Volume 29 Number 5/6 2003 111

Future Trends and Challenges of Financial Risk

Management in the Digital Economy
by Steven Li, Senior Lecturer in Finance, School of Economics and Finance, Queensland
University of Technology, Brisbane, QLD 4001, Australia

Abstract

In this paper, the future trends and challenges of financial risk management are consid-
ered. First, the historical developments and current status of financial risk management
are assessed. Then, key features of the financial industry in the digital economy are dis-
cussed. It is argued that the technology innovations, particularly in computing and tele-
communication, will continue to have an important influence on the future development
of financial risk management. Based the past and present of financial risk management as
well as the general trends in the financial industry, some future trends and challenges of
financial risk management in the digital economy are discussed. Finally, some implica-
tions for financial institutions, corporations and emerging economies are given.

Introduction

Risk is an old concept associated with uncertainty. There have been many different defi-
nitions. However, there has been little consensus on the concept of risk, see Gao (2001)
for a more detailed discussion. In the course of running a business, decisions are made in
the presence of risk. A decision-maker can confront one of two types of risk. Some risks
are related to the underlying nature of the business and deal with such matters as the un-
certainty of future sales or the cost of inputs. These risks are called business risks. An-
other class of risks deals with the uncertainty of such factors as interest rates, exchange
rates, stock prices, and commodity prices. These are called financial risks.

Most businesses are accustomed to accepting business risks such as the uncertainty
of future sales. Indeed the acceptance of business risks and the potential rewards can
come with it are the foundations of the free market economy. But financial risks are a dif-
ferent matter, as often businesses are not accustomed to accepting and managing them.
The paralysing uncertainty of volatile interest rates can cripple the ability of a firm to ac-
quire financing at reasonable cost. Firms that operate in foreign markets can have excel-
lent sales performance offset if its own currency is strong. Managers of portfolios deal on
a day to day basis with widely unpredictable and sometimes seemingly irrational finan-
cial markets. These examples clearly demonstrate that financial risks can be important for
many businesses.

In coping with growing financial risks, various derivative products (e.g., options,
swaps) have been developed in the past 20 years and they are now widely used by large
corporations1, financial institutions, professional investors, and individuals2. Certain
types of derivatives are traded actively in public markets, similar to the stock exchanges.
The vast majority of derivatives, however, are created in private transactions.

The critical importance of using derivatives properly has created a whole new ac-
tivity called financial risk management. Financial risk management is the practice of de-
fining the risk level of a firm desires, identifying the risk level a firm currently has, and
Managerial Finance 112

using derivatives or other financial instruments to adjust the actual level of risk to the de-
sired level of risk (see e.g. Chance, 2000). Financial risk management has also spawned
an entirely new industry of financial institutions that offer to take positions in derivatives
opposite the end users, which are corporate or investment funds.

The need for sound financial risk management was highlighted by a number of
high-profile risk management disasters in the1990s. In each of these cases, a single indi-
vidual or subsidiary company built up huge positions (apparently) without knowledge of
senior management or the parent company. The firms involved then suffered very large
losses when the risks turned sour. Among the most noteworthy of these cases were (see
e.g. Dowd, 1998):

* Metallgesellschaft. A US subsidiary of MG built up very large positions in oil

futures in an attempt to hedge some long-term forward contracts it has sold.
The fall in oil prices in 1993 then led to very large losses, and the German par-
ent company intervened to liquidate the remaining futures positions. The ulti-
mate loss was $1.3 billion.

* Orange County. The County Treasurer, Bob Citron, invested much of the
County’s investment pool in highly leveraged derivatives instruments that
were, in effect, a very large bet on interest rates remaining low. The rise in in-
terest rates in 1994 then inflicted huge losses on the Investment Pool-$1.7 bil-
lion in all—and led to the County’s bankruptcy.

* Barings Bank. Nick Lesson, a trader working out of Baring’s Singapore sub-
sidiary, built up huge unauthorised positions in futures and options. The
amounts involved vastly exceeded the bank’s capital, and adverse movements
in these markets forced the bank into bankruptcy in February 1995. The ulti-
mate loss to the bank was about $1.3 billion.

