But let’s leave the mathematics aside for a moment and discuss risk in intuitive terms.
It seems clear enough that as we move from one broad asset class to another we’ll see a trade-off. U.S. Treasury bonds are safer, and produce a much lower return, than do corporate stocks.
Can we get more granular? Can we look within the world of corporate stocks and define subsets of that asset class, and find the same trade-off at work?
There are various sorts of risk. There are risks associated with the economy as a whole (the risk that the whole ocean will dry up so all the boats will find themselves on the bottom); the risk associated with specific markets or products (the risk that the horseless carriage will hurt all the buggy whip manufacturers); and the risk associated with one specific firm due, for example, to the excellence or incompetence of its managers. These are known as systemic risk, market risk, and idiosyncratic risk, respectively.
How might you protect against systemic risk? We’ll consider for the moment that you are a U.S. investor, with the usual “home bias” in investing, that is, most of your investments will be in U.S. based assets or issuers. On this premise, how might you hedge the risk that the whole of the U.S. equity markets will decline, and decline sharply?
You could take a short position on broad-based indices. And one way in which you could do that, arguably the easiest and cheapest way, is by buying puts on the index. Just as with puts on stock, puts on an index reflect pessimism or hedge against a downward direction. If the index moves up between the purchase and the maturity date, the put expires unused. If the index heads down and crosses the line defined in the original contract, the index has a pay-off.
One of the sorts of risk that any financial concern must manage is liquidity risk, that is, risk immediately relating to cash flow. The balance sheet may look fine, a concern may have a lot of assets, but if it can convert them into cash as necessary to meet its obligations, the owners may well lose control of the enterprise and that value.
Banks are in the “maturity transformation” business. Banks borrow money on short time frames (for example, from depositors who are entitled to withdrawal on demand) and lend money out on longer time frames. Indeed, this is precisely why (in the views of many theorists) there is a pressing need for central banks with the power to control the money supply. The central banks can step in when the process of maturity transformation goes poorly, as in the case of a classic ‘run.’But most enterprises aren’t in the maturity transformation business, and central banks don’t step in when they get in trouble (in the normal course of events, TBTF crises aside). Thus, liquidity risk management is an important part of the business model of anyone who doesn’t accidentally want to get into that business.