Risk exists when a probability of occurrence can be assigned to each of a set of possible outcomes. Thus, risk is measurable. Uncertainty exists when it is impossible to determine the probability of occurrence for each of a set of possible outcomes or when the entire set of possible outcomes is not known. As a result, uncertainty is not measurable. Because risk is quantifiable, it is easier to deal with risk than with uncertainty. In most fields of study, it is assumed that individuals are rational and base their actions on rational decision making. In economics a rational person is one who maximizes his or her utility. In accounting and finance, a rational person is one who is risk-averse. Risk aversion occurs when individuals will not assume risk unless compensated for it. Assume a situation where there are two options. The first option is a coin toss; an individual will receive $100,000 for heads and $0 for tails. Since there is a 50-percent probability that heads will turn up and a 50-percent probability that tails will turn up, the expected value of the toss is [(.5)(100,000) + (.5)(0)] = $50,000. The second option offers a sure $50,000. If the individual chooses the first option, he would be risk-seeking; if he chooses the second option, he is riskaverse. If a group of people were asked which option they would choose, the overwhelming majority of them would choose the second option, the sure $50,000. Few people would choose the first option, the chance of receiving either $100,000 or nothing. Both options have the same $50,000 expected value, but the first option is a risky $50,000, while the second option is a certain $50,000. Because the first option has the same expected value but is riskier, few people would choose it over the second option. This is evidence of risk aversion among the population. BONDS with higher levels of DEFAULT risk offer higher coupon-interest rates than bonds with less risk of default. Junk bonds carry very high coupon rates to induce investors to purchase such bonds and to bear considerable risk of default. Based on the CAPITAL asset pricing model, investors require higher returns from stocks with high BETA COEFFICIENTs than they do from stocks with lower betas. Drivers with bad driving records pay higher INSURANCE premiums to cover the riskiness of their driving than do safe drivers, and smokers pay higher health insurance premiums than do nonsmokers. In general, debentures have higher interest COSTS than do MORTGAGEs. These are just a few of the many examples of risk aversion in business, economics, and finance.
See also COUNTRY-RISK ANALYSIS; EXCHANGE-RATE RISK.