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What is the difference between Risk and Uncertainty in Finance?
Risk and uncertainty are often used interchangeably in financial management literature. However, there are differences between the two and they represent strictly different ideologies. In this brief article, we will highlight the points that differentiate these two terms, risk and uncertainty, when they are used in Finance parlance.
The Concept of Risk
Risk is the process of potential loss for a firm. The concept of risk is broad in finance. In finance, the risk is associated with a bad outcome occurring or a good outcome not occurring at all. For instance,
If the income falls down below a certain mark, it is a risk for the company.
If the business grows 10% instead of the projected 20% rate, that is also a kind of risk for the company.
In finance, risk can be understood and measured. There are two types of financial risks −
Systematic risk refers to the market risk that impacts all businesses equally. In stock markets, systematic risk is measured by Beta.
Unsystematic risks are specific to a company or a business sector. Tough competition, weak profits, etc. are all measures of unsystematic risks.
Uncertainty refers to an absence of certainty, that is, there is no guarantee of something happening in the present or the future. There is an absence of a given outcome in uncertainty. Since the outcome of an event is not certain, there is hardly any measure of uncertainty. That is, we cannot measure uncertainty in the business world. It is a process that can just be stated but not measured.
For example, let’s say that a business can earn 10% or 20% of profit within the next two years. However, it is uncertain because we cannot measure it. So, there is a kind of probability attached to uncertainty which is improbable in the case of risk.
Differences between Risk and Uncertainty
When it comes to risk and uncertainty, the two may look similar. However, there are certain marked differences between the two.
The first difference as mentioned above is that risk is measurable, while uncertainty is not measurable. In the case of risk, there is a process through which it can be measured; while in the case of uncertainty, there is no such measurement process.
Uncertainty refers to a process where the future outcome is largely unknown. Therefore, the probability of an outcome is also unknown in the case of uncertainty. Risk, on the other hand, has a certain probability of occurring in the future. Therefore, risk can be measured and acted upon, while uncertainty cannot be treated so.
From a business point of view, risk can be monitored and measured. An unsystematic risk, for example, can be measured and managed by diversifying the portfolio of stocks. In the case of systematic risk, it can be controlled by Beta Hedging. Therefore, since the outcome is known in the case of risk, it can be controlled; while uncertainty cannot be controlled or measured as the outcome is uncertain.
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