Economic risk

From CEOpedia | Management online

Risk has multiple definitions. Preston B. Cline claims that nowadays most definitions of risk define it by its result: "Potential for loss…"[1]. Ramady M. A. suggest that "risk is a situational characteristic of activity that may have an uncertain outcome and negative effects in case of failure."[2].

The economic risk "should be considered as a process of decision-making under conditions of uncertainty and with respect to economic, political, moral, psychological and other largely negative consequences"[3]. International Country Risk Guide gives tools to weighting and classifying economic risk[4].

Functions of risk

Risk has two functions [5]: stimulative and protective.

  • The stimulative function - has two aspects: constructive and destructive. The first aspect highlights the role of risk as a catalyst in solving economic obstacles, particularly in settling innovative investment decisions. The second aspect explains ‘’that making and implementing decisions with undue risk results in adventurism’’.
  • The protective function - also has two aspects: historic/genetic and social/legal. The first aspect states that everyone "spontaneously search for forms and means of protection from probable negative consequences". This aspect is illustrated in practice through the formation of emergency reserve funds and insurance from entrepreneurial risks. The second aspect highlights a need for establishing the categories of risk justification into economic, labor and criminal legislation.

Economic risk factors

Various factors have an impact on economic risk. Ling D. C. and Naranjo A. considered 7 factors, such as[6]:

  • MKT - "The market portfolio is the excess return on a value-weighted portfolio of NYSE, AMEX, and NASDAQ stocks
  • PREM - The bond default premium is the difference between the quarterly yield on a portfolio of bonds rated Baa by Moody's Investor Services and a portfolio of long-term U.S. government bonds
  • TERM - The term structure premium is defined as the change in the difference between the quarterly yield of a 10-year Treasury bond and a 3-month Treasury bill
  • RLTBL - The real three-month Treasury bill return is the return on a three-month Treasury bill less the quarterly inflation rate as measured by CPI
  • GCONSUM - The real per capita growth rate of nondurable goods and services is defined as the quarterly real per capita growth of personal consumption expenditures for nondurable goods and services
  • GIP - The growth rate of industrial production is defined as the percent of quarterly change in industrial production.
  • UI - Unanticipated inflation is the difference between the realized inflation rate during period t and the expected inflation rate at the beginning of the same period t."

Examples of Economic risk

  • Economic risk refers to the possibility of an individual or organization experiencing a loss due to economic factors such as market volatility, inflation, deflation, political changes, or interest rate fluctuations. Examples of economic risk include:
  • Inflation Risk: This is the risk that the purchasing power of a currency will decrease due to an increase in the general price level. For example, if the cost of goods and services rises faster than wages, individuals and businesses may be unable to purchase the same amount of goods and services they were able to purchase in the past.
  • Interest Rate Risk: This is the risk that interest rates will change, resulting in a change in the cost of borrowing money. For example, if interest rates rise, the cost of borrowing money increases, and this could lead to decreased profits for businesses.
  • Exchange Rate Risk: This is the risk that the value of a currency will change due to changes in exchange rates. For example, if the value of the US dollar decreases relative to the value of the euro, individuals and businesses who are buying or selling goods or services in euros may experience a loss.
  • Political Risk: This is the risk that a change in the political environment will lead to changes in economic policies, which could have a negative impact on businesses. For example, if a new government is elected with a different set of economic policies, businesses may find it difficult to adjust to the new policies, which could lead to decreased profits.

Advantages of Economic risk

Risk management through economics can be an effective way to reduce the potential for loss and maximize profits. Here are some advantages:

  • By assessing risk through economic principles, businesses can identify potential risks and take proactive steps to mitigate them. This helps to ensure potential losses are minimized.
  • Economic risk analysis can also help businesses to identify and capitalize on potential opportunities. By understanding the potential for gain, businesses can make informed decisions and maximize profits.
  • Economic risk analysis can also help businesses to better understand the overall economic environment in which they operate. This can help them to make strategic decisions that are appropriate for the current market conditions.
  • Economic risk analysis can also help businesses to identify and manage external risks, such as changes in the global economy or shifts in customer behavior. By understanding external risks, businesses can better prepare for them and adjust plans accordingly.

Limitations of Economic risk

Economic risk can be limited by considering the following aspects:

  • Unpredictable Nature of Risk: Economic risk is unpredictable. It is impossible to predict the future and the resulting economic costs of any given risk.
  • Ignorance of Risk: Many people are unaware of the economic implications of risk and how it may affect their business. As a result, they may underestimate the economic risk they are taking.
  • Uncontrollable Factors: Risk is affected by uncontrollable factors such as the state of the economy, changes in the political environment, and the actions of competitors. These uncontrollable factors can lead to unexpected losses or gains.
  • Time-Delay: Economic risks can take time to manifest, meaning that the economic costs may not be realized until much later.
  • Difficulty in Quantifying: It can be difficult to accurately quantify the economic costs of risk, making it difficult to accurately assess the potential impact of a risk.
  • Difficulty in Managing: Risk management can be complex and time-consuming. It requires a deep understanding of the external environment, as well as the ability to anticipate and prepare for potential risks.

Other approaches related to Economic risk

Risk is a multi-dimensional concept that can be defined in a variety of ways. Preston B. Cline claims that nowadays most definitions of risk define it by its result: "Potential for loss…". In addition to this, other approaches to defining risk include:

  • Risk as an Uncertainty - Risk is seen as a measure of how certain or uncertain future outcomes are. This approach to risk is used by economists, who define risk as the probability of a given outcome happening.
  • Risk as a Hazard - Risk can be seen as a potential hazard or danger that can cause harm or damage to an individual or organization. This type of risk is related to safety and health risks and is used to assess the likelihood of an individual or organization being harmed or damaged by a hazard.
  • Risk as a Vulnerability - Risk can be seen as a vulnerability to potential losses or damages. This form of risk is used to assess the susceptibility of an individual or organization to losses or damages due to external factors.
  • Risk as a Cost - Risk can be seen as a cost associated with a particular activity or decision. This type of risk is used to assess the economic costs associated with a particular activity or decision.

In summary, risk can be viewed from multiple perspectives, including as a potential for loss, uncertainty, hazard, vulnerability, or cost. Each of these approaches offers a different way of assessing and managing risk.

Footnotes

  1. ↑ Cline P. B. 2004
  2. ↑ Ramady M. A. 2013
  3. ↑ Zhivetin V. B. 2007
  4. ↑ Ramady M. A. 2013
  5. ↑ Zhivetin V. B. 2007
  6. ↑ Ling D. C., Naranjo A. 1997


Economic risk — recommended articles
Systematic risk — Total risk — Indirect loss — Pure risk — Market condition — Cost risk — Market dynamics — Market disruption — Demand shock

References

Author: Joanna Pawlik

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