Risk is a broad term and can be used in different ways, however put simply it is the future uncertainty that an outcome will differ from that previously expected. In finance, risk is present in every investment decision and accordingly, it needs to be acutely assessed by an investor in arriving at the adequate rate of return to compensate the level of risk.
This implies that the higher the level of risk the greater the rate of return. Nonetheless, there are securities classified as riskless securities, such as short-term U.S, Treasuries. Given that such securities are covered by the credit worthiness of the U.S government, they offer little to no risk and are also referred to as safe heaven investments. Accordingly, such investments offer the lowest rate of return and usually form the baseline for measuring risk. This return is what constitutes the risk-free rate.
One of the constituents of risk is time. Naturally, the longer the investment’s maturity the higher the compensation. This concept is what is referred to as the time value of money. A sum of money today will not equate to the same amount of money in 10-years’ time and this is a result of inflation, which will undermine the future purchasing power.
Finance risk is broadly classified in two categories: systematic risk and unsystematic risk. Systematic risks are risks that can affect the economic market in general or a large portion of it. Conversely, unsystematic risks are risks that pertain to a specific industry or company, hence these risks are also referred to as specific risks or idiosyncratic risks.
Systematic risk is the risk of deviation from expected outcomes due to factors, such as country risk, foreign-exchange risk, interest rate risk, political risk, and liquidity risk. On the other hand, unsystematic risk includes specific risk, such as business risk, credit/default risk and counterparty risk. In addition to these risks, unsystematic risk also includes risk due to a change in the company or the market, for instance new competitor, change in the regulator environment of the company, change in management and other factors that can result in lower than expected investment return.
In determining the level of risk, novice investors tend to focus on unsystematic risk rather than systematic risk (also referred to as market risk). Although, the unsystematic risk directly impacts the performance of a company, one should also assess the impact from systematic risk. This is substantiated by the fact that market risk cannot be easily mitigated through portfolio diversification, in contrary to specific risk that can be diversified by investing in a variety of assets.
It is interesting to note that effective risk monitoring is not only performed at investor level, but also at a company level. Given the volatile nature of markets, it is important for corporations to have a robust risk-monitoring program, in order to measure their risk exposure effectively.
This concept is clearly visible in the current market, where large entities are forfeiting revenue/profits in compensation for lowering their risk exposure. For instance, last year the multinational Dutch bank, ING was fined $900 million for failing to spot money laundering. This consequently led to this bank’s de-risking exercise, which amongst others led to ING’s withdrawal of its US dollar correspondent banking service to a major local bank.
Ultimately, risk is an essential constituent of every investment decision both at an individual level and at a corporate level. Effective risk monitoring and the successful implementation of risk measures, is crucial in maintaining a stable investment return and also hedging against unexpected outcomes, the magnitude of which can at times be too significant to underestimate.
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