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Section: 1 What is Risk?
Risk is defined in Webster's dictionary as "a hazard; a peril; exposure to loss or injury". Thus, risk refers to the chance that some unfavorable event will occur. Any investment involves some degree of uncertainty about future holding period returns. All Financial Assets are expected to produce cash flows and the riskiness of the asset is judged in terms of the riskiness of its cash flows. The definition of risk varies from one individual to another. For some, risk is the chance of incurring a loss. For others, it is the volatility in returns. In the field of finance and investments, risk is generally defined as the probability that the actual return would be different from expected return.
It is a universal fact that risk and return are positively correlated. One has to bear additional risk to earn higher return.
There are many ways to measure risk. Some of them measure the variability in
returns of the investment in isolation. Others measure the volatility in stock
price relative to the market movements. In this section, we will discuss some
of the most commonly used measures of risk. The riskiness of an asset can be
considered in two ways: i) on a stand-alone basis (the risk an investor would
be exposed to if he or she held only one asset) ii) in a portfolio context.
We will talk about stand-alone risk here and in a portfolio context in the next
chapter. Sources of investment risk range from macroeconomic fluctuations to
the changing fortunes of various industries, to asset specific unexpected developments.