The Basics of Risk

What is Risk
For most of us, risk refers to the likelihood that in lifes games of chance, we will receive an outcome that we will not like. For instance, the risk of driving a car too fast is getting a speeding ticket, or worse still, getting into an accident. Websters dictionary in fact, defines risk as Exposing to peril or hazard. Risk is perceived almost entirely in negative terms.

Equity Risk and Expected Return

To demonstrate how risk is viewed in corporate finance, we present risk analysis in three steps. First, we define risk in terms of the distribution of actual returns around an expected return.

 Second, we differentiate between risk that is specific to one or a few investments and risk that affects a much wider cross section of investments. We argue that in a market where the marginal investor is well diversified, it is only the later risk called market risk, that will be rewarded.

 Third, we look at alternative models for measuring this market risk and the expected returns that go with it.

Defining Risk
Investors who buy assets expected to earn returns over the time horizon that they hold the asset. Their actual returns over this holding period may be very different from the expected returns, and it is this difference between actual and expected returns that is the source of risk.

Example
Assume that you an investor with a one-year time horizon buying a one- year treasury bill, with a 5% expected return. At the end of the one-year holding period, the actual return on this investment will be 5%, which is equal to the expected return. This is a riskless investment.