Week 4: Introduction

This week’s focus will be on risk management in practice. Risk management is all about how to balance risk and return. In financial markets, high risk implies higher return if the investor can closely forecast future movement of the market. However, high risk can also mean larger losses if things don’t go the way that the investor predicts. In both real and financial sectors, future transactions need to be planned. But information about future transactions isn’t always available. Therefore, for individual investors, financial firms, non-financial firms, and other organisations, risk management matters. In this week’s sessions, we will discuss how to use financial tools to implement risk management in practice. We will start by explaining from a theoretical perspective what causes financial crises.

We will present some theoretical arguments concerning the motivations for non-financial firms to implement risk management, looking at examples of how non-financial firms use financial derivatives to hedge. We will also discuss the information contained in the yield curve, which is very important for policy makers to watch the development of the economy by forecasting changes in the interest rate. The information revealed by the yield curve is also useful for households and in personal finance, because it helps individuals predict the direction in which the interest rate moves. We will end the week by summarising some of the problems faced while implementing risk management in practice.

Although we see those problems mainly in mature financial systems, they do have important implications for policy makers in emerging economies, particularly when designing policy or measures for developing financial systems in emerging markets. Let’s start by looking at what causes financial crises.