CHAPTER ONE

RISK AND RELATED CONCEPTS

Introduction

Due to imperfect knowledge about the future, our activities are likely to result in
outcomes, which are different from our expectations. These deviations are not
desirable. Risk is undesirable outcome that exists due to imperfect foresight about the
future. The future is always uncertain and no one can be perfect about the future.

The more knowledgeable the person is, the more certain it will be concerning the
future events. However, the disappointing phenomenon is that perfect foresight about
the future is something impossible. Thus, risk becomes facts that always remain side
by side with human being activities.
1.1. Definition of Risk

There is no one universal and comprehensive definition of risk that exists so far. It is
defined in different forms by several authors with some differences in the wordings
used. The essence, however, is very similar. Some of the definitions are shown below:
- Risk is a condition in which there is a possibility of an adverse deviation from a
desired outcome that is expected or hoped for.
- Risk is the objectified uncertainty as to the occurrence of an undesired event.
- Risk is the possibility of an unfavorable deviation from expectations; it is the
possibility that something we do not want to happen will happen or something
that we want to happen will fail to do so.

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 - Risk is the variation in the outcomes that could occur over a specified period in
a given situation.
- Risk is the dispersion of actual from expected results.

From the above mentioned and other definitions of risk, we can infer that risk is
undesired outcome or it is the possibility of loss. The important point is there should
be more than one outcome for the risk to happen, i.e. there will be no risk if there is
only one outcome. This is because it is certain that only one outcome will take place.
The absence of risk in this case implies that the future is perfectly predictable.
Variations in the possible outcomes, then, lead to the existence of risk; and the greater
the variability, the greater the risk will be.
1.2 RISK VS UNCERTAINTY

Many textbooks use the terms risk and uncertainty interchangeably. However, the
distinction between the two must be noted. The “risk versus uncertainty” debate is
long-running and far from resolved at present. Although the two are closely related,
quite many authors make a distinction between the two terms. Uncertainty refers to
the doubt as to the occurrence of a certain desired outcome. It is more of subjective
belief. Subjective in a sense that, it is based on the knowledge and attitudes of the
person viewing the situation and as the result, different subjective uncertainties are
possible for different individual under identical circumstances of the external world.

Knight defined “risk” as a measurable uncertainty that can be determined by objective

analysis based on prior experience and “uncertainty” as unmeasureable uncertainty
that is of a more subjective nature because it is without precedent. Risk is dealt with

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every day by weighing probabilities and surveying options, but uncertainty can be
debilitating, even paralyzing, because so much is new and unknown. The practical
difference between the two categories, risk and uncertainty, is that in the risk the
distribution of the outcome in a group of instances is known either through calculation
a priori or from statistics of past experience; while in the case of uncertainty this is not
true, the reason being in general that it is impossible to form a group of instances,
because the situation dealt with is in a high degree unique.

Preffer has noted the difference between risk and uncertainty as “Risk is a
combination of hazards and is measured by probability; uncertainty is measured by
the degree of belief. Risk is a state of the world; uncertainty is a state of the mind.”

In general, many authors indicated that risk is objective phenomenon that can be
measured mathematically or statistically. It is independent of the individual’s belief.
Whereas, uncertainty is subjective that cannot be measured objectively. Of course,
risk and uncertainty may have some relationship. Uncertainty results from the
imperfection of knowledge of mankind of predicting the future. The higher the lack of
knowledge about the future the higher the uncertainty. But, it is debatable to say that
higher uncertainty leads to higher risk. The presence and absence of uncertain does
not necessarily mean the presence and absence of risk respectively. The following
four situations underscore the difference between risk and uncertainty:

1. Both risk and uncertainty are present

eg. a person may be exposed to risk of disability and may experience uncertainty
2. Both risk and uncertainty are absent

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 eg. Sailors at present know that the earth is not flat.
There is no possibility of falling off the edge of the earth.
3. Risk is present but uncertainty is absent
eg. the possibility of loss due to interruption of operation by fire. There may be
no uncertainty because of failure to recognize the existence of such risk,
understatement of the situation or because of preoccupation with other
problems.
4. Risk is absent but uncertainty is present
eg. An hour ago, a man heard that a plane departing from the airport crashed.
The man knows that his wife was scheduled to fly from the airport earlier
today, but he does not know whether she was on the plane crashed. Here
there is no risk as risk refers to future outcomes. However, there is
uncertainty since it relates to past, present and future situations.

Hence, from the discussions above it is clear that risk is primarily objective while
uncertainty relates to the subjective sate of mind. Moreover, there may not be any
necessary relationship between risk and uncertainty Risk exists whether or not a
person is aware of it. It is a state of the world. Uncertainty, however, exists only with
awareness; it is a state of mind. For example, the risk of cancer from cigarette
smoking existed the moment cigarettes are produced. However, the uncertainty did
not arise until the relationship between cigarette smoking and cancer is established
through scientific and empirical research.
Generally, it is possible to conclude that although there is relationship between risk
and uncertainty, they are different practically.

