What is Risk?

What is Risk?

Risk can be defined as exposure to the possibility of loss of an asset. Risk might be used to denote the cause of the potential loss, or the probability of the loss.

In finance, it is common to hear about the correlation between risk and return; more risk may yield a higher return, but it also has the potential for more loss. The situation requires that an investor willing to take such a risk must provide the capital to fund the investment which may grow or may fail.

The greater potential for earnings is the premium that is used to compensate the investor, and is known as risk premium. Insurance is the process of shifting risk from one party to the other, and the insured is willing to pay the insurer a premium for the coverage. Markets are said to be risk-on when bullish conditions are present, meaning that more people are more willing to take more risk.

One measure of risk is Beta, which is used to show a security’s deviation from the standard deviation of an index or benchmark. The Capital Asset Pricing Model is a method used to theorize on the amount of return, or risk premium, that is due to an investor that is willing to take on specific amounts of risk, as plotted on the Security Market Line.

The Sharpe Ratio shows the amount of risk-adjusted return a security has earned.