What are the components of risk?

Reviewing the components of risk is important when there are uncertain market situations in order to separate reality from the panic of the herd mentality. There is no question that the market is repricing risk, bu the issue is whether this is overdone. Market commentaries will discuss risk in broad terms when in reality it differs for each person.

In the simplest case, look at two investors with different portfolios. One may have 100% stocks while the other has 100% in bonds. There is risk in the stock market, but for the bond investor there is no risk from a market downturn. Of course, there are spillover effects from stocks to bonds as measured by their correlation but the direct impact of an equity downturn will not be felt by the bond investor. Going back to basics, risk can be broken up into four parts:

The hazard- What is the problem associated with this trade or situation? How can the potential problem be described? the description of the hazard may actually be very complex. Sub-prime loses by itself may not be a hazard for many investors until those loses reach a threshold.

The exposure - What is the dollar amount of exposure to this strategy or asset? Clearly, if the exposure is small, then the potential risk is also small.

The consequences - What are the potential results that can occur from this hazard? Could you lose all of your money or just a portion of the investment? The consequence for a CBO will be different than the a equity holding in builders.

The probability - What are the chances of this hazard actually occurring? Is it a low probability event with a high potential lose or a high probability event with a potential for a limited lose? The probability will change with time. We already have a a credit problem. The probability is now whether the problem will get worse.

To understand risk, requires an understanding of each of these parts because the ultimate cost from a risk is the combination of these parts. Classifying risks based on these four criteria are not easy but the issue is still manageable. However, risks are often viewed as independent or discrete events. The problem of risk management increases when these events are interrelated or correlated. More pressing is when a risk in one area will create greater or new risks in another. A simple medical analogy works here. Assume that you get one sickness, it may not be fatal, but it may make you more susceptible to other illnesses which could prove fatal. This is the problem of contagion and may be what we are now facing in credit markets.

We now have a sub-prime problem, but you may not be holding any sub-prime debt. The hazard may be present, but your exposure is zero; nevertheless, if there is a spill-over to other markets, there could be significant risks to your portfolio. For example, you may be holding a high grade credit portfolio but an increase in credit risk across the board can mean a extremely high exposure to a low probability event. The contagion is much harder to measure and model because it may not be obvious that there is a connection between markets and strategies. The key connection may be the need for liquidity which can spill-over to other markets. It is the liquidity crisis which may be the most frightening risk.