management, financial risk management requires identifying the sources of risk, measuring risk, and plans to address them. 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. When to use financial risk management Finance theory (i.e. financial economics) prescribes that a firm should take on a project when it increases shareholder value. Finance theory also shows that firm managers cannot create value for shareholders, also called its investors, by taking on projects that shareholders could do for themselves at the same cost. When applied to financial risk management, this implies that firm managers should not hedge risks that investors can hedge for themselves at the same cost. This notion is captured by the hedging irrelevance proposition: In a perfect market, the firm cannot create value by hedging a risk when the price of bearing that risk within the firm is the same as the price of bearing it outside of the firm.In practice, financial markets are not likely to be perfect markets. This suggests that firm managers likely have many opportunities to create value for shareholders using financial risk management. The trick is to determine which risks are cheaper for the firm to manage than the shareholders. A general rule of thumb, however, is that market risks that result in unique risks for the firm are the best candidates for financial risk management. Important financial instruments Derivatives are commonly used in financial risk management, because of their ability to offset specific risks, such as interest rate risk and exchange rate risk. Over-the-counter derivatives such as swaps and forward contracts have the advantage that they can be tailor-made to match exactly the specific risks, though they tend to be costly to create and monitor. Standardized derivatives that trade on futures exchanges, such as options contracts and futures contracts are more cost-effective, but often leave small risks, as the standardized contracts rarely match the risks exactly. Risk in finance "The chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is 31C.f.:
52 usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment". Risk in finance has no one definition, but some theorists, notably Ron Dembo, have defined quite general methods to assess risk as an expected after-the-fact level of regret. Such methods have been uniquely successful in limiting interest rate risk in financial markets. Financial markets are considered to be a proving ground for general methods of risk assessment. However, these methods are also hard to understand. The mathematical difficulties interfere with other social goods such as disclosure, valuation and transparency.