Risk Essay

Risk is a concept that refers to a possibility of occurrence of some undesirable event and is closely related to uncertainty. There is no universally accepted definition of risk. Risk has been considered in many academic disciplines and treated from various points of view. It has been studied as a decisional, behavioral, cognitive, cultural, societal, and emotional phenomenon. It is believed that the notion of risk (similar to the way we perceive it today) first appeared in the Middle Ages in the context of dangers that arise in marine voyages and was used in maritime insurance.

Sometimes risk is defined as a quantity that is characterized both by the probability of the occurrence of a particular event and the magnitude of loss or other undesirable effect resulting from this event. Risk is associated with uncertainty. Sometimes risk and uncertainty are used as synonyms, especially in everyday parlance where risk tends to be a very loose term.

The most famous definition of risk was formulated by Frank Knight, who wrote in the first part of the 20th century when active research and debates on the foundations of probability took place. To understand Knight’s definition of risk, it is important to make a distinction between objective and subjective probabilities. According to the objectivists’ view, the probabilities of events are real; they can be estimated by statistical analysis or discovered by logic. However, those who support the subjective interpretation of probabilities disagree that probabilities are intrinsic to nature. To them, probabilities do not exist objectively and represent nothing more than human beliefs. Objective probabilities can be obtained either a priori, from inherent symmetries (such as those that exist, for example, with the throw of a die) or statistically by examining homogenous data. Knight called “opinions” what others would describe as subjective probabilities. In Knight’s view, probabilities reflect measurable uncertainty, or risk, while opinions describe unmeasurable uncertainty. Thus, Knight made a distinction between risk and uncertainty. The usefulness of such a distinction continues to be a topic of debates.

Some scholars argue that over time, two very important changes occurred in regard to our understanding of risk. At first, the notion of fate, which associated uncertainty with divine intentions and was dominant in the preindustrial epoch, was replaced with the confidence in the human ability to deal with uncertainty by using probability theory and scientific knowledge. Risk assessments based on probability led to the development of insurance, the emergence of a welfare state that provides protection against unemployment, ill health, and other hazards. However, starting roughly from World War II, a so-called risk society has originated—this is the term that sociologists use to describe an industrial society confronted with uninsurable risks such as global warming, the corruption of food chains, a global financial collapse, and so forth. Such risks are worldwide rather than national in nature.

Several academic disciplines have been concerned with decision making in the face of risk. Decision theory is a branch of knowledge developed by mathematicians, statisticians, and economists that studies the choices under uncertainty. Decision theory models people as rational agents who maximize their expected utility by making choices that are consistent with their preferences and objectives. However, problems arise when one attempts to apply these theoretical notions to a practical decision-making context. Psychological research has shown that individuals behave quite differently from the ways their behavior is described in decision theory and mainstream economic literature. There are suggestions that people tend to ignore risk situations that are very remote or highly unlikely, even if they have potentially important consequences. People make different risky choices about the same problem depending on the way it is framed. Another interesting finding is that humans treat absolute gains and losses differently. Low probability but very dramatic events tend to get excessive attention. This behavioral phenomenon has been observed in various contexts, including political decision making. When dealing with risky situations, many individuals prefer to use verbal rather than numerical characteristics of risk.

Types And Measures Of Risk

A number of risks are particularly relevant in the business context. For example, the Basel II Framework, which sets capital adequacy standards, establishes that banks should hold sufficient capital to protect themselves against credit, market, and operational risks. Sometimes risk specialists also tend to analyze environmental risks that include natural disasters, political and regulatory changes, as well as changes in social norms and perceptions. Another risk that is becoming increasingly important is a reputational risk—the possibility of damage to a business that occurs as a result of loss of confidence by any group of stakeholders. It is particularly relevant to service businesses.

A special type of risk that has recently received much attention in the academic literature is a so-called systemic risk. This is the risk that an economic shock, such as a failure of a market, institution, or organization, triggers the collapse of a chain of markets or similar entities. The classic example of systemic risk is a bank run. Often, it begins with a failure of a single bank, which then leads to depositors’ panic and results in defaults of healthy banks that fail because they are unable to satisfy too many simultaneous requests for cash.

Just as there is no single accepted definition of risk, there is no agreement regarding the way risk should be measured. One popular approach is to measure risk as the probability of the occurrence of a hazard. Another measure, especially popular in finance, is variance (or standard deviation) of the price or return of an asset. There were also some efforts to develop risk models based on semivariance where only negative deviations from a mean were taken into account. Semivariance estimates the average loss of a portfolio or a security. Value at risk (VaR) is another widely accepted measure, which is mostly used for the estimation of market risk. VaR shows the maximum amount of loss that can be incurred with a given confidence level over a given time interval.

In spite of the popularity of VaR, it has been subject to heavy criticism, particularly in the context of coherent measures of risk. This concept serves to formulate a set of axioms that imposes specific mathematical conditions that any risk measure should satisfy. Among the four axioms of coherency, a central role is played by the so-called subadditivity axiom, which, in essence, formulates the risk diversification principle: The risk of a portfolio should be less than risks of individual securities that constitute this portfolio. It has been shown that there are cases when VaR does not satisfy the subadditivity axiom, thus making it an incoherent measure of risk. To address this problem, alternative measures of risk have been proposed. One of them is expected shortfall, which incorporates both the probability and magnitude of the potential loss.

Bibliography:

  1. Kevin Buehler, Andrew Freeman, and Ron Hulme, “The Tools: The New Arsenal of Risk Management,” Harvard Business Review (v.86/9, 2008);
  2. Dennis I. Dickstein and Robert H. Flast, No Excuses: A Business Process Approach to Managing Operational Risk (Wiley, 2009);
  3. Global Association of Risk Professionals, Foundations of Banking Risk and Regulation: An Overview of Banking, Banking Risks, and Risk-Based Banking Regulation (Wiley, 2009);
  4. Dave Hitz and Pat Walsh, How to Castrate a Bull: Unexpected Lessons on Risk, Growth, and Success in Business (Jossey-Bass, 2009);
  5. Glyn A. Holton, “Defining Risk,” Financial Analyst Journal (v.60/6, 2004);
  6. Luc Laeven and Ross Levine, Bank Governance, Regulation, and Risk Taking (National Bureau of Economic Research, 2008);
  7. Games G. March and Zur Shapira, “Managerial Perspectives on Risk and Risk Taking,” Management Science (v.33/11, 1987);
  8. Alexander B. Putten and Ian C. MacMillan, Unlocking Opportunities for Growth: How to Profit From Uncertainty While Limiting Your Risk (Wharton School Publishing, 2009);
  9. Larry Rittenberg, Auditing: A Business Risk Approach (South-Western, 2009);
  10. Ben Warwick, ed., The Handbook of Risk (Wiley, 2003).

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