Research Paper on 5 Types of Risk Businesses Face: Strategic, Compliance, Operational, Financial & Reputational

Introduction

Businesses encounter five broad types of risks. Firstly, strategic risks relate to the changes that occur in an industry in a specific time, resulting in potential losses or ineffectiveness (Toma & Alexa, 2012). This type of risk includes changes in consumer preferences, a rise in competition, and emerging technologies that cause current products and services to be obsolete. Businesses also have to deal with compliance risk that includes the challenges introduced by legislation and regulations governing the given industry (Toma & Alexa, 2012). Legislations leave companies at the risk of lawsuits and high operational costs. Besides, financial risks exist virtually in every business and industry and relate to the handling of money. Some financial risks embody fluctuations in financial markets, poor planning and projection, and credit default. Operational risks result from the failure of internal processes such as system breakdown (Toma & Alexa, 2012). Other risks that face businesses are natural disasters, political and economic instability, and skill shortage. In retrospect, this paper discusses the financial risk assessments involving the Millennium Management LLC.

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Necessarily, risk managers mitigate the different risks through five steps, including identifying, analyzing, evaluating, treating, and monitoring and reviewing (Na Ranong & Phuenngam, 2009). Risk identification involves screening problems that have adverse effects on investment. In essence, this step of risk mitigation is vital since unknown risks can afflict an organization with substantial losses. In the analysis phase, risk managers should determine the probabilities and consequences of various risks (Na Ranong & Phuenngam, 2009). Risk evaluation entails the determination of the severity of the identified risks to facilitate prioritization. Therefore, in evaluation, a risk manager should assess if the identified risk falls within the acceptable limits. The treatment of risks describes mechanisms that a business implements to deal with the unacceptable risks. However, some risks may not go away at least within a particular timeframe. Thus, risk managers need to regularly initiate surveillance to identify new risks before they distract operations.

A risk register is one of the tools used in financial risk management. The tool allows risk managers to keep a list of all possible financial risks of an organization, which facilitates prevention, monitoring, and treatment mechanisms. Also, companies utilize value at risk (VAR) that uses probability to determine the minimum loss they can incur over a specified timeframe (Labovic & Damnjanovic, 2008). However, they should also implement financial techniques that mitigate various business risks. Currency invoicing in which a firm invoices its exports using the home currency is an applicable strategy for protecting a business against a possible depreciation of foreign currency (Ito, 2018). Besides, a firm may utilize netting to mitigate the risks involved in the receivables and payables for different currencies (Ito, 2018). In netting, a firm matches receivables with payables. Another financial risk mitigation technique involves switching the production base from one region to another to avoid the consequences of currency depreciation. All these strategies apply alterations to internal processes. Alternatively, firms can mitigate financial risks through joint ventures and forwards. In joint ventures, firms agree to share the risks involved in business transactions. However, in a forward, businesses agree to undertake future transactions at a fixed price that reduces the risk of depreciation and price fluctuations.

Financial Risks for Millennium Management LLC

Iqbal (2012) defined liquidity risk as to the inability to meet depositors' or investors' obligations or to fund assets without incurring acceptable levels of costs and losses. Iqbal (2012) noted that if a bank or a company lacks enough cash to meet the depositors' or investors' need for money, it ends up failing to meet its primary objectives. Mostly, liquidity risk arises if a company cannot find a trader interested in purchasing its assets (Iqbal, 2012). If that happens, the chances of the company holding limited cash are high. Millennium Management is amongst the global largest asset management companies operating in the United States, Europe, and Asia. Indeed, the company manages assets worth $40 billion for 15 clients (Millennium Management LLC, 2020). This hedge fund allows investors to pull a certain amount of money every quarter. Undoubtedly, Millennium Management restricts the amount that an investor can draw quarterly to 5% of their total amount, which somehow mitigates liquidity risk. However, even with such stringent measures, the company may struggle with liquidity, especially if multiple investors decide to withdraw their allowed limits simultaneously. Withdrawals involving large amounts might make the company unable to meet its obligation to investors. Unfortunately, such might demoralize investors and cause some of them to shift their investment to other companies.

