Mitigating risk is the process of managing situations of potential loss to maintain economic gains in the long run. It is a continuous process, and coordinated efforts are undertaken by all levels of management and junior staff, committed to ensuring the security of returns on investment. Risk in itself is the probability for which there is a change in return on investment. Risk mitigation strategies are the methods employed by a company to mitigate risk. The strategies are employed after a careful analysis of the risks involved. Every risk requires a different mitigation strategy, depending on the outcomes of the analysis performed. There are two broad categories of risk mitigation strategies; internal risk mitigation and external risk mitigation (Woods & Dowd, 2008).
Internal risk mitigation strategy is a branch of mitigation strategy in which an organization takes a passive approach to the risks involved. In this approach, the company executives do not try to stop the risk in any way. The methods involved in this include natural hedging and internal netting (Woods & Dowd, 2008).
Natural hedging is a form of risk management strategy where different risks get covered or offset by other risks through negative correlation (Woods & Dowd, 2008). The benefits of natural hedging include protection from changes in interest rates and inflation, minimize losses in currency exchange rates and help the company secure return on investments. On the downside, maintaining low-level risks could hurt the profitability of a company in the long run due to lower returns (eFinance management, n.d.).
Internal netting is a risk management strategy where multiple transactions are consolidated into one and are used to control foreign exchange risks (Woods & Dowd, 2008). The benefits of netting include enhancing faster settlement by reducing the number of transactions. Reducing the number of transactions reduces the chances of a payment defaulting by the other party. Since it is a form of hedging, its biggest disadvantage is that it is subject to the rule of low-risk low return (eFinance Management, n.d.).
External risk mitigation strategies involve the use of second or third parties to spread the risk with or completely transfer the risk to (Zingler & Walker, 1965). These are risk-sharing and risk transfer, respectively. In risk-sharing, the company minimizes loss by bearing part of the risk while its partners handle the other part. Risk-sharing strategies include forwards, swaps, joint ventures, and futures (Zingler & Walker, 1965).
Forward contracts involve setting a price for and a date on which assets will be supplied in the future. The benefit of the forward contract is to protect against fluctuations in asset prices, resulting in losses for the seller or buyer. The common disadvantage of forwards is that drastic changes in the spot price of a commodity will affect profitability for either party. Futures contracts are similar to forwards contracts, with the difference being that the price-setting is done in a standardized format and occurs in organized exchanges (Woods & Dowd, 2008).
A swap is a contract to exchange risk that comes from differences in cash flows. Differences in cash flows can emanate from floating interest rates, in which the interest rate for loans fluctuates depending on market conditions. Swaps can be great for reducing initial capital, to venture into new markets, and bypass regulatory restrictions. The disadvantage is that it could lead to serious losses to the party that agrees to finance the difference should the interest rate go up. At the same time, there are concerns over defaulting by either party to these payments (Woods & Dowd, 2008).
Joint ventures occur when two or more businesses join together to achieve a common goal while still legally remaining as different entities. Joint ventures are useful when it comes to entering a new market where the conditions are uncertain. Businesses assist each other in sharing the risks brought about by the challenges of such market entry. Another benefit of joint ventures is that businesses can share their expertise, knowledge, and experience and thus make better decisions. Joint ventures, however, can suffer from great imbalances caused by unequal resources for either party, a clash of company cultures and beliefs, and they require much research and planning to be successful, which can take long(Woods & Dowd, 2008).
Under external risk mitigation strategies, the second class of strategies is risk transfer. In risk transfer, the company completely transfers risks to a partner while still maintaining the benefits. Strategies under risk transfer include options, insurance, and securitization (Zingler & Walker, 1965).
Options are contracts that give a company the right but not the obligation to buy or sell an asset within a given time period at a known price. The benefit of buying options is that put they protect their owners from potential losses. They also give companies some time to source extra funding to complete transactions without losing the asset of interest. The disadvantage to this is that losses can be incurred if an asset loses value, and the buyer is forced to buy it before the term period is complete, thus buying at a significant loss (Woods & Dowd, 2008).
Insurance contracts are contracts in which a company pays a monthly premium to an insurance company for protection against losses when the asset insured is damaged. The advantage of having insurance is that the company will be fully compensated in case of damage or loss of the insured property. The disadvantage is that the terms of the insurance may not cover the asset due to a particular type of damage, for instance, force majeure. Another disadvantage to insurance is that they take longer to mature, and the returns on maturity might be lower than the cost of premiums (Woods & Dowd, 2008).
Securitization is the process of selling assets that are not easily convertible to cash (illiquid) into assets that are easily convertible to cash (liquid) through a financial medium. Securitization increases the ability of a business to expand by offering other valuable assets as security for more money from lending institutions. An advantage of securitization is that it reduces the cost of funding and shortens the time for loan approval. The disadvantage of securitization is the potential for loss for investors in case of defaulting by the company. The process is also very complex and involves many parties. It also encourages lending to companies with bad credit scores (Diamond, 2016; M, 2019).
References
Diamond, H. (2016). Mechanics and Benefits of Securitization. 1–5.
eFinance management. (n.d.). Natural Hedging – Benefits, Disadvantages And More. Retrieved May 18, 2021, from https://efinancemanagement.com/investment-decisions/natural-hedging
M, . Prachi. (2019, November 25). What is Securitization? Definition, Process, Types, Advantages, Disadvantages – The Investors Book. https://theinvestorsbook.com/securitization.html#Disadvantages
Woods, M., & Dowd, K. (2008). Financial Risk Management for Management Accountants. The Society of Management Accountants of Canada, the American Institute of Certified Public Accountants and The Chartered Institute of Management Accountants., 1–30.
Zingler, E. K., & Walker, E. W. (1965). Essentials of Financial Management. In The Journal of Finance (Vol. 20, Issue 4). https://doi.org/10.2307/2977273
