Risk is a fact of life for investors. Even federally insured certificates of deposit have interest rate risk, meaning a rise in rates could leave you stuck with below-market earnings until the CD matures. Calculating risk exposure is one of the tools savvy investors use to evaluate and manage risk. That's important because investors who understand the risks they face can make better investment choices.
Video of the Day
Risk and Exposure
Risk is the chance that a possible negative event actually will occur. In investing, this means the chance adverse events will cause you to lose money. For example, if you purchase a bond, there is some probability that the bond issuer will default, leaving you out of luck and out of money. A risk exposure calculation tells you how much you are likely to lose due to adverse events.
Estimating Risk Probability
Before you can calculate risk exposure, you need a reasonable estimate of the probability a risk event will occur. Suppose you are considering investing in a corporate bond. Do some research to find the default risk of the bond. For example, during the early 2000s, corporate bonds rated as investment grade by Moody's had a historical default rate of 2.09 percent. Non-investment grade corporate bonds defaulted at a whopping 31.37 percent rate. You can find comparable data for other events, like the odds a startup will fail or commercial real estate will fall in value, by using financial publications or government sources, or by asking your broker for assistance.
Risk Exposure Formula
The formula for calculating risk exposure is the total loss if the risk occurs multiplied by the probability that the risk will actually happen. Suppose you plan to purchase $10,000 worth of investment grade corporate bonds. If the issuer defaults, your loss could amount to the entire $10,000. If the default risk is 2.09 percent, multiplying $10,000 by .0209 gives you a risk exposure of $209.
Evaluating Risk Exposure
Using risk exposure as an investment guide requires some judicious interpretation. For example, an investment with high risk and a low potential loss can yield the same exposure as a low-risk investment with the possibility of a large loss. Another issue to consider is the expected return on the investment. You'll need to make a judgment call as to whether or not the risk exposure is acceptable given the potential profit.