Risk in Finance

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 What Is Risk?

Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.



Summary:

  • Risk takes on many forms but is broadly categorized as the chance an outcome or investment's actual gain will differ from the expected outcome or return.
  • Risk includes the possibility of losing some or all of an investment.
  • There are several types of risk and several ways to quantify risk for analytical assessments.
  • Risk can be reduced using diversification and hedging strategies.
For example:

A $1000 government bond that guarantees it's holder $5 interest after 30 days has no risk because there is no variability associated with the return. A $1,000 investment in a firm's common stock is very risky because the value of that stock may move up or down substantially over the same 30 days.

Sources of Risk in Business: 

There are certain sources of risks that make financial asset quite risky.

  1. Interest rate Risk
  2. Market Risk
  3. Inflation Risk
  4. Business Risk
  5. Financial Risk
  6. Liquidity Risk
  7. Exchange rate Risk
  8. Country Risk

Interest rate risk:

Interest rate risk is referred to variability in returns of a security which result from changes in the level of interest rates. Generally securities are inversely affected by such changes. This means that the price of security moves inversely to the interest rate provided other things being equal. Bonds are more affected by interest rate risk than common stocks but normally both are affected by interest rate risk and it is very significant factor of sources of risk for many investors.

Market risk:

Market risk is considered as the variability in the returns as a consequence of fluctuations in the entire market or aggregate stock market. Mostly common stock is more affected by market risk but all other securities are also exposed to that risk. There is wide range of exogenous factors associated with the securities that are included in the market risk like wars, recessions, changes in the consumer preferences, structural changes in the economy etc.


 

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