Question

How does risk affect a company's financial decisions? What risks should a CFO consider in making a decision? Name at least five and describe each.

Please don't copy some else's work.

Please don't hand write.

Thank you.

Answer 1

Financial risk is caused due to market movements and market movements can include a host of factors. The risks that affect company's financial decisions are:-

• Market Risk:This type of risk arises due to the movement in prices of financial instrument. Market risk can be classified as Directional Risk and Non-Directional Risk. Directional risk is caused due to movement in stock price, interest rates and more. Non-Directional risk, on the other hand, can be volatility risks.

• Credit Risk:This type of risk arises when one fails to fulfill their obligations towards their counter parties. Credit risk can be classified into Sovereign Risk and Settlement Risk. Sovereign risk usually arises due to difficult foreign exchange policies. Settlement risk, on the other hand, arises when one party makes the payment while the other party fails to fulfill the obligations.

• Liquidity Risk:This type of risk arises out of an inability to execute transactions. Liquidity risk can be classified into Asset Liquidity Risk and Funding Liquidity Risk. Asset Liquidity risk arises either due to insufficient buyers or insufficient sellers against sell orders and buys orders respectively.

• Operational Risk:This type of risk arises out of operational failures such as mismanagement or technical failures. Operational risk can be classified into Fraud Risk and Model Risk. Fraud risk arises due to the lack of controls and Model risk arises due to incorrect model application.

• Legal Risk:This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company needs to face financial losses out of legal proceedings, it is a legal risk.

As the principal manager of the company's capital structure, the CFO is the custodian of the company's ultimate risk capital equity. Risk taking is necessary for growth so the question becomes which risks provide the most bang for the buck. CFOs cannot answer this question alone, but they can lead the top management (and board) discussion on risk appetite and preference  and ground it with facts about implications.