Financial Markets and Institutions 3: Measures of risk Flashcards

1
Q

Describe the definition of risk

A
  • According to the dictionary, risk is ”the possibility of loss or injury.”
  • For outcomes of financial and economic decisions, we need a different
    definition.
  • Risk is a measure of uncertainty about the future payoff to an investment,
    assessed over some time horizon and relative to a benchmark.
    1. Risk is a measure that can be quantified.
    ▶ The riskier the investment, the less desirable and the lower the price.
    2. Risk arises from uncertainty about the future.
    ▶ We do not know which of many possible outcomes will follow in the
    future.
    3. Risk has to do with the future payoff of an investment.
    ▶ We must imagine all the possible payoffs and the likelihood of each.
    4. Definition of risk refers to an investment or group of investments.
    ▶ Investment described very broadly.
    5. Risk must be assessed over some time horizon.
    ▶ In general, risk over shorter periods is lower.
    6. Risk must be measured relative to some benchmark–not in isolation.
    ▶ A good benchmark is the performance of a group of experienced
    investment advisors or money managers
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2
Q

What does probability theory state that considering uncertainty requires?

A

▶ Listing all the possible outcomes.
▶ Figuring out the chance of each one occurring

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3
Q

Describe what probability is

A

Probability is a measure of the likelihood that an event will occur.
▶ It is always between zero and one.
▶ Can also be stated as frequencies.

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