* Sumitomo Corporation. In June 1996, Sumitomo announced a loss of $1.8 bil-

lion. These losses had accumulated over a 10-year period from unauthorised
trades by its chief copper trader, Yasuo Hamanaka, which he had managed to
cover up.

In each of these cases, losses were well in excess of $1 billion. However, there were
also many other cases where smaller losses were made in much the same way. These
well-publicised disasters had intensified the ongoing debate about risk management prac-
tice. Consequently, many risk control measures and concepts such as “Value-at-Risk”
(VaR)3 were introduced to prevent such disasters (see e.g. Tortoriello, 2000).

In today’s digital economy, computing and telecommunication technologies are

progressing rapidly. This will continue to bring new challenges and new opportunities for
financial risk management. New products for financial risk management will continue to
grow. For example, the rapidly growing e-commerce calls for new financial products to
managing e-commerce risks, see e.g. Li (2001). In this paper, we attempt to shed some
light on the future trends and challenges of financial risk management, as well as their
implications for financial institutions, corporations and emerging economies.
Volume 29 Number 5/6 2003 113

The Past and Present of Financial Risk Management

In the two decades of 1980s and 1990s, firms have been increasingly challenged by finan-
cial price risks (see e.g. Chance 2001). For examples, changes in exchange rates can cre-
ate strong competitors; similarly, fluctuations in commodity prices can drive input prices
to the point that substitute products become more affordable to end users. It is no longer
enough to be the firm with the most advanced production technology, the cheapest labour
supply, or the best marketing team; price volatility can even put well-run firms out of
business. Due to these challenges and the theoretical breakthroughs marked by the publi-
cation of the option pricing model by Blacks and Scholes (1973) and Merton (1973), a
range of financial instruments and strategies have evolved in the past 20 years. To name a
few, swaps and forwards are becoming increasingly popular in controlling the risk of
price changes in raw materials, credit derivatives including credit swap, credit spread op-
tion etc. are widely used in managing credit risks. As an example, the rapid development
of the option market in Australia is clearly demonstrated in Figure 1.

Figure 1: Australian Option Market (Source: Bruce et al, 1997)

14000000
12000000
Contracts Traded
Traded

10000000
8000000
6000000
Contracts

4000000
2000000
0
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996

Year

Call Put Total

At one level, financial instruments now exist that permit the direct transfer of finan-
cial price risk to a third party more willing to accept that risk. For example, with the de-
velopment of foreign exchange futures contracts, a U.S. exporter can transfer its foreign
exchange risk to a firm with the opposite exposure, or to a firm in the business of manag-
ing foreign exchange risk, leaving the exporter free to focus on its core business. For de-
tails of the derivative products available, we refer to Smithson (1998) and Chance (2001).
At another level, the financial markets have evolved to the point that financial in-
struments can be combined with a debt issue to unbundle financial price from other risks
inherent in the process of raising capital. For example, by coupling their bond issues with
a swap, issuing firms are able to separate interest rate risk from traditional credit risk
(Arak, Goodman & Rones, 1988).

Innovations in financial-contracting technology (futures, options, and other con-

tractual agreements) have played a central role in this development by expanding the op-
portunities for risk sharing, lowering transaction costs, and reducing information and
Managerial Finance 114

agency costs (Chance, 2001). The extraordinary growth in the use of derivatives and the
huge proliferation of new financial products and markets, have made possible the crea-
tion of an increasing number of layers of financial intermediation that are required to cap-
ture the benefits of advances in finance. By increasing the number of financing channels
and better opportunities for swapping, sharing and spreading risks, more efficient finan-
cial systems have emerged in many countries (Blommestein, 2000).

The major growth in the use of derivatives has been fueled by trends towards secu-
ritization and the increased understanding of the role that derivatives can play in unbun-
dling, packaging, and transferring of risks (see e.g. Scholes, 1998). A typical
securitization procedure within the context of mortgage finance is illustrated in Figure 2.

Figure 2. An illustration of securitization process

Financial Special
Intermediary Purpose Investors
Assets Issue asset
Vehicle
Mortgage backed securities
loans

Credit
Enhancer

Service
Manager
Cash flows Cash flows
(loan repayments) (interest and principal)

Today, no longer do financial service firms only sell the same products they buy
from clients. Instead, they break the products down into their component parts or recom-
bining them into new and hybrid custom-tailored financial instrument. And this unbun-
dling and repackaging is only in the beginning stage of evolution. In order to see the
future trends and challenges of financial risk management, we need to analyse the key
features of the financial industry in the digital economy.