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1.3 RISK VS PROBABILITY

It is necessary to distinguish carefully between risk and probability. Probability refers

to the long-run chance of occurrence, or relative frequency of some event. Risk, as
differentiated from probability, is a concept in relative variation. We are referring here
particularly to objective risk.

The probability associated with a certain outcome is the relative likelihood that
outcome will occur. And probability varies between 0 and 1. If the probability is 0,
that outcome will not occur, if the probability is 1, that outcome will occur.

Probabilities are generally assigned to events that are expected to happen in the future.
There may be a number of possible events that will take place under given set of
conditions; and these events may occur in equal or different chance of occurrence.
The weights given to each possible event may depend on prior knowledge, past
experience, statistical or mathematical estimation of relevant data or psychological
belief. Thus, to each possible event is assigned a corresponding probability of
occurrence that leads to probability distribution. This means that probability relates to
a single possible event.

Risk on the other hand refers to the variation in the possible outcomes. This means
that risk depends on the entire probability distribution. It indicates the concept of
variability. Therefore, the concepts of risk and probability are two different things.

The following example illustrates the distinction between risk and probability.
Suppose the occurrence of a particular event is to be considered. One extreme is that

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this event is certainly to take place. Thus, the probability that this event will take
place is 1. There is certainty as to the occurrence of this event with prefect foresight in
this regard. Accordingly, there is no risk. The other extreme is that the event will not
take place at all. Hence, the probability of occurrence is zero. Here, too, there is
certainty and therefore, there is nor risk. In between these two extremes there could be
several occurrences of the events with the corresponding probabilities of occurrence.
It is therefore; risk and probability are different but related concepts.
1.4 DISTINCTION OF RISK, PERIL AND HAZARD
The concept of risk has already been defined above. Two concepts, peril and hazard
must be distinguished from risk. Although, the three concepts have one common
feature in transmitting bad taste or feeling, they are differentiated as follows:

Peril: - refers to the specific cause of a loss. For example, fire, windstorm, theft,
explosion, flood etc. therefore, the source or cause of a loss is called a peril.

Hazard: - refers to the condition that may create or increase the chance of a loss
arising from a given peril. Hazard affects the magnitude and frequency of a loss. The
more hazardous conditions are, the higher the chance of loss. There are three
categories of hazards:

1. Physical Hazard: - This is associated with the physical properties of the item
exposed to risk. Examples of physical hazard include the following:
- type of construction material such as wood, bricks, etc
- Location of property such as near to fuel station, near to flood area, near to
earthquake area, etc.

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 - Occupancy of building such as dry cleaning, chemicals, supermarket etc.
- Working condition such as machines for personal accidents.
- etc.
2. Moral Hazard: - This originates from evil tendencies in the character of the insured
person. It is associated with human nature, qualities, reputation, attitude, etc.
examples include the following:
- dishonesty, fraudulent intention, exaggeration of claims, etc …

3. Morale Hazard: - This originates from acts of carelessness leading to the

occurrence of a loss. It occurs due to lack of concern for events. Examples are:
- poor housekeeping in stores
- Cigarette smoking around petrol stations.
- etc.

In some situations, however, it is difficult to distinguish between a peril and a hazard.

For example, a fire in general may be regarded as a peril concerning the loss of
physical property. It may also be regarded as a hazard concerning auto collisions
created by the confusion in the vicinity of the fire (around the fire).
1.5 CLASSIFICATION OF RISK
Risk can be classified in several ways according to the cause, their economic effect, or
some other dimensions. The following summarizes the different ways of classifying
risks.
1. Financial Vs Non-financial risks

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This way of classification is self explanatory. Financial risks result in losses that can
be expressed in financial terms. Non-financial risk does not have financial
implication. For example, loss of cars (property) is a financial risk, and the selection
of a career, the choice of a marriage partner, having children are a non-financial risks.
2. Static Vs Dynamic risks
Dynamic risks originate from changes in the over all economy which are associated
with such as human wants, improvements in technology and organization (price
changes, consumer taste changes, income distribution, political changes, etc.). They
are less predictable and hence beyond the control of risk managers some times.
Static risks, on the other hand, refer to those losses that can take place even though
there were no changes in the over all economy. They are losses arising from causes
other than changes in the overall economy. Unlike dynamic risks, they are predictable
and could be controlled to some extent by taking loss prevention measures.
3. Fundamental Vs Particular risks
Fundamental risks are essentially group risks; the conditions, which cause them, have
no relation to any particular individual. Most fundamental risks are economic,
political or social.
Particular risks are those due to particular and specific conditions, which obtain in
particular cases. They affect each individual separately. They are usually personal in
cause, almost always personal in their application. Because they are so largely
personal in their nature, the individual has certain degree of control over their causes.
Thus, fundamental risks affect the entire society or a large group of the population.
They are usually beyond the control of individuals. Therefore, the responsibility for

