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Risk

Risk is the potential that a chosen action or activity (including thechoice of inaction) will lead to a loss (an undesirable outcome). Thenotion implies that a choice having an influence on the outcomeexists (or existed). Potential losses themselves may also be called"risks". Almost any human endeavour carries some risk, but some aremuch more risky than others.As risk carries so many different meanings there are many formalmethods used to assess or to "measure" risk. Some of thequantitative definitions of risk are well-grounded in statistics theoryand lead naturally to statistical estimates, but some are moresubjective. For example in many cases a critical factor is humandecision making.

Even when statistical estimates are available, in many cases risk isassociated with rare failures of some kind, and data may be sparse.Often, the probability of a negative event is estimated by using thefrequency of past similar events or by event tree methods, butprobabilities for rare failures may be difficult to estimate if an eventtree cannot be formulated. This makes risk assessment difficult inhazardous industries (for example nuclear energy) where thefrequency of failures is rare and harmful consequences of failure arevery high.

Statistical methods may also require the use of a Cost function, whichin turn often requires the calculation of the cost of the loss of humanlife, a difficult problem. One approach is to ask what people arewilling to pay to insure against death, and radiological release, but asthe answers depend very strongly on the circumstances it is not clearthat this approach is effective.

Types of Risk:

Systematic Risk - Systematic risk influences a large number ofassets. A significant political event, for example, could affect severalof the assets in your portfolio. It is virtually impossible to protectyourself against this type of risk.

Unsystematic Risk - Unsystematic risk is sometimes referred toas "specific risk". This kind of risk affects a very small number of

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assets. An example is news that affects a specific stock such as asudden strike by employees. Diversification is the only way to protectyourself from unsystematic risk.

Now that the fundamental types of risk are determined, let's look atmore specific types of risk, particularly concerned about stocks andbonds.

Credit or Default Risk - Credit risk is the risk that a company orindividual will be unable to pay the contractual interest or principal onits debt obligations. This type of risk is of particular concern toinvestors who hold bonds in their portfolios. Government bonds,especially those issued by the federal government, have the leastamount of default risk and the lowest returns, while corporate bonds

tend to have the highest amount of default risk but also higherinterest rates. Bonds with a lower chance of default are considered tobe investment grade, while bonds with higher chances areconsidered to be junk bonds. Bond rating services, such as Moody's,allows investors to determine which bonds are investment-grade, andwhich bonds are junk.

Country Risk - Country risk refers to the risk that a country won'tbe able to honor its financial commitments. When a country defaultson its obligations, this can harm the performance of all other financialinstruments in that country as well as other countries it has relationswith. Country risk applies to stocks, bonds, mutual funds, options andfutures that are issued within a particular country. This type of risk ismost often seen in emerging markets or countries that have a severedeficit.

Foreign-Exchange Risk - When investing in foreign countries youmust consider the fact that currency exchange rates can change theprice of the asset as well. Foreign-exchange risk applies to all

financial instruments that are in a currency other than one's domesticcurrency.

Financial risk - is an umbrella term for any risk associated withany form of financing. Risk may be taken as downside risk, thedifference between the actual return and the expected return (whenthe actual return is less), or the uncertainty of that return. Risk related

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to an investment is often called investment risk. Risk related to acompany's cash flow is called business risk.

Business risk - The uncertainty associated with a business firm'soperating environment and reflected in the variability of earningsbefore interest and taxes (EBIT). Since this earnings measure hasnot had financing expenses removed, it reflect the risk associatedwith business operations rather than methods of debt financing. Thisrisk is often discussed in General Business Management courses.

Interest Rate Risk - Interest rate risk is the risk that aninvestment's value will change as a result of a change in interestrates. This risk affects the value of bonds more directly than stocks.

Political Risk - Political risk represents the financial risk that acountry's government will suddenly change its policies. This is amajor reason why developing countries lack foreign investment.

Market Risk - This is the most familiar of all risks. Also referred toas volatility, market risk is the the day-to-day fluctuations in a stock'sprice. Market risk applies mainly to stocks and options. As a whole,stocks tend to perform well during a bull market and poorly during abear market - volatility is not so much a cause but an effect of certainmarket forces. Volatility is a measure of risk because it refers to thebehavior, or "temperament", of your investment rather than thereason for this behavior. Because market movement is the reasonwhy people can make money from stocks, volatility is essential forreturns, and the more unstable the investment the more chance thereis that it will experience a dramatic change in either direction.