Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, olatility, Sector, !i"uidity, #nflation risks, etc. Similar to general risk management, financial risk management re"uires identifying its sources, measuring it, and plans to address them. Financial risk management can be "ualitative and "uantitative. As a speciali$ation of risk management, financial risk management focuses on %hen and ho% to hedge using financial instruments to manage costly exposures to risk. #n the banking sector %orld%ide, the &asel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks. Financial risk management is a business process that helps a corporation avoid losses because of changes in financial product prices or business partner defaults. Financial risk management tools typically use mathematical and statistical formulas to identify, assess and control risks. Financial risk management activities focus primarily on market and credit risks. '(R 'OS)S*- A financial risk management process includes all mechanisms and policies that a company+s top management puts into place to avoid ,or limit- losses due to security prices or trade partner defaults. For example, a financial risk management program at .ompany A, a larger retailer in .alifornia, may cover policies that managers establish to avoid losses that may originate from customer defaults. .ompany A+s policies may re"uire credit history checks for all customers %ho use corporate credit cards to purchase more than /0,111 %orth of goods. F(2.3#O2S*- Financial risk management professionals help a corporation prevent losses inherent in financial transactions. A financial risk management specialist typically holds an advanced degree--for instance, a master+s or a doctorate degree--in mathematics, statistics or investments. A financial risk management specialist uses math skills to build complex tools and computer models that appraise and monitor financial risks. A financial risk management specialist also may be a financial auditor %orking for a public accounting firm or the internal audit department of a company. 1
34')S*- Financial risk management activities focus primarily on t%o types of risk---market and credit. 5arket risk is the risk of loss that may arise if security prices vary. For example, .ompany &, a beer distribution company, o%ns /0.6 million %orth of stock in its short-term portfolio. After three months, the portfolio+s value fell to /0 million. 3he loss of /611,111 is due to market risk because security prices in the portfolio dropped. .redit risk is the risk of loss that arises %hen a business partner files for bankruptcy. For example, .ompany & may lose if a ma7or customer ,%ho o%es /0 million- files for bankruptcy. &)2)F#3S*- Financial risk management activities focus primarily on t%o types of risk---market and credit. 5arket risk is the risk of loss that may arise if security prices vary. For example, .ompany &, a beer distribution company, o%ns /0.6 million %orth of stock in its short-term portfolio. After three months, the portfolio+s value fell to /0 million. 3he loss of /611,111 is due to market risk because security prices in the portfolio dropped. .redit risk is the risk of loss that arises %hen a business partner files for bankruptcy. For example, .ompany & may lose if a ma7or customer ,%ho o%es /0 million- files for bankruptcy. When to use financial risk management Finance theory ,i.e., financial economics- prescribes that a firm should take on a pro7ect %hen it increases shareholder value. Finance theory also sho%s that firm managers cannot create value for shareholders, also called its investors, by taking on pro7ects that shareholders could do for themselves at the same cost. 8hen applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. 3his notion %as captured by the hedging irrelevance proposition* #n a perfect market, the firm cannot create value by hedging a risk %hen the price of bearing that risk %ithin the firm is the same as the price of bearing it outside of the firm. #n practice, financial markets are not likely to be perfect markets. 3his suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management. 3he trick is to determine %hich risks are cheaper for the firm to manage than the shareholders. A general rule of thumb, ho%ever, is that market risks that result in uni"ue risks for the firm are the best candidates for financial 2
