Financial risk management in the financial institutions - Dissertation Example

Therefore, it is because of this trend there has been need for the risk management practices in the financial institutions. It has also forced the regulatory authorities and the bankers to improve the internal systems such as pricing, risk evaluation and control (Saita, 1999). It has been found that the traditional banking business of making loans and accepting deposits have declined in the United States in the recent years. People are switching from directly held assets to the pension funds and the mutual funds.

In light of this issue, the banks are attempting to uphold their position relative to the GDP. They are putting emphasis on switching from their traditional business to fee-producing activities. It has been found that the household investors in the US and the UK bear more risk from their investment in comparison to the investors of Japan, Germany and France. However, according to few researchers it has been argued that intermediaries from Japan, Germany and France may be able to manage the risk by holding liquid reserves and intertemporal smoothing.

On the other hand, the countries such as the US and the UK are not able to manage their risk because of the competition that they face from the financial markets. With the decline in the financial innovation and traditional banking business that is normally undertaken by the banks in the US, it can be described as a response to the competition that they face from the markets and the decline in the intertemporal smoothing (Allen & Santomero, 2001). Question Two The design in the new security, advances in the theory of finance along with the improvements in the computer and telecommunication technology have resulted in revolutionary changes in the overall structure of the financial markets and the institutions.

Hedging versus equity has a role to play in managing the risk (Merton, 2000). The corporate hedging can help in reducing the volatility of the firm value. In this perspective, it is important to understand what the term corporate hedging denotes. It generally makes use of the off-balance-sheet instrument such as forwards, swaps, futures and options. For instance, if in case the value of the American manufacturing firm facing competition in the US markets from its foreign manufacturers are inversely linked to the value of the Dollars, then the manufacturing company can hedge the exposure by employing the off-balance sheet instruments.

The exchange rate changes or volatility can be hedged in various ways. It can be done by selling the foreign exchange futures on the foreign currency, entering into the currency swaps, buying a put option or by writing a call option on the foreign currency. Therefore, it can be said that by utilising this tools the firm can hedge the risk. On the other hand, the firm can hedge by making use of the on-balance-sheet strategy (Nance & Et. Al., 1993). Credit options can also be used by the bond investors to hedge against the decline in the price of the bond.

The decline may be caused because of the downgrade in the company’s debt. Credit options are a second type of credit derivatives that can be used to hedge the risk of adverse changes brought about in the credit quality. The debt issuers can also make use of the credit-linked note which is a type of the credit derivative in order to hedge against credit risk. Therefore, it is evident that the conventional methods of managing the risk such as bank loan, assets securitisation and diversification can provide only a