Question

Risk means, in today's language the probability of something bad happening or an unfortunate outcome. Risk in finance however, is defined as the variance of the probability distributions of returns. a. Why do these definition seen contradictory? b. Reconcile the two ideas.

Answer 1

a) These defintion seems contradictory because in finance, risk is generally taken into consideration side by side with the rewards or returns associated with it. For example, there are many financial instruments providing different returns and for that we try to judge various risk that can be associated with it like credit risk, default risk etc. to make our investment based on the risk we can bear or we make diversifed investments, to get an optimum return as per our risk appetite.

Whereas, in today's language risk is just considered as the probability of occurrence of an unwanted event multiplied by the consequence (loss) of the event. This can be be risk of losing people, property etc.

b) To reconcile the two ideas we can say that, ultimately both are probablity of occurance of something uncertain leading to unfortunate outcomes. Even though in finance we consider risk with rewards, but the idea of bad happening is still there as in any other case.

So, to conclude it can be said that both are the definition is pointing the risk in the same way, it is only that in finance it is clubbed with the reward part that one gets taking the risk.