Risk

Explained:

risk


 
   

Risk has two components:

1. uncertainty, and
2. exposure.

If either is not present, there is no risk.

Suppose a man jumps out of an airplane with a parachute on his back. He may be uncertain as to whether or not the chute will open. He is taking risk because he is exposed to that uncertainty. If the chute fails to open, he will suffer personally.

Now suppose the man jumps out of the plane without a parachute on his back. If he is certain to die, he faces no risk. Risk requires exposure and uncertainty.

A synonym for uncertainty is ignorance. We face risk because we are ignorant about the future. After all, if we were omniscient, there would be no risk. Because ignorance is a personal experience, risk is necessarily subjective. Consider another example:

A man is heading to the airport to catch a flight. The weather is threatening, and it is possible the flight has been canceled. He is uncertain as to the status of the flight and faces exposure to that uncertainty. His travel plans will be disrupted if the flight is canceled. Accordingly, he faces risk.

Suppose a woman is also heading to the airport to catch the same flight. She has called ahead and confirmed that the flight is not canceled. She has less uncertainty and faces lower risk.

 
 

In this example, there are two individuals exposed to the same event. Because they have different levels of uncertainty, they face different levels of risk. Risk is subjective.

Risk is a personal experience, not only because it is subjective, but because it is individuals who suffer the consequences of risk. Although we may speak of companies taking risk, in actuality, companies are merely conduits for risk. Ultimately, all risks which flow through an organization accrue to individuals—stockholders, creditors, employees, customers, board members, etc.

Related Internal Links

credit risk Risk due to uncertainty in a counterparty's ability to perform on an obligation.

hedging and diversification Techniques for reducing risk.

legal risk Risk from uncertainty due to legal actions or uncertainty in the applicability or interpretation of contracts, laws or regulations.

leverage Debt financing or anything that can similarly magnify the risk and reward of an investment.

liquidity risk Risk due to uncertain liquidity.

market risk Risk due to uncertainty in the market value of a portfolio.

operational risk Sometimes defined as encompassing all financial risks other than market and credit risks.

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Related Papers

Holton, Glyn A. (2004). Defining risk, Financial Analysts Journal, 60 (6), 19–25.

Related Forum Discussions

Subjective VaR 01 Apr 2004
Subjective nature of risk—is anything truly random?

Why is risk/uncertainty unpleasant? 12 Apr 2003
Modifying investors risk aversion.

Risk Intuition 16 Dec 1998
Debate about the definition of risk.

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copyright © Glyn A. Holton, 2004

Although the information in this website has been presented with care and obtained from sources the author believes to be reliable, there is no guarantee that it is accurate. Such information may be incomplete, condensed, outdated or presented with errors. The content of the website is for information purposes only. It is provided gratuitously, so the author shall not be liable under any theory for any damages suffered by any user. The author does not provide investment advice, and this website is not a vehicle for communicating investment advice.