Key Features of Financial Industry in the Digital Economy

The expansion in technology has had an impact on every major industry segment (see e.g.
Jorgenson, 2001). From consumer and industrial products to agriculture and digital com-
munications, technology is an integral part of our everyday life. It provides the means for
working longer, getting it done faster, accessing your bank account from anywhere in the
world, growing foods in less than optimal climates, and unparalleled medical advances.

In readiness for an e-business world ‘without boundaries’, companies must estab-

lish a new security framework—putting boundaries around the Internet, which currently
Volume 29 Number 5/6 2003 115

has none. That is today’s business paradox. The dilemma organisations face is striking
the right balance between building trust through openness and the historical protection of
their interests from fraud, loss of confidential information, vandalism, employee theft, as
well as other forms of economic loss. The key features of the financial industry in the
digital economy are outlined below.

* Globalisation
A remarkable feature of the financial industry in the digital economy is the inter-
nationalisation and globalisation. Grenville (2000) argued that globalisation
brings with it huge benefits, but at the same time, creates a need for a much more
comprehensive set of rules to govern the way it will be carried out, analogous to
the complex and ubiquitous rules which govern interactions in the domestic
economy.
* IT driven
According to Moore’s law, the computing speed will grow exponentially, the
communication cost will continue to drop quickly. Without any doubt, the ad-
vance in IT will continue to play an important role in the development of the fi-
nancial industry. Improvements in IT have made possible huge increases in both
computational power and the speed with which calculations can be carried out.
Improvements in computing power mean that new techniques can be used and so
enable us to tackle more difficult calculation problems. Improvements in calcu-
lation speed then make these techniques useful in real times, where it is often es-
sential to get answers quickly. Decision makers can now use sophisticated
algorithms programmed into computers to carry out real-time calculations that
were not possible before. The ability to carry out such calculations then creates a
whole new range of risk measurement and risk management possibilities. For
example, Monte Carlo simulation can now be easily used to accurately price
many complex instruments and to obtain VaR estimates.
* Riskier environment
Exchange rates have been volatile ever since the breakdown of the Bretton
Woods system of fixed exchange rates in the early 1970s. Occasional exchange
rate crises have also led to sudden and significant exchange rate changes. There
have also been major changes in exchange rates as the result of shifts in monetary
policies. Firms have therefore had to come to terms with ever-present and some-
times very significant exchange rate risk.
There have been major fluctuations in interest rates, with their attendant effects
on funding costs, corporate cash flows and asset values. Interest rates rose to a
very high level in the developed countries in the mid-1970s, largely as a conse-
quence of previous inflationary monetary policies, and then subsequently came
down again in the later 1970s. For example, interest rates in the US and UK then
both shot up in 1979, peaked in 1981, and gradually came down again (see e.g.
Smithson, 1998). Interest rate instability will likely continue to be a major source
for market instabilities in the digital economy.

Stock markets have also been extremely volatile in the past few decades. Stock
prices rose significantly in the inflationary booms of the early 1970s, then fell
considerably a little later. Stock markets then recovered, fell again somewhat in
Managerial Finance 116

the early 1980s, and rose to a peak in 1987. They then fell precipitously
throughout the world on 19 October of that year. In most countries, equity
markets then recovered and proceeded to grow right through until 2000.

Besides, there have been many other sources of instability. For example, the
oil price hikes of 1973-1974 and 1979. The massive transformation and in-
deed, the globalisation of the financial services industry, as manifested by the
erosion of barriers between different types of financial firms and the emer-
gence of a new breed of financial multinationals operating on a worldwide
scale.

In sum, there is general agreement that the financial environment is riskier to-
day than it was in the past (see e.g. Smithson, 1998). The volatility of foreign
exchange rates, interest rates and commodity prices has been increasingly sig-
nificant.

