Financial Markets and Institutions 3: Measures of risk

Question 1

Describe the definition of risk

Answer 1

• 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

Question 2

What does probability theory state that considering uncertainty requires?

Answer 2

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

Question 3

Describe what probability is

Answer 3

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.