Measures Of Risk Flashcards
What does turning expected return into percentages allow us to do
Compare returns regardless of different sizes of initial investment.
A) £1,000 stock which can rise to £1,400 or fall to £700. Both probabilities of 0.5. Find EV.
B) £1000 stock which can…
Rise in value to £2,000, with probability of 0.1
Rise in value to £1,400, with probability of 0.4
Fall in value to £700, with probability of 0.4
Fall in value to £100, with probability of 0.1
Find EV
Both = 1050, and have an expected return of 5%.
But are not the same, second investment has a wider range of outcomes, and so more risky
So what can we learn from this
The wider range of outcomes (Variability) , the greater risk.
How can we find the variance?
Find EV
Subtract EV from each possible payoff, then square the result.
Multiply each result x probability
Add up the results
Why is standard deviation more useful than variance
Given 2 investments with equal expected payoffs, would we want a high or lower SD?
It deals in normal units, not squared units.
If 2 investments have equal expected payoffs, most will chose the one with lower SD
Sometimes we are less concerned with spread, and more the worst possible outcome.. what is this known as
Value at risk: the worst possible loss over a specific time at a given probability.
Example of value of risk being the most important
In mortgages, the value at risk (worst case scenario) is you not being able to afford your mortgage and losing your home.
Expected value and standard deviation don’t really tell you the risk you face in this instance.
What happens to the risk premium as investments become more risky
The riskier an investment, the higher the risk premium i.e the compensation/benefit investors want
Most people are risk averse, and what do they do as a result
Risk adverse means they prefer certain returns over one with the same expected return but uncertain.
and so are willing to pay to avoid risk through insurance
2 types of risks
Idiosyncratic - affects a small group
Systematic - affects everyone.
Idiosyncratic risks can be classified into 2 types
Risk is bad for one sector but good for another. E.g rise in oil prices good for energy industry but bad for car industry. (Like Pareto efficiency i guess - being better off makes someone else worse off)
Unique risks specific to one person/company and no one else.
How can we reduce idiosyncratic risk?
(SYSTEMATIC IS NOT POSSIBLE)
Diversification - holding more than one risk at a time,
(Via hedging or spreading)
Hedging meaning
Reducing idiosyncratic risk by making 2 investments with opposing risks.
Hedging can spread risks across many investments.
Spreading meaning
Strategy of reducing idiosyncratic risk finding investments unrelated, so the standard deviation becomes negligible!!!
Why can’t hedging always work
Investments are unpredictable.
