Risk
Risk refers to the uncertainty (volatility) or potential for financial loss in an investment or business decision. It reflects the variability in returns due to external and internal factors. The risk of an asset can be quantified in a variety of ways, including the standard deviation of its price.
Furthermore, risk can be broadly categorized into systematic risk and idiosyncratic risk:
- Systematic (market) risk affects the entire market or economy. It cannot be eliminated through diversification.
- Idiosyncratic risk affects a specific company, industry, or asset. It can be reduced through diversification.
However, in theory, other risks exist:
- Fundamental risk is the risk that new information about a security validates a mispricing.
- For example, an arbitrageur shorts an overpriced stock. However, news about dividends validate the price at the current (or higher) level, resulting in losses.
- Noise-trader risk is the risk that investor sentiment exacerbates a mispricing.
- For example, an arbitrageur shorts an underpriced stock, expecting mean reversion. However, pessimistic sentiment drives the stock even lower.
- Horizon risk is the risk that a mispricing could take a long time to correct, so arbitrageurs could end up earning less than the risk-free rate.
- Synchronization risk is the risk that an arbitrageur delays trading on a mispricing because they are unsure whether other arbitrageurs will act too, and attacking it alone would be costly and unlikely to move prices back.