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Financial risk

Financial risk is an umbrella term for any risk associated with any form of financing. Typically, in finance, risk is synonymous with downside risk or the difference between the actual return and the expected return (when the actual return is less). Risk related to an investment is often called investment risk. Risk related to a company's cash flow is called business risk.

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, Volatility, Sector, Liquidity, Inflation risks, etc. Similar to general risk management, financial risk management requires identifying its sources, measuring it, and plans to address them. Financial risk management can be qualitative and quantitative. As a specialization of risk management, financial risk management focuses on when and how to hedge using financial instruments to manage costly exposures to risk.

Methods of Managing Financial Risk

Investing your hard-earned money is a tricky science and no one can predict exactly which way the markets will flow. Financial risk is an inherent feature of investments and an investor's individual personality will dictate exactly how much risk he can handle. For any investor, there are methods to manage the risk and help secure a smoother and more profitable outcome. Hedge Your Bets The most well-known method for managing financial risk is hedging investments. A hedge is a strategy where the investor places some of his money in different instruments that will likely guarantee a positive outcome. In its simplest form this means placing your money in several types of instruments so that even if some go down, some will go up. A hedge is never a sure bet either; it simply reduces risk. Another term for this is diversification--the more fully you diversify your portfolio, the more likely you are to see increases in your investments. Sell Your Position Sometimes the best way to manage risk is to sell a risky position. Any good investor needs to constantly analyze his portfolio and check the markets. If a particular stock becomes too risky, sell it and place the proceeds in another instrument that's less risky. Brokerage firm Charles Schwab recommends always taking the tax advantage into account. If you can sell and save



mufti-faceted. Investing in a range of low-interest instruments is likely to guarantee a low rate of return without much risk to the investor. Solid. Anyone can go it alone. They are highly trained to take your needs into account and offer a broad array of suitable investment possibilities for your purposes. Talk to the Experts Financial planners study investment methods and take intense coursework culminating in difficult exams. Therefore farm managers must know how to identify and prioritize risk. the manager can prioritize the risks. According to "Smart Money Magazine. They often fail. Go for the Low y Lower risk often means lower interest--that's what comes with the territory. The interrelationships among the prices and quantities on a dairy farm can make identifying the point where the financial risk occurs difficult. Sensitivity and break even analyses are tools used to identify risk. Simple transactions to achieve that purpose are the most successful in the long run. Experts can help you reduce that risk by providing information about investments and suggesting models to meet your investment needs. There's a reason risky investments come with higher gains--the borrower has to provide some reason for you to invest with risk and the offset is the potentially high returns. Keep it Simple Often investors are enticed into strange. and began working on ways to reduce those risks. so they can spend as much of their scarce and valuable time on reducing the most important risk factors in their portfolio. However the level and importance of the financial risk on each farm varies. In addition. y y Managing Financial Risk: An Introduction Financial risk occurs whenever production or marketing occurs. methods for prioritizing and reducing financial risk will be examined . and you can move on and start with something new. A portfolio that shows faith in the companies in which you've invested are more likely to reduce your financial risk and deliver solid gains. it might be more worthwhile than sticking it out. Once the source of financial risk is identified. That means buying low and selling high. fancy sounding investment strategies that promise great yields. but without the proper knowledge you may open yourself up to increased risk. This paper will present examples of their use. low-risk investments don't need to promise as much. the ability to manage financial risk is related to production levels and the prices received for that production.taxes." the premise of a good investment strategy is appreciation over the long term. In addition. Financial risk exists on all farms.

The range in the price or quantity analyzed should be from the lowest customarily expected value for variable ³A´ (denoted by ³X´ on the break-even table) to the highest customarily expected value for variable ³A´ (denoted by ³XX´). The level of output or price (usually of the major product) required to break-even on a proposal as another price or quantity varies. The tabular results can look at the either the dollars of profit or cash surplus that will be generated if the price or quantities of selected inputs or outputs change. this financing method has worked but in some cases heavy reliance on debt has resulted in financial stresses or. Break-even analysis An alternative tool to identify and prioritize financial risk is a break-even analysis. Some of the possible alternatives are discussed below. at the extreme. Break-even values can be calculated using the results from the sensitivity table. Again. The farm manager will have some control over the variation in quantity ± weather and other factors will also have an effect. Sensitivity and break-even analysis help the manager to ³ruminate´ on a project or proposal. For many. do not use once in-a-100-years values. The certainty of a fixed interest rate loan is attractive but so is the lower interest rate that is always available with a variable rate plan. Strategies for Reducing Financial Risk Traditionally farmers have financed their farm businesses largely with loans obtained from commercial lenders. Rumination is a stage in creative thinking process when an individual allows an idea to be broken down and reformulated by ³chewing´ on it. bankruptcy. The problem is .Tools for Identifying Financial Risk Sensitivity Analysis A sensitivity analysis looks at how susceptible your business is to changes in either the price or quantity of key inputs or outputs. Enter your results into the appropriate cells in the table. because this may cause you to discount the entire analysis as being unrealistic. Blending Loans to Control Interest Rate Risk One of the decisions farmers must make when they are negotiating loans is whether they want a fixed or variable interest rate loan. The range in the price or quantity analyzed should be from the lowest customarily expected value for the price or quantity to the highest customarily expected value. These ranges may be key to prioritizing financial risk. farmers need to consider some alternatives that will reduce the costs and risks of financing businesses. To avoid these negative outcomes from using large amounts of debt to finance farm businesses. This will give you a range and a visual image of the production response required to alleviate the financial risk associated with your proposal.