* Increased complexity
As indicated above, the structural changes in the past 20 years have enabled a
broad unbundling and repackaging of risks through innovative financial engi-
neering. These changes have resulted in very complex financial products and
markets. Common stocks and debt obligations have been augmented by a vast
array of complex hybrid financial products, which allow risks to be better allo-
cated and priced. For example, recent hybrid securities are in the border terri-
tory between loans and bonds, such as deferred-pay options bonds, floating
interest rate subordinated term securities and equity linked venture invest-
ment securities.

* Increased competition
The competition for capital has increased dramatically, both in national mar-
kets and globally (Blommestein, 2000). This fierce competition for the alloca-
tion of savings means that investment projects and public policies are more
restrictively scrutinised. It also means that this capital, in times of stress, also
flees more readily to securities and markets of high quality and high liquidity.
The new financial landscape is defining a more competitive beauty contest
among countries and markets with greater rewards for good policies and proj-
ects but also greater punishments for mistakes.

Blommestein (2000) highlights that the competition in the financial industry

has increased strongly due to the following structural forces: the removal or
weakening of barriers to entry; the liberalisation of diversification; the re-
moval or reduction on ownership structures; globalisation of business activi-
ties, innovations and technological advances.

Increased competition has resulted in a lower cost of financial services and an

increase in the expansion of the range and quality of financial services. For ex-
ample, the Internet offers investors unprecedented access to financial tools
and services worldwide at relatively low cost and relative ease. Asset manage-
ment services are being now offered at low costs with a wide range of choice
of products and other modalities.
Volume 29 Number 5/6 2003 117

Development Trends in the Financial Industry

Balino and Ubide (2000) summarise four fundamental trends that are changing the finan-
cial world: consolidation of institutions, globalizations of operations, development of
new technologies and universalisation of banking.
Financial institutions around the world are consolidating at a rapid pace. The
number of institutions is declining and their average size is increasing. For example, in
the United States, the lifting of interstate banking restrictions in 1994 triggered a wave of
mergers. European integration has intensified consolidation in Europe-which the intro-
duction of the Euro in January 1999 has further encouraged. In many emerging markets,
such as Argentina, Brazil, and Korea, consolidation is also well under way as banks seek
to become more efficient and more resilient with respect to stocks.
Nor has consolidation confined by national borders. In a drive that has created
powerful “national champions” in many industrial countries, financial institutions have
not waited for opportunities for growth and increased profitability to be exhausted do-
mestically before transcending national frontiers. This process of globalization has been
dominated by industrial country banking groups’ exploitation of the growth potential in
emerging markets, as witnessed by the expansion of Spanish banks in Latin America,
German banks in Eastern Europe, and U.S. banks in East Asia (Balino and Ubide, 2000).
At a somewhat slower pace, cross-border consolidation is also taking place between in-
dustrial countries, initially in the form of strategic alliances that offer the benefits of di-
versification without the costs of merging different business cultures.
Developments in technology, and especially the impressive growth of Internet
banking and brokerage services, have allowed globalization to go beyond the ownership
structure of financial conglomerates and to reach the retail markets. In fact, many banks
are using their online operations to expand into foreign markets, avoiding the costly pro-
cess of building retail brick-and-mortar networks of branches. Moreover, the emergence
of alliances between major banks and telecommunications conglomerates suggests that,
in the future, competition in the electronic marketplace will be fierce. In addition, the ap-
pearance of virtual banks and the development of electronic money for the global Internet
market have created the possibility for the growth of nonbank (and, possibly, largely un-
regulated) institutions that provide credit to, and collect funds from the public. Faster
communications require faster reactions from both markets and policy makers but also
quickly make information obsolete.
The universalisation of banking is increasingly blurring the boundary between
bank and nonbank financial services. This trend is already well developed in certain
European countries—as exemplified by the widespread distribution of insurance products
through bank branches, the repeal in 1999 of the Glass-Steagall Act (which restricted
banks’ involvement in equity financing and artificially separated investment banks from
commercial banks).
Future Trends of Financial Risk Management
The future will be a continuation of the present. Financial innovation will continue at the
same, or even at an accelerating, pace because of the insatiable demand for lower-cost,
more efficient solutions to client problems. Information and financial technology will
continue to expand and so will the circle of understanding of how to use this technology.
Managerial Finance 118

