What is Risk?

The Merriam Webster Online dictionary defines risk as:

  1. The possibility of loss or injury
  2. Something that creates or suggests a hazard
  3. The chance that an investment (such as a stock) will lose value

There are variations on these definitions of risk, but what they all have in common is the possibility of a negative realization among a set of uncertain outcomes. Often, risk is equated with uncertainty. For the sake of precision, however, it’s more accurate to think of uncertainty as a lack of certainty, whereas risk refers to uncertainty where at least one potential outcome is unfavorable.

Risk is often seen as having two dimensions. The first is the likelihood or probability that a negative outcome will arise, while the second dimension is the magnitude or depth or severity of the feared outcome, in the event it does arise.

Examples of risk

The second dimension of uncertainty or risk depends on the realization of the first dimension. That is, there is no relevance to the depth or severity of the negative outcome if the first dimension is not realized to begin with. In professional language, it is often said that the second dimension is conditional on the realization or manifestation of the first.

Furthermore, if it’s known that the second dimension will result in zero (or negligible) loss or damage, it’s reasonable to conclude that effectively there is no risk. A classical example is a situation in which a borrower has provided a very large amount of collateral for a loan. The lender doesn’t feel it has entered into a risky loan because even if the borrower defaults, the collateral is worth enough to cover the exposure.

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