How to Approach Financial Risk Management
From economic volatility to current financial risk management strategies and tools, here's what to know about risk management factors for your business.
The American economy has enjoyed a period of long-term growth as it came out of the Great Recession. Interest rates rose, investor confidence grew, and unemployment figures dropped into single-digits for the first time in five years.
Still, fears of a recession abound on Wall Street and Main Street alike, as we enter the period in which previous boom cycles have begun to show weakness. This, coupled with market volatility due to slowing manufacturing demand and trade battles between Washington and Beijing, makes it harder for firms to navigate the risks that come with an uncertain market.
That uncertainty can also create opportunities for savvy middle-market businesses to diversify their investments and internal strategies.
"Currently the Foreign Exchange markets are experiencing their lowest volatility in a decade," said Michael Orefice, managing director of Currency and Commodity sales at Fifth Third. "What people perceive about markets given the current state of world events and what is actually happening in the currency markets, are two different things."
That doesn't necessarily mean that the market is entirely stable. With real-time financial news available at our fingertips, it's easy to be well-read but significantly harder to be informed. Headline-grabbing news may signal uncertain market conditions at first blush, but trends may not necessarily align with current events. This makes it all the more important to figure out which factors indicate risk for your individual business.
Here are the key risk management factors to master for your business.
1. Learn How to Read Signs of Economic Volatility
There are several traditional factors that can signal turbulent economic times ahead. The Bureau of Labor and Statistics' Jobs Report provides a monthly breakdown of the number of jobs created or shed within the previous reporting period. Should the report demonstrate a pattern of negative growth over a discernible amount of time, it may signal that the demand for products and services is diminishing—hence the lack of employment growth.
Another key indicator of economic health is Federal Reserve interest rate changes. As we've seen throughout 2018 and 2019, the Fed will typically raise rates when the economy is growing at an accelerated rate and wants to attempt to keep the market from overheating. Alternatively, the Fed will often decrease interest rates when the economy is showing signs of slowing or retracting, hoping to spur lending by making it less expensive to borrow cash.
Last but not least are volatility indices. These financial instruments are designed to help demonstrate market volatility in real-time. These tools can help investors gauge overall market movements at a glance. They're not necessarily replacements for more in-depth analysis and expert advice, but they can help you keep on top of market moves in real-time.
2. Understand How Market Volatility Impacts Risk Management
Understanding which factors are key to understanding market volatility is just the start. It's equally important to figure out how volatility impacts your business in the short-, medium-, and long-term. For example, international trade wars and tariffs can make it more expensive for manufacturers to import raw materials and goods. This may narrow your company's profit margins as more money is spent on manufacturing a product, even if your vendor contracts locked in lower prices.
Risk management isn't limited to global economic policy, either. In fact, some of the most important factors to watch might be within your own firm's financial strategies. Certain capital-intensive plans, such as expansion into new markets or into new lines of business, can generate risk if done so at the cusp of an economic downturn. Accruing debt before market conditions change can impact revenue projections quickly if the market for your wares suddenly dries up. If you've raised capital through debt, you may have a harder time paying back what you've borrowed, too.
3. Determine Which Risk Management Tips and Tools Your Business Needs
Despite unnerving headlines, social media posts that rattle Wall Street, and key volatility indices fluctuating on a daily basis, there may not be as much cause for doom and gloom as you might think. For example, despite Brexit-related political uncertainty in the United Kingdom, the value of the Pound Sterling has stayed relatively stable. Headlines may not necessarily reflect this kind of relative stability, especially if a country's political environment is more turbulent than its economic conditions.
This doesn't mean that corporates can afford to take a rosy outlook on global news, however. "The truth is, businesses still can’t hedge against event risk," said Orefice. The potential for unexpected turbulence is high, and volatility indicators can only forecast so much. To keep your risk management strategies in shape, Orefice suggests the following tips may help:
- Stress-test your existing risk management strategy. You're always keeping an eye on your business' overall health, and stress-testing its threshold for volatility and risk can help turn your observations into actionable insights. Stress-testing your business against potential risk scenarios will help identify weak spots that you can then strategize against.
- Diversifying your investments may help brace yourself for slow growth*. Going overboard on volatile investment vehicles, many not be the best plan. Instead, consider mixing long-term, short-term, and low-volatility investments to help hedge against overexposure.
- A portfolio that has bonds and other financial vehicles may help hedge overexposure during a market downturn. Offsetting stocks and equities with bonds, may help safeguard losses if volatility turns into a recession.
- Stretch your money further by watching interest rates. Interest rates may drop if the economy shows more signs of a slowdown. If so, you may be able to take advantage of low rates in order to finance capital improvements.
- Get ready to play the long game. The period of shareholder-centric investing may show signs of change as large firms pledge to incorporate other stakeholders in their financial decisions. Determine what your long-term investing and financial strategies look like before (and if) a recession is near.
In addition to these tips, one of the best risk management tactics to take is to bank with a partner you trust. Reading the markets during an era of information overload can be a Herculean—if not downright impossible—task for even the savviest investors. Forging a relationship with a bank that understands your industry, risk, and opportunities can help you separate signal from the noise.
Market volatility isn’t a comfortable reality for most businesses. The best prepared companies, however, can guard themselves against the risks that may come with uneasy financial trends. The most vital practices are, thankfully, the most rudimentary as well: take stock of existing internal conditions and inventory your existing risk in order to go into any long-term economic shifts with confidence.
*Diversification and asset allocation do not guarantee better performance and cannot eliminate the risk of investment loss.
Foreign exchange, interest rate and commodities risk management products offered through Fifth Third Financial Risk Solutions (“FTFRS”), a division of Fifth Third Bank, National Association, which is a provisionally registered Swap Dealer with the Commodities Futures Trading Commission and National Futures Association. The information presented herein is not, and should not be considered to convey, investment advice, a recommendation or an opinion to enter into a specific transaction. Please carefully read the Disclosure of Material Information for Swaps that is provided prior to entering into swap transactions for important information regarding the material risks, characteristics, incentives and conflicts of interest that may be associated with swap transaction.