risk management. 3he concepts of financial risk management change dramatically in the international realm. 5ultinational .orporations are faced %ith many different obstacles in overcoming these challenges. 3here has been some transactions exposure, accounting exposure, and economic exposure. INTR!"CTIN Risk 5anagement is the process of managing the risks involved in various activities. #t is, in fact, a 9rapidly developing discipline: %hich applies to 9any activity %hether short or long term: ,#R5, A#R5#., and A!AR5, ;11;* 0-. Risk 5anagement is being increasingly implemented in various disciplines, organi$ations and industries to minimi$e negative impacts and form a sound basis in decision making ,Stoneburner, <oguen, and Feringa, ;11;-. W#$ RISK MANAGEMENT% 3ranslation practice is a purposeful activity re"uiring constant decision making. =o%ever, decisions cannot be made %ithout considering the re"uirements of the 7ob at hand, the client, the governing la%, market, recipients, norms, culture, budget and other factors. !ooking at the translation industry, %e can also trace a broad range of responsibilities and decision making situations %hich translation service providers and outsourcers are faced %ith and must handle every day. 8hen the factors affecting the decision making process increase 7ust like above, it becomes really difficult to take into account and manage all of them in an all-inclusive manner. 8ithout a proper risk management scheme, handling this extensive range of decision making situations and risks and taking into account all issues affecting and resulting from the decisions can turn into a laborious task. Also, in the current competitive market %hich more often than not, role players prefer not to share their management plans and experiences %ith others, it is even harder and more exhaustive for the beginners to survive. 3hey, in fact, have to pass through a long term trial and error to learn ho% to make proper decisions. 3his inevitably involves frustration, unexpected failure and profit loss before they can gain some experience to come up %ith a proper scheme. 3hat is all because, they have not been taught ho% to deal %ith decision making situations and risks involved in translation practice and industry during theireducation. 'erhaps it is better to say, there has been no risk management guideline, scheme, or policy in the first place to be incorporated into translator training programs. 3
#t can be claimed that the process of risk management has al%ays been there in translation practice and industry in the sense that translators and pro7ect managers in translation companies have al%ays been subconsciously trying to control the risks pertinent to their activities. 3his is in fact %hat 'ym has been trying to prove by interpreting the results of other researchers> investigations in terms of risk management ,'ym ;11?@ ;11A-. RISK MANAGEMENT IN TRANSLATIN Risk management here can be defined as the process %hereby role players in translation practice and industry systematically address the risks attached to their activities %ith the goal of achieving success %ithin each activity and across the portfolio of all activities. According to #R5 et al ,;11;* ;-, 93he focus of good risk management is the identification and treatment of these risks: and 9#t increases the probability of success, and reduces. RISKS AN! S"CCESS IN TRANSLATIN 3he purpose in translation practice and industry is to achieve success in general. Success is, in fact, the 9re%ard: ,'ym, ;11A- role players achieve %hen they handle their 7ob properly. =ere are some examples of re%ard* self satisfaction, financial re%ard in forms of monthly salary, bonus or a raise in the salary, successful communication, avoidance of criticism, getting published, being %ell received by the society, etc. 3herefore, re%ard can be defined as %hat the role players in translation practice and industry expect to achieve from doing their activities. #t is also %orth mentioning that re%ards can fall under various categories, three of %hich have been pointed out by 'ym ,;11A- as financial, symbolic or social. As you can see, success is mostly mutual, meaning that you benefit from your %ork if your recipients %ho can be your manager, your client, or the public are satisfied %ith your Risk in translation practice and industry, is better reali$ed %hen in correlation %ith success. 3herefore, risk %ould be the potential for events, decisions and conse"uences in translation practice and industry %hich constitute opportunities or threats to success. Risk itself can be divided into three categories of low,medium and high based on the probability or fre"uency of occurrence and the impact of occurrence. Also factors resulting in risks or 9drivers of risks: ,#R5 et al, ;11;- can be internal or external to translation activity or a mixture of both. 3here are five ma7or risks %hich role players in translation practice and industry have to constantly deal %ith considering the types of activities they are engaged in* market risks, financial risks, &ro'ect risks, &ro(uction &rocess risks, and &ro(uct risks. 4