By combining the past developments of financial risk management with the features and
trends of the general financial industry in the digital economy as discussed above, we can
foresee the following trends of financial risk management in the future.
Emerging new risk management instruments and markets
Theoretical breakthroughs (such as derivatives pricing techniques) enable financiers to
invent and price new instruments. The forward and options contracts are the building
blocks of modern risk management. New instruments based on these basic derivatives
will continue to emerge. For example, there are nascent markets in weather-linked con-
tracts (see e.g. Anonymous, 1999), telecom bandwidth and in corporate-earnings insur-
ance. At the same time, the spread of existing technologies is hastening an upheaval
among financial institutions and making it easier for risk to end up with the people most
willing to bear it.
While much progress has been made in financial risk management, it is still far
away from the goal of being able to model and manage almost any conceivable risk. Once
financiers can strip out risks at will, a great prize is within their grasp, because firms can
lay off the kind of risk they want to, and to just the degree they want to. In the same way,
investors can take on precisely the risk that most suits them. To achieve this objective,
new theoretical inventions and instruments will be necessary and bound to emerge.
Emerging new markets in risk
Before recent developments in financial theory such as option pricing techniques, firms
typically had few choices about how to manage risk. Gradually, however, many firms be-
gan to use derivatives as protection against movements in prices and interest rates. For
example, those operating internationally realised that by hedging their exposure to
changes in foreign exchange rates, they could make their profits less volatile and hence
more valuable to investors.
New ideas and instruments are continuously extending this frontier. For example,
until recently, an ice cream maker could do little about the risk of a cool summer, which
would lower demand for its products. Similarly, energy companies suffer during mild
winters, because they lead consumers to turn down their central heating.
The risk of adverse weather seems inevitable, but financial wizards have come up
with a way to avoid it. Over the past few years traders have done around $4 billion of
weather-related deals tailored to firms’ needs “over the counter”. Since September 1999,
the Chicago Mercantile Exchange has traded weather-linked derivatives whose value var-
ies with the temperature measured by an index of warmth in four large American cities
(cf. Anonymous, 1999). Deregulation of the American and European energy markets has
created a deep pool of demand for such instruments.
Unbundling and repackaging corporate risks
When financiers package business risks as securities of some form or other, they are tink-
ering with the components of existing securities, such as debt and equity, that today pass
aggregated risks to investors. Given the new technology of finance (e.g., bundling and
unbundling risks), some of the financial instruments that are taken for granted today may
eventually become obsolete. Equity, for example, might be replaced by a series of risk-
Volume 29 Number 5/6 2003 119

linked contracts offering specific payouts. Loan agreements might routinely include con-
tingencies that affect the interest rate.
To understand why, consider the mechanism by which firms typically try to protect
themselves from harm: insurance. In a normal year, it will experience numerous small
setbacks that cause small losses-the firm expects these to happen, just as a bank expects
some of its loans to go sour, so these might be called “expected losses”. Insurance premi-
ums paid up-front to cover these expected losses are equivalent to a tax-efficient (but
non-interest-earning) bank deposit that is drawn down as the losses occur. In other words,
the company has every expectation that most of the premium will be claimed back.
But firms can also suffer larger, more expensive reverses, which are a nightmare
for managers. The odds that catastrophe might wipe out the entire business are very
small. But there is a bigger chance of some event that might seriously dent profits. And fi-
nancial markets hate the unexpected. Securities analysts, who will discount a surprise
gain as a one-off, will panic if presented with an unexpected loss. From the firm’s per-
spective, therefore, an unexpected loss may be even worse than it looks. This gives a
company an incentive to lay off any risk that is not intrinsic to its core business.
This sort of insurance is being sought by companies, but it is also being promoted
by sophisticated insurers, such as Marsh & McClennan, SwissRe, AIG, XL Capital and
Ace. They specialise in pricing the tiny odds of very rare events. They also want to im-
prove their traditional insurance business by wrapping it up with financial protection-
foreign-exchange contracts, for example-that used only to be available from the capital
markets. They can do this effectively because these risks are uncorrelated with normal in-
sured risks. By packaging them, the insurer creates a portfolio that is more attractive for
an investor. In other words, these are “win-win” deals.
This broad trend in finance is known as “alternative risk transfer” (ART). It in-
volves the ever-closer proximity of insurance and the capital markets, once almost en-
tirely separate activities. For further details regarding ART we refer to Zalkos (2001).
More efficient markets due to technology advances
As in the past, technologies, particularly telecom and computing, will play an important
role in financial risk management. As these become more powerful, they enable informa-
tion and ideas to be communicated across vast numbers of people at very low cost. Plenty
of traditional businesses, including auction houses and bookshops, are scrambling to re-
act and finance is no exception. Already, new information technology is eroding the dis-
tinction between different parts of finance, such as banking and insurance. As the Internet
matures, financial intermediaries risk seeing their margins flattened; and entirely new
business models will emerge.
These technologies enable the financiers to exploit their unbundling skills to the
full. Harnessing the Internet, ART providers and other firms will parcel risks into differ-
ent classes of securities. They may keep some themselves, but mostly they will sell them
on to different types of investor.
Technology also has the power to demolish existing boundaries between different
parts of the financial world. Banks are no longer the only providers of credit. Insurers are
competing with investment banks to serve big corporate clients. Mutual and pension
Managerial Finance 120

