Introduction to Corporate Finance

ONLINE CHAPTER

23 -1 OVERVIEW OF FINANCIAL RISK

MANAGEMENT

Risk management involves identifying potential events that represent a threat to a company’s cash

flows, and either minimising the likelihood of those events occurring or minimising their impact on the

company’s cash flows. This process includes company-specific events, such as workers’ compensation

claims, product recalls, product liability claims and loss from fire or flood. However, in this chapter

we focus on elements of risk management that deal with market-wide sources of exposure, such as

movements in foreign exchange rates, interest rates and commodity prices.

23 -1a RISK FACTORS

Chapters 6 and 7 introduced the concepts of systematic and unsystematic risk. Systematic risks affect a

broad class of securities simultaneously, and cannot be eliminated through diversification. The underlying

forces that drive systematic risks are largely out of the control of managers, but managers can take certain

actions to minimise the impact of these risks on their companies’ cash flows.

If a change in the level of interest rates will adversely affect the cash flows of a company, that

company is exposed to interest rate risk. An increase in interest rates might reduce a company’s cash flows

by increasing the company’s borrowing rate, but a decrease in interest rates could also have a negative

impact on cash flows by reducing the returns that a company earns on its assets. According to the survey

of risk managers by Bodnar and colleagues, interest rate risk is the single most common concern among

LO23.1

FIGURE 23.1 RISK MANAGERS REPORT INCREASES IN COMMON RISKS FACING THEIR COMPANIES

Survey responses from 1161 risk managers around the world indicate that a majority of the managers believe that foreign

exchange risk, interest rate risk and commodity price risk have all increased significantly since 2006.

0%

10%

20%

30%

40%

50%

60%

70%

Increased No change Decreased

Foreign exchange risk Interest rate risk Commodity price risk

interest rate risk
The risk that changes in
market interest rates will
cause fluctuations in a
bond’s price. Also, the risk of
suffering losses as a result
of unanticipated changes in
market interest rates

Source: Bodnar, Graham, Harvey and Marston, ‘Managing Risk Management: Evidence from a Global Survey of Risk Managers’. Unpublished working paper.