Market risks .an be defined as those risks in the market %hich can positively or negatively affect the translation practice and industry and include among others market fluctuations and rivals. Financial risks Are those risks %hich can affect the profitability of translation activity or translation companies in a positive or negative %ay. One example can be the current ups and do%ns in foreign exchange rates %hich may cause freelance translators and translation companies to revise the foreign currencies they accept either to benefit from %hat may appear to them as opportunity or prevent loss. )ro'ect risks Refer to the risks each ne% pro7ect brings %ith it %hich can affect the profitability of the translation activity or company, the production process and the final product of translation activity in a positive or negative %ay. 'ro7ect risks include those risks regarding the clients> reliability, pro7ect difficulty, soft%are needed for the pro7ect, %ord count, deadline, human resources and the like. #t might be argued that the remaining t%o categories can fall under the pro7ect risks category@ ho%ever as you %ill see, due to their importance and different nature, production process risks and product risks have each formed a category, "uite separate from the pro7ect risks category. &y production process, the author is referring to the actual act of translation@ thus, &ro(uction &rocess risks 8ould be those risks %hich role players constantly face during the process of translation and the %ay they treat such risks may ultimately bring about success or failure for them. &ro(uct risks Are those risks %hich can positively or negatively affect the success of the final product of the translation process. Risks related to the acceptability, formatting and B3' issues of the translation product can be categori$ed under the product related risks. From the definitions provided above, %e can categori$e market, financial, and pro7ect risks as externally driven risks and production process and product risks as internally driven risks. #t is important to note that according to the definitions provided above, risks are not al%ays considered as threats and they may ultimately constitute an opportunity for benefit and 5
success. Furthermore, as you can see these risks can be interrelated and the occurrence of one can intensify the occurrence and impact of another. RISK MANAGEMENT )RCESSES #n order for role players in translation practice and industry to successfully manage risks, they must go through a series of risk management processes. .lose adherence and follo% up of these processes, %hich are briefly described belo%, is crucial to the achievement of success. RISK ASSESSMENT Risk Assessment is defined by the #SOC#). <uide ?D as the overall process of risk anal*sis and risk e+aluation. RISK ANAL$SIS According to #SOCB#S D0111 ,;11E-, Risk analysis is performed through* Risk I(entification Risk !escri&tion Risk Estimation Risk Identification helps the role players in translation practice and industry find out their 9exposure to uncertainty: ,#R5 et al, ;11;* 6-. 3o successfully identify possible risks, role players need to have professional kno%ledge of their 7ob, be a%are of the market condition and re"uirements, and kno% the legal, social, political and cultural environment in %hich they are %orking. Risk Description is meant to display the identified risks in translation practice and industry in a structured format %hich explains the name, scope, nature, and significance of the risk along %ith the role player+s risk tolerance and control mechanism. Finally, Risk Estimation is made in terms of the probability of occurrence and the possible conse"uence of the risks in translation practice and industry. Role players need to use the result of the risk analysis process to produce a risk profile %hich gives a significance rating to each risk and provides a tool for prioriti$ing risk treatment efforts. RISK E,AL"ATIN Risk evaluation is used to make decisions about the significance of risks to translation practice and industry and %hether each specific risk should be accepted or treated. 3he 6
