Risk (finance)
Risk in finance encompasses the possibility of losing something of value, which can include monetary assets, time, or opportunities. The relationship between risk and reward is fundamental; typically, as the level of risk increases, so does the potential for reward. Understanding risk involves several interconnected disciplines, including risk perception, assessment, management, and decision-making. Risk perception refers to individuals' subjective judgments about the level of risk associated with various ventures, which can often be miscalibrated. Effective risk assessment and analysis involve identifying and evaluating risks, using both quantitative and qualitative methods, to determine how to mitigate those risks to an acceptable level.
Risk management is the practical application of this assessment, focusing on reducing threats and uncertainties in any course of action. The implications of risk are vast, influencing decisions in corporate settings, financial markets, military operations, and everyday personal life. For instance, individuals routinely assess risks when engaging in activities like driving, where different strategies—such as wearing seat belts or adhering to speed limits—help to mitigate risks. Overall, understanding and managing risk is essential for informed decision-making across various domains.
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Risk (finance)
In the world of economics and finance, the term risk refers to the possibility of losing something of value. Value in the sense of risk can be anything which has a measure of worth, be it monetary, time, or opportunity costs. Risk varies with uncertainty. Typically, as risk increases, so too does reward. Risk has many different areas of study that further the understanding of risk, to include risk perception, risk analysis, risk management, and decision making. The impact of risk and reward, as well as the studies that further the understanding of risk, have applications in corporate, financial, military, and personal processes.
Background
Financial risk is the focus of several areas of academic study, to include risk perception, risk assessment and analysis, risk management, and the application of risk to decision making. These topics are all interconnected to varying degrees and are used in a wide range of fields of study.
Risk perception is a value judgment made by an individual as to what the level of risk is in any given venture. Individuals may be willing to accept low or high levels of risk in their portfolios. The study of risk perception began in the 1960s and combines the financial sense of risk with the psychological study of perception. Risk perception demonstrates that individuals often weight risk factors incorrectly because of their perceptions of the world. For example, many people view the risk of terrorism as more significant than the risk of dying in an automobile accident. While there may be places in the world where the chance of dying as the result of an act of terrorism is greater than that of dying in an automobile accident, the vast majority of the world is at greater risk from the latter than the former. As a result of poor risk perception, risk assessment and analysis become flawed.
Risk assessment and analysis is the process of determining what risks and threats are present in any given venture and how to reduce risk to a more acceptable level. Risk assessment and analysis is a quantitative and qualitative study. The trend in risk assessment and analysis is tending toward a mathematical and algorithmic approach, as opposed to a simple qualitative study. After risk is assessed and analyzed it is then managed.
Risk management is the process of reducing risk and operating within a given level of acceptable risk. This is done by identifying the threats inherent in the proposed course of action and determining what can be done to mitigate those threats to an acceptable level. This composes a large portion of the decision-making process, which involves the analysis of risk and application of how to invest with a given level of risk. The final step of the decision-making process is when the actual investment or course of action takes place.
Topic Today
Risk and reward drive corporate, financial, military, political, and personal processes for people. Each entity seeks to perceive risk accurately, assess the risk to be the actual and appropriate level, and then manage the risk and take actions based on the perception and mitigation of risk.
Corporate risk exists within markets, and mitigation of corporate risk requires determining the best course of action for the business or corporation. Risks exist in large part during buyouts and corporate mergers, when one or both parties may have incomplete information that prohibits either group from having an accurate picture of the operating environment. Under risk assessment and analysis, during a merger the corporation needs to assess the risks if the merger is not successful. As an example, the corporation needs to consider what impact a possible failed merger would have on its stockholders.
Financial risk exists on a daily basis in worldwide stock markets, mutual funds, investment banking, and currency exchanges. Due to the fluctuations of markets throughout the world, there is an inherent risk in losing assets, primarily monetary ones. This risk can be mitigated by careful study of the markets, or the use of a professional trader. Individuals who are risk averse, those who do not like risk, tend to avoid trading in the markets.
Risk also exists in one’s personal life, as does risk assessment, analysis, mitigation and management. Many activities that ordinary people engage in have an associated risk factor. Consider when a person drives an automobile. There are inherent risk factors in operating a vehicle. Those factors are mitigated by the use of seat belts, speed limits, driver’s education, and choice of motor vehicle. Individuals who allow more risk into their lives may choose to drive faster, endorse a vehicle that is not as safe, or take other chances that a more reasonable person would not. It is the daily assessment of risk that allows individuals to continue to live their lives.
Bibliography
Bessis, Joel. Risk Management in Banking. Hoboken: John Wiley, 2015. Print.
Coleman, Thomas. A Practical Guide to Risk Management. Charlottesville: Research Foundation of CFA, 2011. Print.
Crouhy, Michel, Dan Galai, and Robert Mark. The Essentials of Risk Management. New York: McGraw-Hill, 2014. Print.
Gardner, Dan. Risk: The Science and Politics of Fear. Toronto: McClelland and Stewart, 2008. Print.
Hubbard, Douglas. The Failure of Risk Management: Why it’s Broken and How to Fix it. Hoboken: John Wiley, 2009. Print.
McNeil, Alexander J., Rüdiger Frey, and Paul Embrechts. Quantitative Risk Management: Concepts, Techniques and Tools: Concepts, Techniques and Tools. Princeton UP, 2015. Print.
Ross, John. Living Dangerously: Navigating the Risks of Everyday Life. New York: Basic Books, 2000. Print.
Tetlock, Philip E., and Dan Gardner. Superforecasting: The Art and Science of Prediction. New York: Crown Publishing, 2015. Print.