What is the Concept of Risk?
Risk exists because of inability of the decision-maker to make perfect forecasts. It may be understood as the possibility of adverse happening. Forecasts cannot be made with perfection or certainty since the future events on which they depend are uncertain. An investment is not risky if, we can specify a unique sequence of cash flows for it. But the whole trouble is that cash flows cannot be forecast accurately, and alternative sequences of cash flows can occur depending on the future events. Whether a particular situation involves risk or-not depends on with what precision we can estimate the possibility of occurrence of a particular event. This give rise to the following three states of possibilities:
Certainty reflects happening of a particular event as expected with zero deviation in case of certain ‘All Truths’, there will be no deviation.
Uncertainty is a situation that makes prediction difficult. One may not be sure of the occurrence of a particular event with any degree of precision. To illustrate, let us suppose that a firm is considering a proposal to commit its funds in a machine, which will help to produce a new product. The demand for this product may be very sensitive to the general economic conditions. It may be very high under favorable economic conditions and very low under unfavorable economic conditions. Thus, the investment would be profitable in the former situation and unprofitable in the latter case. But, it is quite difficult to predict the future state of economic conditions. Because of the uncertainty of the economic conditions, uncertainty about the cash flows associated with the investment derives.
Risk is said to be a situation lying in between the above two states i.e. certainty and uncertainty. It is a form of a continuum with certainty and uncertainty on the two ends and risk covering the middle ground, which is the third state of possibility.
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Risk is a situation in which future outcomes, together with their associated probabilities are known. It is said to be as dispersion in a subjective probability distribution. Thus, risk arises in investment evaluation because we cannot anticipate the occurrence of the possible future events with certainty and consequently, cannot make any correct prediction about the cash flow sequence. The theory of finance, therefore, realizes the significance of risk in final decision-making.