decision needs to be made based on the risk criteria %hich can include associated costs and benefits, and legal re"uirements of dealing %ith each risk. RISK RE)RTING AN! CMM"NICATIN Risk reporting and communication needs to be done at t%o levels* #nternal and )xternal. #nternal reporting and communication involves publishing a clear risk management policy by the freelance translator or the manager of the translation company to be used %hen facing a risk. )xternal reporting %orks on a bigger scale and can target the publication industry, organi$ations, and ministries governing education and publication. 3ranslation companies and translation departments of universities can report and publish their risk management policies and their effectiveness in achieving ob7ectives on a regular basis and actively take part in producing and updating risk management policies for translation practice and industry. RISK TREATMENT According to #R5 et al ,ibid-, 9risk treatment is the process of selecting and implementing measures to modify the risk:. An important fact role players in translation practice and industry need to keep in mind is that risk treatment actions must be financially 7ustifiable, meaning that they must be cost effective. Risk treatment actions in translation practice and industry need to be prioriti$ed in terms of their potential to success and re%ard achievement and as mentioned earlier, they must be concerned %ith both positive and negative aspects of risk. 'ym ,;11A, p. ;1- has ackno%ledged the importance of such an approach in his la% like formulation about ho% translators translate* 93ranslators %ill tend to avoid risk by standardi$ing language andCor channeling interference, if and %hen there are no re%ards for them to do other%ise:. Four ma7or strategies role players can implement in order to successfully manage risks in the translation practice and industry, are explained belo% %ith an example for each of them. Risk A+oi(ance ,avoiding or eliminating the risk-* e.g. during the process of translation, you come across a complex sentence and there is the fear that some part of the meaning implicit in the original text might be lost or the reader %ould not be able to understand the meaning if the sentence is translated as a complex sentence. 3herefore, you decide to avoid the risk by breaking the original sentence and translating it into a compound sentence. One possible re%ard* avoiding misunderstanding, or achieving communicationF 8hat explained is called 9explicitation: according to &aker ,0EEG, p.0A1- and is one of &aker>s proposed 7
universals. =o%ever, bear in mind that explicitation is not exclusive to risk avoidance and may be used as a risk reduction strategy in another context. Risk Re(uction-Mitigation ,reducing or mitigating the risk-* e.g. %hile translating, you come across a term %hich does not have any e"uivalence in the target language and its translation turns into an a%k%ard phrase. 3o reduce the risk of miscommunication, you may resort to transliteration. One possible re%ard* achieving communicationF Risk Transfer ,outsourcing or transferring the risk-* e.g. you have translated a book but you are not sure about the market response and don>t %ant to budget for the publication. 3herefore you %ould try to transfer the risk by managing to convince a publication company to publish the translation and pay for the publication expenses and in return you revoke your re"uest for royalty. One possible re%ard* you get publishedF Risk Retention ,accepting the risk and budgeting for it-* e.g. the publication company you %ork %ith, does not accept to pay for the publication of a book you have chosen to translate or have already translated@ ho%ever for some reason, you are determined to translate and publish the book and decide to take the risk and pay for the publication expenses. One possible re%ard* self satisfaction perhapsF Also you get publishedF- 3hese strategies can be used separately or in combination based on the freelance translators and translation companies> risk management plan. MNITRING AN! RE,IEW F T#E RISK MANAGEMENT )RCESSES As mentioned earlier, in order for risk management to be effective, %e need 9a reporting and revie% structure to ensure that risks are effectively identified and assessed and that appropriate controls and responses are in place: ,#R5 et al, ;11;* 00-. #mplementation of this stage also ensures that our risk management plan is up-to-date and in consistent %ith current translation market situation. 8
RISK MANAGEMENT IN ACTIN #n order to sho% ho% risk management can be implemented into translation practice and industry, a case scenario is created in %hich a financial risk is raised. 3he pro7ect manager of a translation company has received an offer for a translation 7ob. After checking issues such as client reliability, 7ob difficulty, %ord count, and deadline of the pro7ect, the pro7ect manager is no% considering the rate suggested by the client. 3he follo%ing table represents the pro7ect description* Ta.le )ro'ect (escri&tion .lient 5r. H, returning client, reliable 'ro7ect 2ame &us manual Service needed 3ranslation Source text difficulty Bifficult@ 3echnical 8ord count D1111 %ords Beadline 3ight@ 01 days Soft%are need SB! 3rados 35 2ot provided .lient>s suggested rate 1.1G (SB per %ord .ompany>s ideal rate for such 7ob based on 5arket rates 1.1A (SB per %ord Rate usually paid to translator,s- of the company for such 7ob 1.1I (SB per %ord Other costs 1.116 (SB per %ord 9
