Risk (Finance)

Risk, in finance, is the possibility that the actual result of an investment, loan or business decision will differ from the expected result, and in particular that it will turn out worse. It covers both the chance of loss and the uncertainty of outcomes in general: a share whose price swings wildly is described as risky even if it has gone up. Investors, banks, insurers, companies and regulators all build their decisions around measuring, pricing and limiting risk.

Economists draw a line, following Frank Knight in 1921, between risk, where the possible outcomes and their odds can be estimated, and Knightian uncertainty, where they cannot. Financial risk is closely tied to return: investors demand a risk premium for holding risky assets, which gives the risk–return trade-off. The international standard ISO 31000 defines risk broadly as the effect of uncertainty on objectives.

Think of planning a picnic. You know roughly how often it rains in your town at this time of year, so you can judge the chance of a soggy afternoon and decide whether to pack an umbrella or book a covered spot. That known chance of things going differently from plan is risk.

Money decisions work the same way. Lending to a friend, buying a share or starting a shop all come with a range of possible results, some better and some worse than you hope. Finance tries to measure how wide that range is, how bad the worst cases could be, and what reward is fair for taking the chance.

• Market risk. Losses from movements in prices, interest rates, exchange rates or commodity prices; see market risk and interest rate risk.
• Credit risk. The chance that a borrower or issuer fails to pay; see credit risk.
• Liquidity risk. Being unable to sell an asset or raise funding quickly without a large loss; see liquidity risk.
• Operational risk. Losses from failed processes, systems, people or outside events such as fraud and cyberattacks; see operational risk.
• Sovereign and political risk. Losses from government actions, default or capital controls; see sovereign risk.
• Systematic and systemic risk. Systematic risk is the market-wide part of an asset's risk that diversification cannot remove; systemic risk is the danger that the financial system itself breaks down.

The most common measure is the variability of returns, captured by standard deviation or its square, variance. For a set of possible returns $R_i$ with probabilities $p_i$, variance is:

• $\sigma^{2}$ is the variance and $\sigma$ its square root, the standard deviation.
• $p_i$ is the probability of outcome $i$.
• $R_i$ is the return in outcome $i$ and $\bar{R}$ is the expected (probability-weighted average) return.

Worked example: an investment returns +20% or −10% with equal probability. The expected return is 5%. Each outcome is 15 points away from it, so the variance is $0.5 \times 15^{2} + 0.5 \times 15^{2} = 225$ and the standard deviation is 15 percentage points.

Other measures focus on specific aspects: beta measures sensitivity to the market; value at risk and expected shortfall estimate losses in bad cases; duration measures sensitivity to interest rates; credit ratings and default probabilities measure credit risk; and stress tests ask what happens in a severe but plausible scenario. Many measures assume returns follow a normal distribution, but real returns have fat tails, with extreme moves more common than that model suggests.

Because most people show risk aversion, riskier assets must offer higher expected returns to attract buyers. Models such as the Capital Asset Pricing Model (CAPM) set the required return on a share according to its systematic risk, and comparisons between investments use risk-adjusted return measures. Each investor's risk tolerance then shapes how much risk they choose to take.

Risk can be reduced, transferred or accepted. Diversification spreads money across many assets so that single failures matter less. Hedging with derivatives such as futures, options and swaps offsets specific exposures. Insurance transfers defined risks to an insurer for a premium. Banks hold capital and liquidity buffers set by international standards such as Basel III, and firms use limits, collateral and internal controls as part of wider risk management.

Risk numbers rest on past data and on models, and both can fail. Correlations between assets often rise in a crisis, just when diversification is needed most. Rare events outside the historical record, sometimes called a black swan, may not appear in any estimate. Critics such as Nassim Nicholas Taleb argue that precise-looking measures can encourage excess leverage by giving false comfort, which is why regulators pair models with stress tests and simple limits.

• Investor.gov (US SEC): What is risk?