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
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
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.