Figure Financial risk management mo(el Cre(it risk is an investor+s risk of loss arising from a borro%er %ho does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk. #nvestor losses include lost principal and interest, decreased cash flo%, and increased collection costs, %hich arise in a number of circumstances* A consumer does not make a payment due on a mortgage loan, credit card, line of credit, or other loan A business does not make a payment due on a mortgage, credit card, line of credit, or other loan A business or consumer does not pay a trade invoice %hen due A business does not pay an employee+s earned %ages %hen due A business or government bond issuer does not make a payment on a coupon or principal payment %hen due An insolvent insurance company does not pay a policy obligation An insolvent bank %on+t return funds to a depositor A government grants bankruptcy protection to an insolvent consumer or business. 10
Financial Risk Management Financial Risk Management is the sub7ect %here you %ill find the %ay to manage to your all types to financial risk. 2o% it has been in ma7or business sector specialists are doing optimi$ation on risk management. #t doesn+t mean that financial risk management %ill come in the same. Risk management is certainly a good manner to save companies asset J keep distance from liabilities. &ut financial risk management is not a big part of risk management. 4es some ho% it+s related # can not push aside. Finance theory provides that a middle level company should take a pro7ect %hen shareholder value %ill increase. And it has been also seen that share holders value creates by business manager, %hich is also kno%n as investors %hen you are applying your thoughts for optimi$ing financial risk management means, business managers should not prevaricate risks those investors can protect them the same cost. 3his impression is captured by the coverage irrelevance suggestion* #n market, the company can create value by covering a risk %hen the price of abiding that risk %ithin the enterprise is the same as the price of carrying out the company. 2o% the eti"uette of financial risk management is getting changed %orld %ide. Some %here financial risk management is related to enterprise risk management ,)R5- that is the extent of financial risk management, in a sense, the financing contingency. 3his concept is some%here elusive that has different meanings to different people. .ompanies have experimented %ith the concept, %hich combines financial risk management, contingency plans and purchasing insurance in a single business unit. &ut some expertise professionals are there %ho can maintain both. Financial risk management is applied in different %ays if you see organi$ationally. #n the board, there may be a risk committee. (sually there has some kind of risk committee composed of senior managers. #n practice, several names are given to these t%o committees. Kust like .RO ,chief risk officer- and =R5 ,=ead of the risk management-. 3hese designation looks into the risk management. 3hey look into the financial risk management %hich includes credit risks, operational risks, and market risks. 11
3he financial %orld re"uires professionals %ith strong analytical J mathematical skills basically this is the combination of finance %ith mathematics, economics, accountancy, and risk management. 'repare you for a career in investment management and risk management. 4ou can choose one of t%o speciali$ations* Risk 5anagement 'rofessional and Chartere( Financial Anal*sis/ Fi+e 0a*s to manage financial risk Financial risk management is a sub7ect from %hich %e can get the kno%ledge to manage our all financial risk. 2o% the "uestion is ho% to manage the financial risk. 0st of all %e should kno% that %hat kind of financial risk there... =ere pointed out some ma7or risks... Market Risk Cre(it Risk Li1ui(it* Risk &erational Risk re&utation risk Count* Risk No0 ho0 0ill *ou manage financial risk% #ere *ou 0ill fin( fi+e 0a*s to manage financial risk 2 12
