Risk is the possibility of an event occurring that will have an impact on the achievement of objectives. Risk is measured in terms of impact and likelihood.
Risk is a key word in finance. An asset is risky if the return it actually generates potentially differs from what was initially anticipated. Thus, risk is about asset return variability. To quantify risk, a statistical indicator is traditionally used. This statistical indicator combines the probability of receiving a return which differs from what was expected and the difference, when there is any, between actual and expected returns. The name of the indicator is the standard deviation. Risk aversion means that investors are ready to take a risk but they require a return which is proportional to the risk they have taken. The cost of capital takes into account the respective risk premiums required by both shareholders and bankers. As the value of any asset lies in its ability to generate cash flow discounted at the cost of capital, it is clear that the value of an asset is negatively correlated with its risk. However, there is one instrument whose value is positively correlated with uncertainty, and this is the option. An option’s value is positively correlated with the risk carried by the underlying asset, as the right to exercise or not the option gives the investor the ability to grasp opportunities without being penalized by downside potential.