IGNOU : M.COM : MCO 7 : UNIT 4 : Q - 2. Define the concept of Risk.

Ans. CONCEPT OF RISK

Risk may be understood as the possibility of adverse happening. We consider those situations as risky, if they involve larger deviations from the expectations. Whether a particular situation involves risk or not depends on with what precision we can estimate the possibility of occurrence of a particular event. This gives raise to the following three states of possibilities:

A. Certainty

B. Uncertainty

C. Risk

Certainty is a situation reflecting the happening of a particular event as expected with zero deviation. In case of certain ‘All Truths’, there will be no deviation. Like the sun rising in the east and inevitability of death. Similarly, there may be some business situations involving near certainty. Expecting to sell a certain number of bags of rice in a locality, when you are a monopolistic and rice is the staple food of the people of the locality.

Uncertainty is a situation that makes prediction difficult. One may not be sure of the occurrence of a particular event with any degree of precision. People find it often difficult to make predictions pertaining to weather. So also, the meteorological department , sometimes. To attempt to define uncertainty with any rigor presents extremely  complex and hazardous conceptual and mathematical problems. In practice also, it is difficult to deal with the situations of uncertainty, since nothing stands to prediction.

                             Continuum Reflecting the possibility of occurrence of an Event

              Certainty (100%)                                      Risk                                 Uncertainty (0%)

The third state of possibility, i.e., risk, is said to be a situation lying in between the above two states, viz., certainty and uncertainty. This can be best understood in the form of a continuum with certainty and uncertainty on the two ends and risk covering the middle ground.

In statistical terminology, Risk is referred to be a situation in which future outcomes, together with their associated probabilities are known. In other words, it is said to be as dispersion in a subjective probability distribution.

As a matter of fact, a businessman can face confidently, the situation of risk only. There will be no difficulty in making decisions under the situation of certainty; and he will not be precise with any amount of sophistication of tools under uncertainty. Therefore, what can a manager reasonably perform are the situations of risk only. The theory of finance, therefore, realizes the significance of risk in final decision-making.

Ex-ante and Ex-Post Risk :  Risk, as a concept, has both ex-ante and ex-post meaning. Ex-ante risk refers to a decision variable reflecting the probability of realizing unfavourable outcomes in the future as a result of a decision made currently. Ex post risk refers to observed variation in outcomes during prior periods. This risk is historical. The estimation and evaluation of future outcomes, based on current information, is the most difficult exercise involved in financial decision making. Finance literature considers the ex ante concept of risk as having greater value than the ex-post concept of risk, since it is the former that a finance manager confronts.