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Risk Treatment Strategies

Once a risk is measured, four responses are available: avoid it (do not take the exposure), retain it (accept and self-insure, ideally within an explicit appetite), mitigate it (reduce its likelihood or severity), or transfer it (shift it to a third party). Transfer and mitigation are achieved through three classic mechanisms: insurance (pay a premium so an insurer bears the loss), hedging (take an offsetting position, typically with derivatives), and diversification (spread exposure so idiosyncratic shocks partly cancel). The right choice depends on cost, on how cheaply the risk can be laid off, and on which risks the firm is actually paid to bear.

Why it matters

Treat it like a leaky roof. You can avoid it (do not buy that house), retain it (keep a repair fund and pay as it leaks), mitigate it (patch the worst spots to slow the damage), or transfer it (buy insurance so someone else pays). Hedging is the financial version of an offsetting bet, diversification is not putting every barrel under one hole, and insurance is paying a premium to make the loss someone else's problem. A firm should keep the risks it understands and is rewarded for, and offload the rest cheaply.

Formulas

Hedge ratio (transfer via offset)
h∗=ρS,F σSσFh^* = \rho_{S,F} \, \frac{\sigma_S}{\sigma_F}
The minimum-variance hedge ratio: how many units of the hedging instrument FF offset one unit of exposure SS, using their correlation ρS,F\rho_{S,F} and volatilities. A hedge transfers price risk to the counterparty.
Diversification (variance of an equal-weight portfolio)
σp2=1n σˉ2+n−1n cov‾\sigma_p^2 = \frac{1}{n}\,\bar{\sigma}^2 + \frac{n-1}{n}\,\overline{\mathrm{cov}}
As nn grows, the first term vanishes and only average covariance remains. Diversification removes idiosyncratic risk but cannot remove the common (systematic) component.

Worked examples

Scenario

A wheat farmer faces a falling harvest price. Map one example to each of the four treatments.

Solution

Avoid: plant a different crop and skip wheat-price exposure. Retain: accept the price swing and hold a cash buffer. Mitigate: stagger sales across the season so no single low price dominates. Transfer: sell wheat futures (hedging) to lock a price, or buy crop-price insurance. The farmer is paid to grow wheat, not to speculate on its price, so transferring price risk while retaining production risk is the natural split.

Common mistakes

  • ✗Hedging removes all risk. A hedge offsets a targeted exposure but introduces basis risk and counterparty risk, and an imperfect correlation leaves residual risk behind.
  • ✗Diversification can eliminate every risk. Diversification removes idiosyncratic (firm-specific) risk, but the common systematic component remains no matter how many names you hold.
  • ✗Insurance and hedging are the same thing. Insurance pays a premium to transfer loss to an insurer (one-sided protection), while hedging takes an offsetting market position that also gives up upside.
  • ✗Retaining a risk means ignoring it. Retention is a deliberate choice to bear a risk within appetite, usually backed by capital or reserves, not a failure to act.

Revision bullets

  • •Four treatments: avoid, retain, mitigate, transfer
  • •Three mechanisms: insurance, hedging, diversification
  • •Hedging = offsetting position; transfers price risk, adds basis/counterparty risk
  • •Diversification kills idiosyncratic risk, not systematic risk
  • •Keep risks you are paid to bear; lay off the rest cheaply

Quick check

A company buys an insurance policy against factory fire. Which risk treatment is this?

Diversifying across many stocks reduces which kind of risk?

Connected topics

What Is RiskRM ProcessRisk TaxonomyMarket Risk

Sources

  1. GARP FRM Part I — Foundations
    Global Association of Risk Professionals. FRM Exam Part I: Foundations of Risk Management. GARP, 2023.
    Catalogues risk responses (avoid, retain, mitigate, transfer) and the roles of hedging, insurance, and diversification.
  2. Hull (2018), Ch. 1, 7
    Hull, J. C. Risk Management and Financial Institutions. 5th ed. Wiley, 2018.
    Covers hedging and diversification as core mechanisms for reducing and transferring financial risk.
How to cite this page
Dr. Phil's Quant Lab. (2026). Risk Treatment Strategies. Derivatives Atlas. https://phucnguyenvan.com/concept/frm-risk-treatment
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