2.4 Measuring Risk

Question 1

What does risk mean in a financial sesne?

Answer 1

Risk is the possibility that an investment’s actual
future return will differ from its expected return. The difference could be due either to lower returns
than expected or to higher returns than expected. Financial risk measures the variability of investment
returns

Question 2

What are the two main tools for measuring financial risk?

Answer 2

The two tools for measuring financial risk are:

1) Variance
2) Standard deviation

Question 3

What is Variance?

Answer 3

Variance is a measure of how far a set of data points varies from the mean: the greater the range of possible returns, the higher the variance, and the greater the
financial risk

Question 4

How to calculate Variance?

Answer 4

In order to calculate Variance you must calculate, for each investment return, its deviation from
the arithmetic mean. We then square these, before calculating the arithmetic mean of these squared
deviations.

Question 5

What does the term ‘Population’ mean, in regards to Variance?

Answer 5

Population stands for the group of data points being analyzed, such as all of the investment points over the designated period

Question 6

What does the term ‘Observation’ mean, in regards to Variance?

Answer 6

Observation stands for each individual data point being analyzed, such as an individual investment return, amongst a group of investment returns

Question 7

What does the term ‘Population Variance’ mean, in regards to Variance?

Answer 7

Population Variance means the degree of variance found within the population.

Question 8

What is the formula for calculating Variance?

Answer 8

The formula for calculating Variance is:

Variance = σ2 =
∑(x – µ)2[Squared]
—
n

where:
σ2 = the symbol for the population variance (called sigma squared).
x = the value of one observation in the population (eg, the return in a particular year).
µ = (pronounced mew) the arithmetic mean of the population (eg, the average annual return).
∑ = sum of all (x – µ) observations (called sigma).
n = the number of observations in the population (eg, the number of years being analyzed).

Question 9

How to calculate Population Variance?

Answer 9

There are five steps to calculate the population variance:

1. Calculate the mean of the population of observations (µ).
2. Calculate the difference between each observation and the mean result (x – µ).
3. Square the difference of each value found in step 2 (x – µ)2.
4. Add up the total of all the squared differences (∑).
5. Divide the total by the number of observations (n).

Question 10

What do the terms Population, Observation and Population Variance mean?

Answer 10

The term ‘population’ means the group of data points being analysed, and the term
‘observation’ means an individual data point being analysed. ‘Population variance’, therefore, means the
degree of variance found within the population