funds are making direct equity investments, bypassing securities firms. Many of the best
financial firms 20 years hence will rely on intellectual more than monetary capital. Their
skills, above all, will lie in packaging and marketing. Investors will measure their per-
formance not simply in terms of their returns on capital, but also in terms of how risky
they are.

If these trends play out, capital markets will approach a state of theoretical perfec-
tion. Thanks to the diversification made possible by the Internet, the rewards will go to
those who assume the risk of doing badly in bad times. There will be an unprecedented
degree of risk-sharing. Far more risks will end up with those investors most willing and
best able to hold them. These developments could deliver a new level of efficiency and
stability in the global economy.

Implications for Financial Institutions

Risks associated with de-segmentation, securitisation, financial innovations, globalisa-

tion and increased competition have emerged. Increased volatility, greater interdepend-
ence and new risks have also made the structure of the risk exposure of banks and other
financial institutions more complex. For banks, the traditional activity was “on balance
sheet” lending, and the associated risk management technique was credit risk analysis.
However, lending now accounts for a smaller share of total activity than in the past for
many banks. Newer activities are investment banking, organisation, trading (agency and
proprietary), mergers and acquisitions and information systems—where the risks are dif-
ferent. The fact that banks will increasingly hold a wider set of instruments (money mar-
ket assets, bonds, equities, derivatives) and that some of the risks in these assets will be
retained while others are passed on implies that risks must be continually identified and
systems must be set in place to offset risk or to hold sufficient capital against any risk that
is retained. Also OECD capital markets have changed beyond recognition. Domestic de-
regulation and external liberalisation have resulted in major changes in competitive con-
ditions. Advances in communications and information systems enhanced the capacity of
financial market participants to use the opportunities offered by the new financial envi-
ronment. The product cycle in financial services is operating at a faster pace. New finan-
cial services require constant innovation with constant pressure on margins.

These developments have increased the need for better risk management. Financial
institutions must improve their capabilities for defining, managing and pricing risk. The
general objective is to build and use systems for the disciplined management of credit
risk, market risk and liquidity risk. The primary components of a sound risk management
process are: a comprehensive system for measuring different types of risk; a framework
for governing risk taking, including limits, guidelines, and other relevant parameters; and
an adequate management information system for monitoring, reporting and controlling
risks. To achieve these goals, financial institutions are facing some immediate challenges.

Conventional financial assets (equity, bonds, loans etc.) can be measured in a tradi-
tional accounting system (book or market valuation). However, swaps and other off-
balance sheet contractual arrangements can not be incorporated in a similar value frame-
work. The traditional accounting system is therefore not very suitable to identify risk al-
locations.
Volume 29 Number 5/6 2003 121

