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Risk
In my major, Finance, every decision, from investing in stocks to lending money,
carries some unpredictability. This uncertainty, known as risk, is the very element that makes
financial planning both challenging and essential. Although definitions of risk can vary
slightly throughout sources, they consistently emphasise its fundamental idea:
unpredictability and the potential for gain or loss. Hence, while risk is a critical component of
Finance, I will describe how its true complexity comes from its diverse types, including
market, credit, and systemic risks, which significantly affect financial decisions.
Investopedia has described risk as “The chance that an outcome or investment’s actual
gains will differ from an expected outcome or return” (Investopedia, n.d.). On the other hand,
Oxford's Dictionary of Finance and Banking defines risk as “the possibility that an
investment will yield a lower-than-expected return or result in a loss of value” (Law &
Smullen, 2008). Both definitions emphasise that risk is centred around uncertainty and the
potential for outcomes to differ from expectations. The key concepts include the potential of
loss and the variability of returns. Investopedia’s definition highlights the difference between
expected returns, including both possible gains and losses. However, The Oxford Dictionary
strictly focuses on the negative aspects of risk, highlighting a loss or reduced return.
Different types of finance risks include systematic, market, and credit risks. Systemic
risk is the possibility that a corporate-level event could lead to wide instability across an
entire industry or economy (Nguyen et al., 2024). This term is closely linked to portfolio
management, a fundamental concept in Finance. Hence, understanding systematic risk is
crucial for investors, as it highlights market-wide events like economic recessions or
geopolitical crises that cannot be entirely avoided, regardless of how diversified their
portfolios are. Market risk, however, is the potential for financial loss resulting from
fluctuations in market prices (Kellner & Rösch, 2016). Regarding the daily decisions
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financial professionals make, market risk is significant. It involves predicting how changes in
interest rates, prices, or currency values will affect the worth of assets. In addition, it
necessitates preparing for unforeseen occurrences like a pandemic, which can disrupt markets
and cause severe financial losses. On the contrary, Credit risk is the possibility that a
borrower will not make payments on their debt, such as the inability to pay back a loan.
Failure to repay debts can result in severe financial loss for lenders and other financial
institutions such as banks (Hermansson, 2018). This has caused them to grow greatly
concerned about this type of risk. Evaluating borrowers' creditworthiness and estimating their
payback chances are critical to effective credit risk management.
Risk is a fundamental idea in finance that informs all investment decisions and
company strategies. As a finance major, understanding risk is essential because it helps assess
the potential for gain and loss. Finance professionals have to consider credit risk, which is the
possibility of failing to repay loans; market risk, which is price changes; and systemic risk,
which is the effect of a company's failure on the economy as a whole. Risk is essential
because of the risk-return trade-off, where taking more significant risks might increase
benefits and the likelihood of losing money. Finance professionals who understand risk
management can make well-informed judgments by weighing potential advantages against
potential losses.
I saw how risk impacted my dad’s investment during the COVID-19 pandemic. My
dad invested in a mall called “Avenue Mall”, where he rents multiple shops to businesses.
Before the pandemic, his mall generated stable rental income due to its prime location.
However, when COVID-19 hit, strict lockdowns and restrictions drastically reduced visitor
numbers. In his mall, many cafés had to close temporarily, most of the boutiques saw a
significant drop in sales, and the restaurants struggled as fewer tourists visited. As a result,
my dad’s tenants couldn’t pay the total rent or, in some cases, had to close their businesses.
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This situation highlights market risk, where unexpected events like a pandemic can
lead to sudden financial losses. My dad had to negotiate rent reductions with his tenants to
keep them in business. The pandemic showed how even Malls, once considered safe
investments, can face severe challenges due to unforeseen risks, underscoring the need for
careful risk management and flexibility in times of crisis.
Considering these factors, risk is a critical term in finance encompassing much more
than mere unpredictability. It encompasses various types—systematic, market, and credit
risks—significantly shaping financial decisions and strategies. Although risk can bring
potential advantages or losses, careful risk management is crucial, particularly during volatile
times, as demonstrated by my father's experience during the COVID-19 pandemic. Finance
professionals must develop a solid understanding of risk to make informed judgments,
balancing the trade-off between risk and return.
[787 words]
References
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Hermansson, C. (2018). Can self-assessed financial risk measures explain and predict bank
customers’ objective financial risk? Journal of Economic Behavior & Organization,
148, 226–240. https://doi.org/10.1016/j.jebo.2018.02.018
Investopedia. (n.d.). Risk. https://www.investopedia.com/terms/r/risk.asp
Kellner, R., & Rösch, D. (2016). Quantifying market risk with Value-at-Risk or Expected
Shortfall? – Consequences for capital requirements and model risk. Journal of
Economic Dynamics & Control, 68, 45–63. https://doi.org/10.1016/j.jedc.2016.05.002
Law, J., & Smullen, J. (2008). A Dictionary of Finance and Banking (4th ed.). Oxford
University Press https://doi.org/10.1093/acref/9780199229741.001.0001
Nguyen, P. A., Nguyen, N. P., & Le, H. M. D. (2024). Systemic risk and financial system
network using financial risk meter: the case of Vietnam. Applied Economics, 56(9),
1012–1034. https://doi.org/10.1080/00036846.2023.2174936