What Is Risk

Topics: Risk management, Risk, Risk aversion Pages: 10 (3104 words) Published: February 9, 2015
Topic 1: Basics of Risk

This reading is designed to offer a very brief introduction to risk and risk management, the first topic in RMI 2302. Instead of assigning a large reading I have condensed much of my thoughts on risk and risk management into a more manageable sized reading. There is a wealth of information available on these topics online. Wikipedia is actually pretty helpful for the level of understanding of these topics that we are discussing in this course. We will be discussing some math in this section. It is not the most important topic we will be discussing, but it is a valuable skill to have in risk management. What is Risk?

There are many definitions of risk. All of which include some type of uncertainty about potential outcomes. We are going to be very broad in this class, the definition of risk is uncertainty regarding loss. In other words, there are two components to the definition. One is uncertainty (don’t know for sure what the outcome will be), the other is that at least one of the potential outcomes is unwanted (bad, negative, a loss, etc…). This view of risk applies to all three points of view we are going to be taking this semester. Individual:

This definition of risk works very well for individuals. There is risk associated with playing sports, driving a car, investing money, etc…
Risk:
Uncertainty regarding loss.

Organization:
Organization’s often follow well defined risk management plans. These plans typically define risk. A common definition of risk is: Risk:
It is an uncertain future event which could adversely affect the achievement of an organization’s objectives.

This can be applied to activities such as a new product launch, employee incentive programs, hiring and firing decisions, etc… The definition is not much different from our definition, just more specific to organizations.

Society:

Society’s definition of risk often has additional constraints that the outcome has to affect a large portion of its constituents.

Risk:
It is an uncertain future event which could adversely affect large portions of the population.

Society’s definition of risk often focuses on specific areas such as economic risk, health risk, etc… Again, not much different from our definition, just more tailored to a broader base. Be careful when using the term risk!

The term risk is often used in a variety of ways and varies widely.

Take the following example:

You are given the option of jumping off of a 1-story building or a 25-story building, which one is riskier?

Often hear people refer to someone (or something) that has a higher chance of loss as being “riskier”. “Bill is a high risk driver”, “Kathy is a high risk for skin cancer”. This use of risk really just refers to the probability of loss being higher, not necessarily the uncertainty.

These uses of the term risk are very common, but not completely consistent with our definition of risk. By our definition the highest risk would have a 50% chance of occurring. If the probability of something occurring is one, then there is no risk.

How do you measure risk?
Well, the short answer is math. How often does something occur? How bad is it when it happens? We can typically measure these things. When we discuss how often something occurs we often use the term “frequency”. How often something happens is usually compared to how many times it could have happened. This is referred to as probability. Out of 10 flips of a fair coin how many will be heads? For a fair coin, the probability of getting a heads is .50 or 50%. So how often you get a heads on 10 flips of the coin would be the frequency of events (could be zero, five, seven, anywhere between 0 to 10). The probability of a single event occurring times the number of trials yields the expected frequency. When we discuss how bad it is when something happens we often use the term “severity” or “impact”. Severity is often...
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