1.1 Introduction
So here we are at the outset of our inquiry into Country Risk . We will explore a wide range of topics that are complicated, nuanced, and the subject of intense debate. This includes trade, treaties, political regime change, economic policy, and much more. Before we can delve into these topics, we initially need to ask two essential questions: āWhat is Risk ?ā and āWhat is Risk Management ?ā
1.2 What Is Risk ?
1.2.1 A Multifaceted Concept
āRisk ā is a multifaceted concept. Risk is about the futureāwhat may occur this afternoon, tomorrow, next year, or further out in time. It is about outcomes that are unknown. It is a consequence of every meaningful action undertaken by an organization. It occurs in strategy setting, new product creation, employee hiring, model design, and so much more. Risk can create substantial financial gain or loss. It can also enhance or damage an organizationās reputation.
The term ārisk ā is often used synonymously with the term āuncertainty ,ā although it has no universal definition. It has been used in different ways for different purposes.
The term has assumed multiple meanings in āeverydayā conversation.
- āI will take that risk .ā
- āThis is a high risk strategy.ā
- āThere are risks in proceeding.ā
- āI want to avoid this risk .ā
- āWe may incur risk here.ā
- āWe donāt want any risk .ā
- āWe run the risk of something we did not anticipate.ā
- āThe program is at risk .ā
- āWe can manage the risk .ā
We use this term, moreover, across the spectrum of business, government, and the non-profit sectorāyet not always in a consistent manner. We work in departments of risk management staffed by risk analysts and led by chief risk officers . We engage in risk assessments, build risk models, and review risk statistics. We serve on risk committees , attend risk conferences, and read risk journals. We communicate with specialized terminology, referring to specific types of risk asāamong othersācredit risk , market risk , and operational risk . Yet, across this varied range of activity, we use multiple definitions, follow different policies, and engage in diverse practices relating to risk and risk management . We also encounter differencesāsome times significantāamong organizations and working groups that have sought to promote common standards for risk management . (See Box 1.1, Definitions of Risk .)
So how can we improve our understanding risk and risk management ? How can we have more constructive discussions about these essential concepts? How, ultimately, can we make better decisions about the future?
1.2.2 Risk , Uncertainty , and Ambiguity
A useful way to begin is to understand the nature and degree of uncertainty we confront in any particular decision. We need to ask how confident we are about the basis for our decisions. We further need to ask how much we know about the probabilities for outcomes associated with our choices. To answer these questions, we need additional definitions and a more specific meaning for the word risk itself. At the outset, three new definitions are important: Uncertainty , Risk , and Ambiguity .1
They have their origins in the ideas of two influential economists (among others): John Maynard Keynes (1883ā1946), the founder of modern macroeconomics,2 and Frank Knight (1885ā1972), a leader of the Chicago School of Economics at the University of Chicago . (See Box 1.2, Frank Knight ās Legacy: Risk , Uncertainty , and Ambiguity .) These definitions are not, of course, the only valid ones for these concepts, but they serve as a useful starting point for our inquiry into the nature of Country Risk .3
For our purposes then, we define these terms as follows.
- āUncertainty ā is an overarching term that refers to any condition where the particular outcome is not known (i.e., the set of potential outcomes may or may not be known). As we have observed, this term is often used synonymously with the term risk in āeverydayā discourse, but we can refine our terminology if we think of risk as a subset of uncertainty .
- āRisk ā is a special case of uncertainty where we know both the set of potential outcomes and the probability of such outcomes. This has also been referred to as āmeasurable risk ā or āKnightianā risk (in reference to Frank Knight ās distinction between risk and uncertainty ). Another complementary definition is āa situation in which there are well defined, unique and generally accepted objective probabilities ā (Kelsey and Quiggin 1992, 134ā135). (An often-used example of measurable risk is the ātossā of an evenly balanced coin. For each individual toss, there are only two unique outcomes, and for each such outcome there is a 50% probability that the coin will land on one side or the other side. One significant aspect of this definition of risk is the potential to insure against loses or negative outcomes. Familiar examples include individual insurance policies to cover health care, automobiles, homes, or a personās life. In such cases, insurance providers take into account extensive historical experience about potential outcomes, including average behaviors and measurable deviations from the average.)
- āAmbiguity ā is a special case of uncertainty where we know the set of potential outcomes but do not know the probability of such outcomes.4 A complementary definition is āuncertainty about probability, created by missing information that is relevant and could be known ā (Camerer and Weber 1992, 330).
Another subset of uncertainty refers to the case where we do not even know the nature and extent of the possible outcomes. This is sometimes called Knightian uncertainty in reference to Frank Knight ās framework. Another name for this, formulated by the economist David Dequech , is āfundamental uncertainty .ā This form of uncertainty can arise from a complex interplay of factors, including innovation and technological change as well as changes in cultural, social, and political conditions. Dequech writes: āThe future...