obligations, the willingness of parties to arrive at a compromise, and the degree of autonomy of the judicial system.  In this sense, tradable financial contracts (such as futures and exchange traded options contracts) are the safest in terms of the third party guarantee becoming automatically and consistently applied to ensure that the contractual obligations are met.

A comprehensive discussion of the taxonomy of risk management techniques is beyond the scope of international finance.  But risk management is fundamental to international finance since all parties to contracts that involve cross-border movements of currency desire risk management solutions.  Here we examine risks from the perspective of the business firm as a purchaser of inputs and seller of output, and from the perspective of the investor in financial securities. Selection of risk management method is also subject to availability. Enterprise risk management is a new discipline which examines a holistic treatment of financial and non-financial risks.  Risk management is central to value maximizing behavior, and as in the case of financial management, the objective of the firm is assumed to be wealth maximization.  Some of the most significant risks are political risk, exchange rate risk, counter-party risk and liquidity risk.