Types of Risk: Assessment and Measurement

Risk refers to the probability of loss or lower ROI investors face while investing in a specific portfolio. It implies the future uncertainty related to deviation from the expected earnings or outcomes.

So, what are the different types of risk in finance? Let us now discuss it in detail. We will also

Table of Contents

• What is risk in Finance?
• How do professionals assess risk?
• Types of risk
• Risk measurement metrics

What is Risk in Finance?

Before proceeding to understand the different types of risk, let us first understand the meaning of risk in finance. Risk refers to the probability of an actual result differing from the expected results. While studying the CAPM, the risk is indicated as the volatility of returns. If a payoff or cash flow is farther away in the future, the uncertainty increases, thus the risk as well. Do understand that there is a strong and positive correlation between time and uncertainty.

Components of Risk Mitigation:

• Risk Identification: Recognizing and documenting potential risks that could negatively impact the project or organization.
• Risk Assessment: Evaluating the potential impact of the identified risks. This often involves quantitative and qualitative methods.
• Risk Prioritization: Ranking risks based on their potential impact and likelihood to help focus on the most significant threats.
• Risk Response Planning: Developing strategies to address each risk. Common strategies include:
  • Avoidance: Taking actions to eliminate the risk.
  • Mitigation: Bringing down the likelihood or impact of the risk.
  • Transfer: Shifting the risk to another party, often through insurance or contracts.
  • Acceptance: Acknowledging the risk and preparing to deal with its consequences.
• Implementation: Putting the risk response plans into action.
• Monitoring and Review: Continuously monitoring the environment for new risks and reviewing the effectiveness of the risk response strategies.
• Communication: Keeping all stakeholders informed about the risks and the measures taken to address them.
• Contingency Planning: Preparing backup plans in case the primary risk response strategies fail.
• Risk Documentation: Maintaining a risk register or database to document all identified risks, their assessments, response plans, and status.
• Training and Education: Ensuring that team members and stakeholders are aware of the risks and understand their roles in the risk mitigation process.

How do professionals assess risk?

Let us understand the following ways in which professionals assess any risk:

• Risk assessment: It is a process that identifies potential hazards and assesses what may happen in case a hazard occurs. Using business impact analysis (BIA), the potential impacts are determined that may occur due to the interruption of critical business processes.
• Risk analysis: It is the process of identifying and analysing any potential future events that can adversely impact any company. The company performs risk analysis for understanding what might occur as well as the financial implications of an event. In this process, the steps taken to mitigate and eliminate the risk are also assessed.
• Risk evaluation: It is the process to identify and measure risk related to projects, operations and investments. In this step, the probability and impact of every identified risk are identified. This can be done by rough estimation in terms of low, medium and high. 
• Risk management: This process involves identifying, assessing and controlling financial and legal risks to the earnings of an organization. These threats root in several reasons, such as strategic management errors and legal liabilities. In case an unforeseen event occurs without any backup, its impact can be minor to serious. 

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Types of Risk

The following are different types of risks in finance:

1. Financial Risk

For most businesses, one of the biggest concerns is financial risk. It refers to the losing money due to a business or an investment decision. Risks associated with finances may lead to loss of capital for both businesses and individuals. When a financial risk occurs, there is a possibility that the cash flow of the company may be insignificant to fulfil its obligations. Different types of financial risk include credit risk, operation risk, liquidity risk, foreign investment, and legal and equity risk.

2. Systematic risk

Systematic risk is also known as volatility risk, market risk or undiversifiable risk. It is a risk that is inherent to either the entire market or to a market segment. This type of risk is both unpredictable and inevitable. However, the impact of systematic risk can be mitigated through hedging to a certain extent. Systematic risk involves inflation, recession, interest rate changes and other changes.

3. Unsystematic risk

This type of specific risk is unique to a particular company. It is a non-systematic risk that can be reduced via diversification. The main difference between systematic and unsystematic risk is that systematic risk is inherent in the market. Strikes, natural disasters and legal proceedings are some examples of unsystematic risks. Here is the unsystematic risk formula:

Unlike systematic risk, which affects the entire market, unsystematic risk is unique to a particular company or industry.

There is no standardized formula to calculate unsystematic risk directly, but it can be derived using the total risk formula:

Total Risk = Systematic Risk + Unsystematic Risk

This formula can be rearranged for solving unsystematic risk:

Unsystematic Risk=Total Risk−Systematic Risk

Here:

Total Risk is the overall risk associated with an investment, often measured by the standard deviation of the returns.

By understanding the total risk and the systematic risk, you can derive the unsystematic risk, which represents the risk factors specific to the individual company or industry.

4. Market risk

Market risk refers to the possibility that an individual or an entity will experience losses. This may occur due to several factors that can impact the overall performance of investments in financial markets. It is synonymous with systematic risk and thus cannot be eliminated via diversification. Recession, political upheavals, interest rate change or any natural calamity can cause market risk. Such type of risk is capable of impacting the entire market at the same time.

5. Business Risk

This represents the exposure to an organization due to the factors that will lower its profits. Anything that disrupts the ability of a company to achieve its financial goals is known as a business risk. All these factors hamper the company’s ability to achieve financial goals and collectively cause business risk. 

6. Foreign Exchange Risk

It is the loss borne in an international financial transaction that may incur due to currency fluctuations. Foreign exchange element of risk is also known as currency risk. It describes the possibility that an investment value may decrease due to changes in relative value of involved currencies.

7. Credit Risk

Credit refers to trust that allows one party to offer money and resource to other party. The second party does not immediately reimburse the first party. However, the promise to repay or return these resources in future is made. Credit risk arises when follower fails to repay on time and does not meet their obligations.

Risk Measurement Metrics

The following risk metrics can be used for measuring risk:

1. Expected Value of Loss

One of the ways to measure risk involves calculating the expected value of the loss. Here, the probabilities and consequences are combined into a single value. Here:

R = (probability of an accident occurring) x (expected loss in the case of an accident)

Suppose the probability of suffering from an accident is 0.01. Here, the loss is $1000. In this case, the total risk is a loss of $10. The product of 0.01 and $1000. 

2. Probability Distributions

When all consequences are expressed in the same unit, in that case, the risk can be expressed as a probability density function that describes the uncertainty about an outcome.

R = p(x)

It can also be expressed as the cumulative distribution function (CDF) or an S curve. 

3. Outcome frequencies

The risk of discrete events such as accidents is measured as outcome frequencies or the expected rate of specific loss events per unit of time. The outcomes may be either individual or group risk. In the case of individual risk, the frequency of a given level of harm to an individual is measured. In the societal or group risk, the relationship between the frequency and number of people suffering from that harm is calculated. 

4. Volatility

This refers to the degree of variation of trading price over time. It is usually measured by the standard deviation of logarithmic returns. According to the modern portfolio theory, using variance or standard deviation, the risk of asset prices is measured as:

R = σ

The volatility of an individual asset to overall market changes is measured by the beta coefficient. This refers to the contribution of assets to the systematic risk that cannot be eliminated using portfolio diversification. This is the covariance between an asset’s return and market return. It is expressed as the fraction of market variance.