3/ Carr* the right amount of insurance. 4es, #nsurance is right %ay to manage your finance. 4ou %ill see that there is very less percentages that have got the right amount of insurance. 5any people takes an enormous risk of not having auto insurance coverage, %hile many more are 7umping out in medical insurance, health insurance or any ma7or coverage. (nfortunately, sometimes to cover the premiums there is not enough in the budget. &ut if you can afford it, do be sure to keep policies should be up to date and ade"uate for their circumstances. 4/ !i+ersif* *our income 5 *our in+estment/ 8hen # read about the problems of %orkers in the auto industry, # can understand about the importance of developing multiple %ay of income. 5y best advice is that invest your money as earliest possible to start %orking for you. 4ou should about your money that its source of another income generator, other %ays to create ne% revenue =ere is some evidence that demonstrates that diversification of the stock market %orks and is the best %ay to balance the overall portfolio risk. 6/ 7uil( an emergenc* fun(/ 8hen # started to save, my first priority %as to build an emergency fund. Becided that part of my savings should be in a short-term savings ,savings aCc preferable- and ho% much to 13
implement in the long-term investments. 8/ Kee& *our sa+ings un(er F!IC limits/ Al%ays try to keep your savings under FB.# limits, and remember that if your bank gets folded then you can lost your money as your banker %ill give you guarantee up to certain FB#. limits. 9/ Limit (e.t an( use cre(it 0isel*/ 4ou should not carry a much amount of debt. &ut you can use credit card, if you have control on your spending. 4ou should remember that credit is tool and %e should not abuse it. And if you follo% these five %ays to manage financial risk certainly you %ill be beneficial. T*&es of Li1ui(it* Risk 5arket li"uidity - An asset cannot be sold due to lack of li"uidity in the market - essentially a sub-set of market risk. 3his can be accounted for by* 8idening bidCoffer spread 5aking explicit li"uidity reserves !engthening holding period for aR calculations Funding li"uidity - Risk that liabilities* .annot be met %hen they fall due .an only be met at an uneconomic price .an be name-specific or systemic &erational risk An o&erational risk is, as the name suggests, a risk arising from execution of a company+s business functions. #t is a very broad concept %hich focuses on the risks arising from the people, systems and processes through %hich a company operates. #t also includes other categories such as fraud risks, legal risks, physical or environmental risks. A %idely used definition of o&erational risk is the one contained in the &asel ## regulations. 3his definition states that operational risk is the risk of loss resulting from inade"uate or failed internal processes, people and systems, or from external events. 14
3he approach to managing operational risk differs from that applied to other types of risk, because it is not used to generate profit. #n contrast, credit risk is exploited by lending institutions to create profit, market risk is exploited by traders and fund managers, and insurance risk is exploited by insurers. 3hey all ho%ever manage operational risk to keep losses %ithin their risk appetite - the amount of risk they are prepared to accept in pursuit of their ob7ectives. Financial risk mo(eling Financial risk mo(eling refers to the use of formal econometric techni"ues to determine the aggregate risk in a financial portfolio. Risk modeling is one of many subtasks %ithin the broader area of financial modeling. Risk modeling uses a variety of techni"ues including market risk, value at risk ,aR-, historical simulation ,=S-, or extreme value theory ,)3- in order to analy$e a portfolio and make forecasts of the likely losses that %ould be incurred for a variety of risks. Such risks are typically grouped into credit risk, li"uidity risk, interest rate risk, and operational risk categories. 5any large financial intermediary firms use risk modeling to help portfolio managers assess the amount of capital reserves to maintain, and to help guide their purchases and sales of various classes of financial assets. Formal risk modeling is re"uired under the &asel ## proposal for all the ma7or international banking institutions by the various national depository institution regulators. #n the past, risk analysis %as done "ualitatively but no% %ith the advent of po%erful computing soft%are, "uantitative risk analysis can be done "uickly and effortlessly. !i+ersification #n finance, (i+ersification means reducing risk by investing in a variety of assets. #f the asset values do not move up and do%n in perfect synchrony, a diversified portfolio %ill have less risk than the %eighted average risk of its constituent assets, and often less risk than the least risky of its constituents. 3herefore, any risk-averse investor %ill diversify to at least some extent, %ith more risk-averse investors diversifying more completely than less risk-averse investors. Biversification is one of t%o general techni"ues for reducing investment risk. 3he other is hedging. Biversification relies on the lack of a tight positive relationship among the assets+ returns, and %orks even %hen correlations are near $ero or some%hat positive. =edging relies on negative correlation among assets, or shorting assets %ith positive correlation. 15