Additionally, Millennium Management faces pricing risk because the hedge fund sector lacks a standardized pricing model, as many hedge fund managers adopt varying valuation models. However, Dolgui and Proth (2010) revealed that the pricing model plays a critical role in business financials. According to these researchers, a pricing model is a basis upon which a firm can optimize sales, revenue, and augment its competitiveness (Dolgui & Proth, 2010). The lack of a standardized pricing model puts a firm at an increased risk of competition and losses (Dolgui & Proth, 2010). In particular, Millennium Management holds stocks for Honeywell International Inc, Bank New York Mellon Corp, and Pacific Premier Bancorp, amongst others. The company may not have a specific model for pricing the assets for all the clients (Dolgui & Proth, 2010). On the one hand, the company might establish prices so high that it discourages potential customers. On the other hand, Millennium Management may develop the price that does not match its costs and thus compromise profitability.

Also, like other hedge fund companies, Millennium Management experiences credit risk that exists if borrowers are unable to repay their loans (Ameur, 2016). This risk also develops if a firm fails to meet its loan obligations, thereby exposing itself to different expenses (Ameur, 2016). Notably, Millennium Management does not particularly offer loans. However, it utilizes debt financing to sustain some of its operations. Even though this approach is necessary for consistent operations, it exposes the firm to different risks. Mostly, credits have corresponding interest rates that increase the operational cost. Also, defaulting elicits lawsuits that also increases costs due to the charges for court proceedings. Besides, the hedge fund might endure credit risk if clients fail to pay some assets on time. According to Spuchlakova et al. (2015), credit risk is likely to happen if a firm lacks proactive loan policies, deficiencies in risk pricing, and the excessive reliance on collaterals. If Millennium Management does not have mechanisms to mitigate possible defaults or assess clients' abilities to pay for assets, it would ultimately experience cases of defaulting. However, payment defaults expose the company to losses or the lack of operating revenue in a given period. Indeed, business operations run consistently if managers foster consistency in cash inflow and outflow. Defaults imply that the particular business fails to meet cash inflows that can balance the amount of cash the company moves outside its operations like in paying for investors' withdrawals.

Furthermore, Millennium Management might face currency risk, which, as Alvarez et al. (2017) explained, occurs if the currency of foreign market changes. As indicated earlier, this firm operates mainly in three continents, Europe, Asia, and North America, particularly in the U.S. These markets are exposed to political and economic conditions that might be similar and different at times. Thus, Millennium Management might experience risks related to changes in the currencies in one or all of its markets. In their analysis, Plakandaras et al. (2017) found that the value of the pound has depreciated by 15% since the United Kingdom made the Brexit decision. Also, Caporale et al. (2018) informed this discussion by arguing that the uncertainties surrounding Brexit have made financial markets around the world quite volatile. These insights suggest that Millennium Management is potentially exposed to the changes in currencies in its primary markets. Depreciation, which refers to the reduction in the value of a currency, mainly reduces the company's profit margins as well as its value (Plakandaras et al., 2017). In the U.K., going by the mentioned 15% reduction in the value of the pound, Millennium Management must incur declines as clients access assets at a reduced value. Another suitable example of currency devaluation happened during the 2007-2008 financial crisis when most markets around the world, including the U.S. and the U.K., endured a recession, implying that Millennium Management must have incurred significant financial losses as shown in table 1 below.

Table 1: Risk Prioritization

A Strategy that Millennium Management Can Implement to Mitigate Financial Risks

Notably, the financial risks facing Millennium Management are quite diverse and, therefore, can only be managed through a multifaceted approach. In particular, liquidity risk is somehow unrelated to currency and pricing risks, implying that no single technique can mitigate them. Firstly, the company needs to access insurance coverage that transfers the perceived risk to another entity (Jones2010). Specifically, Millennium Management needs to insure its operations against credit risks, particularly those related to client default. In this case, the company will need to pay premiums to an insurance firm so that it can receive compensation from the insurer in the case of defaults. This approach is proactive since it transfers the risk before an event happens. However, the approach is disadvantageous in that it increases the operational costs, as evident in the payment of premiums.

Another option in the multifaceted approach is the limiting of withdrawals of money among investors to a sustainable amount. As noted earlier, the hedge fund currently limits the amount to 5% of the amount that a client invests (Parmar, 2020). However, the management may need to reduce the amount further as part of preventing possible liquidity challenges, which might be highly disruptive. On the same note, Millennium Management may need to devise more stringent policies other than restrictions of the amount. For instance, it needs to formulate policies to ensure that investors can only pull money annually instead of quarterly. The increment in the duration of withdrawing funds can give the company the time to accumulate cash. In the end, this policy should be able to cushion Millennium Management against liquidity problems.

In mitigating pricing risk, Millennium Management needs to adopt cost-plus pricing by selling its assets at prices higher than their unit cost...