Risk Aversion

(noun)

Risk Aversion is a concept that addresses how people will react to a situation with uncertain outcomes. It attempts to measure the tolerance for risk and uncertainty. Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff.

Examples of Risk Aversion in the following topics:

  • Risk Aversion

    • In the realm of finance and economics, Risk Aversion is a concept that addresses how people will react to a situation with uncertain outcomes.
    • It attempts to measure the tolerance for risk and uncertainty.
    • People fall under different categories of risk aversion.
    • A risk-averse, or risk avoiding person would take the guaranteed payment of 50, or even less than that (40 or 30) depending on how risk averse they are.
    • A risk neutral person would be indifferent between taking the gamble or the guaranteed money.

  • Reasoning

  • Approaches to Assessing Risk

    • Since planned actions are subject to large cost and benefit risks, proper risk assessment and risk management for such actions are crucial to making them successful.
    • As risk carries so many different meanings, there are many formal methods used to assess or to "measure" risk.
    • In enterprise risk management, a risk is defined as a possible event or circumstance that can have negative influences on the enterprise in question.
    • In a financial institution, enterprise risk management is normally thought of as the combination of credit risk, interest rate risk or asset liability management, market risk, and operational risk.
    • In project management, risk management can include: planning how risk will be managed, assigning a risk officer, maintaining a database of live risks, and preparing risk mitigation plans.

  • Information and Risk Trade-Off

    • IT risk relates to the business risk associated with the use, ownership, operation, involvement, and adoption of IT within an enterprise.
    • Risk is the product of the likelihood of an occurrence times its impact (Risk = Likelihood x Impact).
    • IT risk management can be viewed as a component of a wider enterprise risk management (ERM) system.
    • IT risk transverses all four of the aforementioned categories and should be managed within the framework of enterprise risk management.
    • Risk appetite and risk sensitivity of the whole enterprise should guide the IT risk management process.

  • Commercial Banks

    • Risk management (i.e. foreign exchange risks, interest rates, hedging commodities, derivatives)
    • Credit Risk – Risk that a borrower may not return the entirety of the payment owed.
    • Liquidity Risk – Risk that an acquired asset cannot be traded quickly enough to capture profit.
    • Market Risk – Virtually any capital asset has a market, and is therefore subjected to the risks of it's respective market.
    • Operational Risk – Risk that an operational issue will diminish returns.

  • Reinvestment Risk

    • Reinvestment risk is the risk that a bond is repaid early, and an investor has to find a new place to invest with the risk of lower returns.
    • Reinvestment risk is one of the main genres of financial risk.
    • Reinvestment risk is more likely when interest rates are declining.
    • Pension funds are also subject to reinvestment risk.
    • Two factors that have a bearing on the degree of reinvestment risk are:

  • Types of Risk

    • Prepayment risk is the risk that the buyer goes ahead and pays off the mortgage.
    • Credit risk or default risk, is the risk that a borrower will default (or stop making payments).
    • Liquidity risk is the risk that an asset or security cannot be converted into cash in a timely manner.
    • Operational risk is another type of risk that deals with the operations of a particular business.
    • Foreign investment risk involves the risk associated with investments in foreign markets.

  • Comparing Price Risk and Reinvestment Risk

    • Price risk is positively correlated to changes in interest rates, while reinvestment risk is inversely correlated.
    • Price risk and reinvestment risk both represent the uncertainty associated with the effects of changes in market interest rates.
    • So there is little reinvestment risk.
    • There is, accordingly, more reinvestment risk.
    • In summary, price risk and reinvestment risk are two main financial risks resulting from changes in interest rates.

  • Applications of Classical Conditioning to Human Behavior

    • Aversion therapy is a type of behavior therapy designed to encourage individuals to give up undesirable habits by causing them to associate the habit with an unpleasant effect.

  • Expected Risk and Risk Premium

    • Overall riskiness of an asset is composed of its own individual risk (beta) along with its risk in relation to the market as a whole.
    • A certain amount of risk is inherent in any investment.
    • Systemic risk is the risk associated with an entire financial system or entire market.
    • On the other hand, unsystematic risk is risk to which only specific classes of securities or industries are vulnerable.
    • The term risk premium refers to the amount by which an asset's expected rate of return exceeds the risk free rate.