Cash reserves such as saving accounts. Keeping Adequate Liquidity Cash or inventory reserves help in dealing with financial risk. it is only a short run solution. heifer housing. feeding systems. using temporary or inexpensively refurbished existing facilities. for the other needs. and other financial paper are excellent. mutual funds. It is a low return investment. or other agricultural commodities. when debt repayment on the land purchase is included.deciding whether it is advantageous to forego the lower interest rate on a variable rate loan in order to have a guaranteed interest rate for as long as thirty years. there seems to be little argument about the purchase of land. This higher rate is what compensates lenders and investors for assuming the risks that borrowers are unwilling to assume. The risk in question is the chance that interest rates can rise and bankers or investors will not benefit from this interest rate change because they have agreed to keep interest rates constant. especially in terms of labor. This is largely because they are in growth or expansion phases and holding major financial reserves are not possible. This strategy has some appeal because it helps farmers keep their financing costs lower (low interest on variable rate loans) while building some stability into their repayment requirements on loans (constant payment on fixed rate loan) Step-Wise Investments There is always a debate about turn-key operations (investments) versus step-wise investments. and renting land or purchasing feed can reduce cash flow demands. until cash flow improves and some debt is repaid. Rather than putting all of their loans on a variable rate these farmers have the option of splitting their financing between variable rate and fixed rate loans. of sorts. in the non-expansion operation. The disagreements arise when the discussion turns to cattle. but most farmers do not have many of them. so land purchases are usually stepwise. Others feel that investing in temporary or refurbished facilities is a waste of funds and a source of inefficiency. manure handling. at least in the short run. corn. Choosing a fixed interest loan is a hedging activity. However. Locking the interest rate protects one from higher interest expenses but the protection comes at the cost of a higher initial interest rate. Some farmers would like the protection of a fixed rate loan but are unwilling to use these loans because they are too expensive. Some individuals recommend investing in cattle and milk cow housing first. is a strategy that can alleviate cash flow problems. and/or milking systems. Postponing capital expenditures. much like forward pricing milk. feed storage. in the long run the durable assets require replacement. bonds. . milk cow housing. stocks. However.

Farm managers establish a line of credit at their financial institution in excess of their anticipated needs. If the additional financial risk is a precursor to potential profits. A line of credit may fall into the credit reserve arena. This means when the hot water heater. However the manager borrows only $350. if needed. The two most prominent are loss in value due to price and quality changes. but can borrow up to the full amount. The family should keep its own liquidity reserve. Short-term Cash Surpluses There are certain years when the prices and conditions are favorable and the dairy farm manager finds the business in a cash surplus. They are charged interest on only the amount borrowed. This quandary is not a problem. One way is to provide feed for livestock in poor crop years and the other is as an asset that can be sold without disrupting the business.000 in reserve. Credit Reserve A credit reserve is a common response to financial risk.000. In those cases some farm managers will decide to acquire more financial risk.000. based on the farm¶s profitability. leaving $150. Lines of credit are usually only available for operating expenses. in and of itself. refrigerator. From a borrower¶s perspective. this elimination of principal and interest payments is a major benefit because it reduces the need for the farm business to generate cash flows in the short-run. equity capital is preferable to debt. They are risks associated with using inventories as your reserve. cash flow. or TV breaks down it can be replaced without incurring additional personal debt or foregoing farm business obligations. something separate from the farm business. another financial risk. A farm manager may limit the amount of money borrowed on an expansion or other project so they have a reserve to draw on in the event of an unexpected need for cash. Example: A farm manager could borrow up to $500. rather than pay the taxes.Inventory reserves help in two ways. Equity Capital In terms of cost and risk. The are many cases where good business loans have failed because unexpected personal expenditures could not be handled without using the farm business reserve. and equity. this is a common response to variability in asset values. Also. The problem arises if this additional cash is taxable business profit. use the cash as a down payment on a capital purchase. however some borrowers are also given a capital expenditure line of credit. it could be a wise expenditure of funds. However if the expenditure increases both the . at any time ± without additional approval. as a financing source because there are no repayment requirements associated with equity capital financing.

farmers may wish to use an alternative source of credit. In low income years farm businesses can suffer very serious cash flow strains and financial stresses as they use their scarce cash resources to pay principal and interest payments on debts. referred to here as subordinated debt. When you have additional cash and no pressing capital requirements: 1) Reduce debt 2) Make non-farm Investments 3) Build a liquid monetary reserve. Subordinated Debt One of the problems with debt financing is that interest payment requirements remain the same regardless of a farm business¶ earnings.short-run tax-deductible cost and the long run cost of production. Rather than subject themselves to these financial risks. the manager may find that paying the taxes would have made the business more profitable in the long run. .

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