Introduction to Risk
Risk is the exposure to any uncertain and undesirable event. Three elements identify Risk: the undesirable event, the intensity of the undesirable event and the probability of its occurrence. Every investment is characterised by its return – or by its expected return – and by its Risk; it can therefore be identified by the measure of this two quantities. Risk and Returns are directly correlated. The Returns of any investment can be considered as the compensation for the Risk that is being taken; it is therefore correct to intuitively expect higher Risks from higher yielding investments, and vice versa, to expect lower yielding investments for lower Risks. The definition of Risk (undesirable event) of an investment is the possibility of obtaining a lower return than the expected one. This Risk can be divided in three macro categories: business risk, non-business risk and financial risk.
The Financial Risk can be furthermore divided into: Market Risk (fluctuation of market prices); Foreign Exchange Risk (FX Risk – fluctuation of currencies exchange rates); Credit Risk (failure to make due payments to creditors), Sovereign Risk and Settlement Risk can also be included in this category; Solvency Risk and Liquidity Risk (when an asset is not readily sellable); Execution Risk (technical or human error in the execution of a transaction); Legal Risk. Risk can actually affect us in many more ways as this is only a Synthesis of the universe of Risks.
Every investment has a Risk component – some investments have an extremely low Risk, but not without Risk. Furthermore, the optimization and manageability of the risk of a single financial activity is scarce. It is interesting to note that “risk free” investments have extremely low returns (if not negative in real terms) which is acceptable only for short periods; the investor is therefore obliged to take higher risks in order to reach returns considered acceptable.
In reality, we should not be interested in the Risk of a single security as it usually is only a part of a more complex portfolio composed by a multitude of investments. Our concern should therefore be the Risk of the entire portfolio. This measure is not intuitively deductible as it is determined by different factors and not by the Risk of each single investment.
It is therefore necessary to measure the Risk of the entire portfolio and of its variations due to new investments and, eventually, to new market conditions. As opposed to the measure of Risk of a single security, the measure of the Risk of a portfolio is manageable, modifiable and can therefore be optimized.