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WHEN TO USE FINANCIAL RISK MANAGEMENT Finance theory (i.e. , the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm.'' In practice, financial markets are not likely to be perfect markets. This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is that Market Risk s that result in Unique Risk s for the firm are the best candidates for financial risk management. IMPORTANT FINANCIAL INSTRUMENTS Derivatives are commonly used in financial risk management, because of their ability to offset specific risks, such as Interest Rate risk and Exchange Rate risk. Over-the-counter Derivatives such as Swaps and Forward Contract s have the advantage that they can be tailor-made to match exactly the specific risks, though they tend to be costly to create and monitor. Standardized derivatives that trade on Futures Exchange s, such as Options Contracts and Futures Contract s are more cost-effective, but often leave small risks, as the standardized contracts rarely match the risks exactly. REFERENCES 1 2 3 4 5 SEE ALSO EXTERNAL LINKS
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