!i+ersifia.le an( non:(i+ersifia.le risk 3he .apital Asset 'ricing 5odel introduced the concepts of diversifiable and non- diversifiable risk. Synonyms for diversifiable risk are idiosyncratic risk and security-specific risk. Synonyms for non-diversifiable risk are systematic risk, beta risk and market risk. #f one buys all the stocks in the SJ' 611 one is obviously exposed only to movements in that index. #f one buys a single stock in the SJ' 611, one is exposed both to index movements and movements in the stock relative to the index. 3he first risk is called 9non-diversifiable,: because it exists ho%ever many SJ' 611 stocks are bought. 3he second risk is called 9diversifiable,: because it can be reduced it by diversifying among stocks, and it can be eliminated completely by buying all the stocks in the index. Of course, there+s nothing special about the SJ' 611@ the same argument can apply to any index, up to and including the market portfolio of all assets. 3he .apital Asset 'ricing 5odel argues that investors should only be compensated for non- diversifiable risk. Other financial models allo% for multiple sources of non-diversifiable risk, but also insist that diversifiable risk should not carry any extra expected return. Still other models do not accept this contention . S*stematic risk #n finance, s*stematic risk, sometimes called market risk, aggregate risk, or un(i+ersifia.le risk, is the risk associated %ith aggregate market returns. &y contrast, uns*stematic risk, sometimes called specific risk, i(ios*ncratic risk, resi(ual risk, or (i+ersifia.le risk, is the company-specific or industry-specific risk in a portfolio, %hich is uncorrelated %ith aggregate market returns. (nsystematic risk can be mitigated through diversification, and systematic risk can not be. L0M Systematic risk should not be confused %ith systemic risk, the risk of loss from some catastrophic event that collapses the entire financial system. S*stematic risk an( &ortfolio management <iven diversified holdings of assets, an investor+s exposure to unsystematic risk from any particular asset is small and uncorrelated %ith the rest of the portfolio. =ence, the contribution of unsystematic risk to the riskiness of the portfolio as a %hole may become negligible. 16
#n the capital asset pricing model, the rate of return re"uired for an asset in market e"uilibrium depends on the systematic risk associated %ith returns on the asset, that is, on the covariance of the returns on the asset and the aggregate returns to the market. !enders to small numbers of borro%ers ,or kinds of borro%ers- face unsystematic risk of default. 3heir loss due to default is credit risk, the unsystematic portion of %hich is concentration risk. #e(ge A he(ge is an investment position intended to offset potential losses that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, for%ard contracts, s%aps, options, many types of over-the- counter and derivative products, and futures contracts. 'ublic futures markets %ere established in the 0Eth century L0M to allo% transparent, standardi$ed, and efficient hedging of agricultural commodity prices@ they have since expanded to include futures contracts for hedging the values of energy, precious metals, foreign currency, and interest rate fluctuations. T*&es of he(ging =edging can be used in many different %ays including foreign exchange trading. LDM 3he stock example above is a NclassicN sort of hedge, kno%n in the industry as a pairs trade due to the trading on a pair of related securities. As investors became more sophisticated, along %ith the mathematical tools used to calculate values ,kno%n as models-, the types of hedges have increased greatly. #e(ging strategies )xamples of hedging include* For%ard exchange contract for currencies .urrency future contracts 5oney 5arket Operations for currencies For%ard )xchange .ontract for interest 5oney 5arket Operations for interest Future contracts for interest 3his is a list of hedging strategies, grouped by category. 17
Financial derivatives such as call and put options Risk reversal* Simultaneously buying a call option and selling a put option. 3his has the effect of simulating being long on a stock or commodity position. Belta neutral* 3his is a market neutral position that allo%s a portfolio to maintain a positive cash flo% by dynamically re-hedging to maintain a market neutral position. 3his is also a type of market neutral strategy. 18