Financial Risk Management - Essay Example

This study involves a comprehensive study of the risk management policies followed by Bear Stearns and how it led to its demise. Risk Management: An Overview Risk is a term associated with any type of business entity. Without risk it would have been an easy task for managers of a company to allocate its resources in the most effective way. And with the world experiencing the global financial crisis in the year 2008, effective and efficient risk management is the key to success for any financial enterprise.

The idea of risk management may differ from person to person. In case of regulators risk management is a means of control, for traders it is a means of hedging their risks and for risk managers it is a means of obtaining the highest return possible by allocating capital in the best possible way. Risk management takes into consideration the magnitude as well as the nature of risks involved. It is all about optimizing the risk-return profile of a company. Sources of risk are many and it is due to the uncertainties of future events.

In today’s world banks are engaged in wide range of activities like trading of derivatives to its customers which results in exposure, finally leading to risks. Thus risk management plays a vital role in case of banks. Study and analysis of risk begins with study of Markowitz model of portfolio analysis where he defined selection of portfolios based on mean of variances in return of portfolios. Sharpe and Lintner further added to this analysis by assuming the existence of risk free assets. The rate of return of a risky asset is governed by its systematic risk and ‘beta’ is the measure of this type of risks.

Next Black-Scholes model for pricing of options gives a measure of the risk of an underlying security by measuring the volatility in the form of standard deviation. Again works of Modigliani and Miller showed that value of the firm is not dependent on the capital structure of the firm. Increase of debt, leading to greater leverage in the capital structure of a firm increases the financial risk for the shareholders of the firm. This means, reengineering of capital structure of the firm would not help the firm, and the management should consider implementing strategies to increase the value of the firm economically.

However, it is very difficult and possesses a challenging task for a company to implement these risk management theories practically. For any financial institutions like global banks, before taking up risk management system they must ensure that, they are up to date with their databases regarding various financial transactions within the company and are also aware about financial rates available in the outside market. Also they must have relevant statistical tools to analyze those data. Risk management policies followed by Bear Stearns Bear Stearns was once considered as one of the most efficient managers of risk but at the end it was their faulty risk management policies that led to their downfall.

Bear Stearns most profitable division was the securitization of mortgage, which brought in almost half of the company’s revenues. Regarding mortgage securitization, the company followed a model that was vertically integrated and made profit at every step starting from originating loan, securitizing them and then selling them. These