Risk definition
/What is Risk?
Risk is the probability of a negative outcome. It is a major consideration when deciding whether to make an investment.
A high level of risk is associated with a high standard deviation for the expected return associated with an investment, while a low level of risk is associated with a low standard deviation for expected returns. A business may still elect to make an investment when the associated risk level is high, if the expected returns are also expected to be high. For example, a firm might decide to invest in a country that has a high risk of asset expropriation, if the profits to be earned are also high. In these cases, a business may engage in several risk mitigation tactics, such as altering procedures, outsourcing activities, and buying insurance. In some cases, a business is not willing to take on risk, and so will invest in securities that are considered to be risk-free, such as issuances of the United States government.
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Types of Risk
There are many types of risk, including business risk, counterparty risk, credit risk, currency risk, default risk, downside risk, foreign exchange risk, market risk, operating risk, reputation risk, residual risk, system risk, transaction risk, translation risk, and unsystematic risk. The most important ones are covered in more detail below.
Business Risk
Business risk is associated with the viability of a business. The essential issue is whether the business has a sufficient competitive position, pricing, and cost structure to allow it to remain in business. If it is unable to conduct normal operations while generating a reasonable profit, then it is considered to have a high business risk. This risk is enhanced when a business has poor employee training programs, weak or nonexistent procedures, and incapable managers. The level of business risk will increase when strong competitors enter a market, raw material prices are subject to spikes, and there is a significant risk of lawsuits.