Value at risk (VaR) is the most widely used risk management model. However, in
extreme situations, VaR models do not function very well. That is why these models have
been supplemented with “scenario” or “stress” testing. But this approach may not be ade-
quate to control risks. An obvious limitation is that important extreme scenarios will be
excluded from the analysis. For example, it seems doubtful that risk managers in their
stress scenarios foresaw the extreme “LTCM 1998 episode” (Kimball, 2000).
A fundamental limitation of the current generation of sophisticated risk manage-
ment models is that they are based on the probability calculus of “a game against nature”.
In other words, these risk management systems neglect strategic factors in the behaviour
of market participants.
Implications for Corporate Financial Risk Management
Corporate financial risk management seeks to manage a company’s exposure to curren-
cies, interest rates, energy, commodities and other factors driven by the financial market.
It should be viewed as an ongoing process that continually evolves with the company as it
encounters new and unforseen risks. However, in reality, many companies that have iden-
tified various risks in their businesses do not have formal risk policies or strategies in
place to manage these risks within a corporate approved process (cf. Baldoni, 2001 and
Jalilvand et al 2000). Many companies regard risk management as a series of unrelated
transactions tied to a specific event or process. With this transactional approach to man-
aging risk, one begins with a blank sheet of paper each time a new issue or problem
arises, and then develops an independent solution for each disparate problem. After a
time, this string of unrelated solutions themselves can become an exposure as the under-
lying risks shift. While the dangers of this kind of approach seem obvious, it is surprising
how many companies rely on transactional approach. Clearly, companies would benefit
from a process that is woven into their overall business strategies and management pro-
cess. However, for senior management to help shape such integrated approaches to man-
aging risk, they must be better informed about risk and its impact on the company.
No doubt there will continue to be a need for unique and innovative risk manage-
ment strategies and performance measurement methodologies. However, to unlock the
true value and potential of the risk management process, we must continue the journey by
going beyond current, silo-driven approaches. If we can apply and combine already de-
veloped techniques to equip senior management with a deeper, more comprehensive set
of decision support tools, risk measurement and management processes can be elevated
to their rightful status in the decision making process.
Implications For Emerging Economies
Emerging economies face more domestic vulnerabilities such as an over reliance on the
exports of raw materials, inadequate bank supervision and capitalization, immature capi-
tal markets, and policy mistakes by governments etc. Consequently, emerging economies
are more volatile than industrial countries4.
In addition to domestic vulnerabilities, emerging economies also face risks from
global factors beyond their control. First is the health of the global economy, which im-
pacts both the price of commodities and the quantity of imports demanded from develop-
ing countries. Also, important are monetary policy and its effects on foreign exchange
policy, as changes in developed country exchange rates can dramatically impact both the
Managerial Finance 122

trade and capital accounts of developing countries. Changes in trade policy can also have
tremendous impact on the fortunes of emerging markets. Raising tariff on imported goods
and services or closing borders all together can devastate developing countries (Martins
et al, 2001).

Given these characteristics of emerging economies, one can see that the above im-
plications for financial institutions and corporations do apply in emerging economies. Be-
sides, due to the additional domestic uncertainties in emerging economies, financial risk
management in emerging economies will face additional complications.

The financial industry in emerging economies is often heavily regulated and thus
many risk management products, which are available in developed economies, may not
be available. At the mean time, the technological infrastructures for emerging economies
are often lagging behind that in the developed economies. Thus financial risk manage-
ment in emerging economies has a long way to go5.

On the other hand, the awareness and willingness of companies in managing their
risks has definitely increased in the emerging economies due to impact of events such as
the Asian financial crisis. That is, the demand for financial risk management is increas-
ing, especially in the past few years. Due to the great business potential, financial institu-
tions from industrial economies are keen to explore the financial risk management in
emerging economies. Thus the development of financial risk management in emerging
economies will be likely at a fast pace.

In sum, the emerging economies have to face the trends of financial risk manage-
ment in the digital economy and thus face similar challenges. But the specific challenges
faced by each emerging economies also depend on other factors such as the regulations
on the financial industry and the technological infrastructure etc.

Concluding Remarks

In today’s digital economy, the financial industry is changing rapidly. We are facing an
increase in the pace of financial innovations, a rapid expansion of cross-border financial
transactions, the faster pace of transmitting shocks or mistakes throughout the interna-
tional financial system and greater sensitivity on the part of financial market prices to
changes in preferences. These changes in turn determine the trends of financial risk man-
agement in the future. Financial risk management will evolve at a faster pace: new risk
management products will continue to emerge and the financial risk management system
will continue to improve.

Acknowledgement

The author would like to thank Prof. Simon Gao for many useful comments and sugges-
tions.
Volume 29 Number 5/6 2003 123

Endnotes

1. For example, Fatemi and Glaum (2000) found that a large proportion of German firms
(88% of the respondent firms in their study) use derivative instruments.