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controlling these risks is left for the society it self. Examples include: unemployment,
famine, flood, inflation, war, etc. Particular risks are the responsibility of individuals.
They can be controlled by purchasing insurance policies and other risk handling tools.
Examples include: property losses, death, disability, etc.
4. Objective Vs Subjective risks
Some authors classify risk in to objective and subjective. These two types of risk are
also mentioned as measurable and Non-measurable risk.
Objective risk has been defined as “the variation that exists in nature and is the same
for all persons facing the same situation”. it is the state of nature (world). However,
each individual’s estimate of the objective risk varies due to a number of factors.
Thus, the estimate of the objective risk which depends on the person’s psychological
belief is the subjective risk. The problem, however, is that it is difficult to obtain the
true objective risk in most business situation.
The characteristics of objective risk is that it is measurable. In other words, it can be
quantified using statistical or mathematical techniques.
5. Pure Vs Speculative risks
The distinction between pure and speculative risks rest primarily on profit/loss
structure of the underlying situation in which the event occurs. Pure risks refer to the
situation in which only a loss or no loss would occur. There are only two distinct
outcomes: loss or no loss. They are always undesirable and hence people take steps to
avoid such risks. Most pure risks are insurable. Pure risks are further classified in to
three categories: personal risk, property risk, and liability risk.
i. Property risk

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This refers to losses associated with ownership of property such as destruction of
property by fire. Ownership of property puts a person or a firm to property exposure,
i.e. the property will be exposed to a wide range of perils.
ii. Personal risk
This refers to the possibility of loss to a person such as death, disability, loss of
earning power, etc. There are losses to a firm regarding its employees and their
families. Personal risks may arise due to accidents while off duty, industrial accident,
occupational disease, retirement, sickness, etc. Generally, financial losses caused by
the death, poor health, retirement, or unemployment of people are considered as
personal losses. Either the workers and their families or their employers may suffer
such losses.
iii. Liability risk
The term liability is used in various ways in our present language. In general usage,
the term has become synonymous with “responsibility” and involves the concept of
penalty when a responsibility may not have been met. A person may be generally
obligated to another, because of moral or other reasons, to do or not to do something;
the law, however, does not recognize moral responsibility alone as legally
enforceable. One would be legally obliged to pay for the damage he/she inflicted upon
other persons or their property.
Speculative risks, on the other hand, provide favorable or unfavorable consequences.
The situation is characterized by a possibility of either a loss or a gain. People are
more adverse to pure risks as compared to speculative risks. In speculative risk
situation, people may deliberately create the risk when they realize that the favorable

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outcome is so promising. Speculative risks are generally uninsurable. For example,
expansion of plant, introduction of new product to the market, lottery, and gambling.
Both pure and speculative risks commonly exist at the same time. For instance,
accidental damage to a building (pure risk) and rise or fall in property values caused
by general economic conditions (speculative risk). Risk managers are concerned with
most but not all pure risks. For the detail refer unit 2.
1.6 RISKS RELATED TO BUSINESS ACTIVITIES
Most risks in business environment are speculative in nature. The finance literature
considers five types of risks that business organizations face in the course of their
normal operation: business risk, financial risk, interest rate risk, purchasing power
risk, and market risk.
1. Business Risk: - This the risk associated with the physical operation of the firm.
Variations in the level of sales, costs, profits, are likely to occur due to a number of
factors inherent in the economic environment. Business risk is independent of the
company’s financial structure.
2. Financial Risk: - This is associated with debt financing. Borrowing results in the
payment of periodic interest charge and the payment of the principal upon maturity.
There is a risk of default by the company if operations are not profitable. Other
financial risks include: bankruptcy, stock price decline, insolvency, etc. Bond holders
are less exposed to financial risk than common stock holders because they have a
priority claim against the assets of an insolvent firm.

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3. Interest Rate Risk: - This is a risk resulting from changes in interest rates. Changes
in interest rates affect the price of financial securities such as the price of bonds,
stock, etc---
4. Purchasing power Risk: - This risk arises under inflationary situations (general
price rise of goods and services) leading to a decline in the purchasing power of the
asset held. Financial assets lose purchasing power if increased inflationary tendencies
prevail in the economy.
5. Market Risk: - Market risk is related to stock market. It refers to stock price
variability caused by market forces. It is the result of investors reactions to real or
psychological expectations. The market in many cases, is also affected by such events
like presidential election, trade balances, wars, new inventories, etc. market risk is
also called systematic or non diversifiable risk. All investors are subject to this risk. It
is the result of the workings of the economy; and cannot be eliminated through
portfolio diversification.

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