The Basics Of Risk

Risk, in traditional terms, is viewed as a negative and something to be avoided. Webster's dictionary, for instance, defines risk as "exposing to danger or hazard". The Chinese symbols for risk, reproduced below, give a much better description of risk -

The first symbol is the symbol for "danger", while the second is the symbol for "opportunity", making risk a mix of danger and opportunity. It illustrates very clearly the tradeoff that every investor and business has to make - between the "higher rewards" that potentially come with the opportunity and the "higher risk" that has to be borne as a consequence of the danger. The key test in finance is to ensure that when an investor is exposed to risk that he or she is "appropriately" rewarded for taking this risk.

In this chapter, we will lay the foundations for analyzing risk in corporate finance and present alternative models for measuring risk and converting these risk measures into "acceptable" hurdle rates.

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