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Understanding and managing risk
Understanding and managing risk

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2 A helicopter overview of risk

2.1 Defining risk

Having looked at the general context of ‘risk’, we can now define more clearly what we mean by it and then categorise it into its main forms. We can then consider how we might analyse and manage both financial and non-financial risk for an organisation through risk assessment and risk mapping.

How do we define risk? You may have already met a couple of empirical definitions that cover the concept of the variability of stock prices (measured either by the standard deviation, or the beta of the returns of the stock or portfolio) as the definition of risk in the context of portfolio theory.

We now extend this into a more comprehensive definition.

The word ‘risk’ is thought to derive either from the Arabic word rizq or the Latin word risicum (Kedar, 1969, pp. 255-9). The two possibilities quite neatly combine to give us the meaning for the English term in our context. The Latin word originally referred to the challenge presented to seafarers by a barrier reef and so implied a possible negative outcome. The Arabic word, on the other hand, implies ‘anything that has been given to you (by God) and from which you draw profit’ and has connotations of a potential beneficial outcome.

A twelfth-century Greek derivative of the Arabic rizq related to chance outcomes in general with no positive or negative implications (Kedar, 1970). We can combine the above definitions to derive our concept of risk as being ‘an uncertain future outcome that will improve or worsen our position’.

There are two implied elements about this definition that should be noted:

  1. It is probabilistic – the likely outcome can be assessed, but is not known with certainty.
  2. The outcome may be favourable or unfavourable.

It should be noted that the definition does not necessarily imply ‘symmetry’, where the ‘upside’ and ‘downside’ are of an exact equivalent magnitude. Indeed in many risk situations the outcomes are skewed – for example, more ‘downside’ than ‘upside’ risk. For many financial matters, however, which are our main concern here, risk is more or less symmetrical or is assumed to be so. However, there can be dangers in this assumption – we will discuss these in more detail later on.

The term ‘risk’ as it is used in finance differs from the way it is commonly used in everyday life in that it can be quantified in terms of probabilities. In a situation where there are many potential outcomes, both negative and positive, and their probability cannot be quantified, the financial term to describe it is ‘uncertainty’, to differentiate it from risk (Russell-Jones and Day, 2005). Though outside the scope of this course, it is important to know that we can still assess and manage uncertainty through techniques such as ‘worst case scenario analysis’ (Crouhy et al., 2005).