Risk: A Financial View

Markets and money are imperfect metaphors for security metrics when it comes to risk analysis. But, as Senior Editor Todd Datz's discussion with Kellogg School finance professor Kathleen Hagerty demonstrates, CSOs can learn from economists

There's also the idea that there are different kinds of risk. There's a distinction between risk you can do something about through diversification and risk you can't do anything about. Here's an example of two risks that you can do something about: 1. A CEO gets sick; 2. Someone in that CEO's firm accidentally discovers NutraSweet. You get these sort of good and bad things across different firms, and those kind of net each other out. If I had an [investment] portfolio of a lot of different firms, these kinds of idiosyncratic good and bad things [can offset] each other. You can kind of eliminate that kind of risk in a portfolio as a whole by holding a lot of different stocks.

There's another [type] of risk, which is a risk you can't eliminate. For example, certain things in the economy affect every firmfor instance, oil prices, recessions, taxes and regulatory policy. They all kind of hit everybody the same way. So diversification doesn't work. What types of data, numbers and metrics are important for figuring out risk in finance?In finance, most of the measures we use come straight from statisticsstandard deviation, expected value, variance. The data we work with is mostly price data, such as the bond and stock prices and exchange rates. Price data is pretty cut and dry; there's no question what the price of IBM is. You're interested in how prices move around and there's good data on prices, tons of publicly available information; the price of IBM you can see all day every day. You also have a really good sense, historically, of the behavior of IBMthe volatility, the average, how listings have changed over time. There's almost a problem of too much information. Are there any data categories that are less precise, a little fuzzier?There are parts of financial markets where people are very interested in seeing prices, but aren't able. There are two venues where people trade. One is on exchanges, such as the NYSE and the Chicago Mercantile Exchange. Those are public exchanges; everybody can see all the prices. The other big part of financial markets are trades between banksinvestment banks. [Those transactions aren't] run through exchanges; so they're not publicly available. So there's all these trades between institutions that you don't see; prices you don't see.

Also the cost of trading can be hard to see. What are the commissions? If I buy 10 shares, I'll get one price. If I buy 10,000 shares, I have to pay a different price. What are those two different prices?