To understand how to measure risk, we need to first understand what drives risk. Risk drivers are the fundamental global and domestic macroeconomic and industry factors that create risk.
Risk management can control some risks but not all.
Common measures of risk:
It is difficult to measure rare events such as operational risk and default risk.
Methods of Risk Modification
There are four broad categories of risk modification.
Risk prevention and avoidance. Completely avoiding risk sounds simple, but it may be difficult or sometimes impossible. Furthermore, does it even make sense to do so? Almost every risk has an upside. There is always a trade-off between risk and return.
Risk acceptance. Risk can be mitigated internally through self-insurance or diversification. This is to bear the risk but do so in the most efficient manner possible.
Risk transfer. This is to pass on a risk to another party, often in the form of an insurance policy. An insurer attempts to sell policies with risks that have low correlations and can be diversified away.
Risk shifting. This refers to actions that change the distribution of risk outcomes. The principal device is a derivative which can be used to shift risk across the probability distribution and from one party to another. There are two categories of derivatives: forward commitments and contingent claims.
The primary determinant of which method is best for modifying risk is weighing the benefits against the costs, with consideration for the overall final risk profile and adherence to risk governance objectives.