2. For example, an individual investor may use the protective put strategy to limit the pos-
sible loss in an investment.

3. VaR refers to the loss that can occur over a given period at a given confidence level, for
details see Chance (2001).

4. See Hausmann and Gavin (1996) who found the volatility of Latin American GDP
Growth was at least twice as great as that in industrial economies over the 1970-1992 pe-
riod.

5. For example, Lee (2001) claims that the Asian derivatives market is in the very early
stages of development and Asia as whole is lagging behind its European counterparts in
this sector as much as 10 years.
Managerial Finance 124

References:

Anonymous, 1999, Schools brief: the future of finance, The Economist, London, Dec 11,
71-72.

Arak, M., Goodman, L.S. and Rones, A., 1988, Credit lines for new instruments: swaps,
over-the-counter options, forwards and floor-ceiling agreements, Bank Structure and
Competition, 437-56.

Baldoni, R., 2001, Financial risk management: journey or destination? Directorship,

June, 13-20.

Balino, T.J.T., and Ubide, A., 2000, The new world of banking, Finance and Develop-
ment, June, 41-44.

Black, F. and Scholes, M.S., 1973, The pricing of options and corporate liabilities, Jour-
nal of Political Economy, May-June, 81(3), 637-54.

Blommestein, H.J., 2000, The changing nature of risk and the challenges to sound risk
management in the new global financial landscape. Financial Market Trends,
March,171-194.

Bruce, R., McKern, B., Pollard, I., and Skully, M., 1997, Handbook of Australian Corpo-
rate Finance, 5th edition, Butterworths.

Chance, D.M., 2001, An introduction to derivatives and risk management, 5th edition,
Harcourt.

Dowd, K., 1998, Beyond value at risk, John Wiley & Sons.

Fatemi, A. and Glaum, M., 2000, Risk management practice of German firms, Manage-
rial Finance, Vol. 26 N0 3, 1-17.

Gao, S., 2001, Strategic risk management and high-tech risks, The Proceedings of Risk
Management Forum on the High-Tech Industry in Taiwan and the UK, May 2001, Tai-
wan.

Grenville, S.A., 2000, Globalisation and the international financial architecture: writing
(and righting) the rules, Reserve Bank of Australia Bulletin, July.

Hausmann, R. and Gavin, M., 1996, Security stability and growth in a shock-prone re-
gion: the policy of challenge for Latin America. In Ricardo Hausmann and Helmut Re-
isen, eds., Security stability and growth in Latin America, OECD.

Jalilvand, A., Switzer, J. and Tang, C., 2000, A Global perspective on the use of deriva-
tives for corporate risk management decisions, Managerial Finance, Vol. 26 N0. 3, 29-
38.

Jorgenson, D.W., 2001, Information technology and the U.S. economy, The American
Economic Review, Vol 91 No.1, 1-31.
Volume 29 Number 5/6 2003 125

Kimball, R.C., 2000, Failures in risk management, New England Economic Review,
Jan/Feb, 3-12.
Lee, J., 2001, Derivatives market yet to mature, Asia money, London, Vol.12, Issue 3,
36-38.
Li, S., 2001, Some thoughts on managing e-commerce risks, Proceedings of the 2nd Inter-
national We-B Conference, Edith Cowan University, 165-170.
Martins, L.F., Petrov, C. and Kelly, J.M., 2001, Managing market risk for an emerging
market debt portfolio, Journal of Portfolio Management, Vol. 27, Issue 2, 75-90.
Merton, R.C., 1973, theory of rational option pricing, Bell Journal of Economics and
Management Science, 4(1), 142-83.
Scholes, M.S., 1998, Derivatives in a dynamic environment, The American Economic Re-
view, Vol 88, No.3, 350-370.
Smithson, C.W., 1998, Managing Financial Risk, A guide to derivative products, finan-
cial engineering and value maximization, McGraw-Hill.
Tortoriello, B., 2000, Basel Proposal for a new capital adequacy framework, Banking
Policy Report, New York, Jan 3.
Zolkos,R., 2001, Alternative risk transfer tools growing in popularity, Business
Insurance, Vol 35, Issue 20,16-19.