Week 2a Flashcards
what is risk in economics
Risk is a measure of uncertainty about the future payoff to an investment,
assessed over some time horizon and relative to a benchmark.
what happens to the price when the investment is riskier
the investment is less desirable hence the price is lower
how is risk related to investment
Risk refers to the uncertainty of future outcomes, particularly in terms of potential losses or negative impacts on investments.
how can risk be quantified
Risk can be quantified by assessing the probability and magnitude of potential losses associated with an investment.
What contributes to the emergence of risk in investments?
Risk arises from uncertainty about future outcomes, where the exact outcome among many possibilities is unknown.
Why is it essential to consider the future payoff when evaluating risk?
Evaluating risk requires considering all potential future payoffs and their likelihoods to understand the variability in investment outcomes.
Can risk be assessed over any time horizon?
Yes, risk must be evaluated over a specific time horizon, with shorter periods generally associated with lower risk.
How should risk be measured?
Risk should be measured relative to a benchmark or reference point, such as the performance of experienced investment advisors or comparable investments.
what does probability theory state that considering uncertainty requires
listing all the possible outcomes
figuring out the chance of each one occurring
what is true about probability
its always between 0 and 1
can also be stated as frequencies
what is the expected value
Expected value is the mean : the sum of their probabilities multiplied by
their payoffs.
How does the range of potential outcomes relate to risk?
The wider the range of possible outcomes, the greater the perceived risk associated with an investment.
What is a risk-free asset?
A risk-free asset is an investment with a known future value and a guaranteed return, typically equal to the risk-free rate of return.
Why is measuring the spread important in assessing risk?
measuring the spread allows for the quantification of risk by assessing the variability or dispersion of potential outcomes, providing insight into the level of risk associated with an investment.
what is the variance
The variance is the average of the squared deviations of the possible
outcomes from their expected value, weighted by their probabilities
what are the steps to calculate the variance
- compute expected value
- subtract expected value from each of the possible payoffs and square the result
- multiply each result time the probability
- add up the results
Why is standard deviation considered more useful than variance?
Standard deviation is preferred as it is expressed in the same units as the original data, making it easier to interpret and compare across different investments.
How can standard deviation be converted into a percentage?
Standard deviation can be expressed as a percentage of the initial investment, allowing for a clearer understanding of the risk relative to the investment amount.
Why is comparing investments based on standard deviation helpful?
Comparing investments based on standard deviation enables investors to assess the relative level of risk associated with each investment, aiding in decision-making.
When given a choice between two investments with equal expected payoffs, what is the usual preference?
Given equal expected payoffs, investors typically prefer the investment with the lower standard deviation, as it signifies lower variability and perceived risk.
what is VAR value at risk
The worst possible loss over a specific horizon at a
given probability.
what question does VAR provide the answer for
how much will I lose if the worst possible
scenario occurs
Why do most people prefer to avoid risk?
Most individuals are risk-averse, meaning they dislike uncertainty and are willing to pay to avoid it, as seen in behaviors such as purchasing insurance.
How does risk aversion influence investment choices?
Risk-averse investors will consistently favor investments with certain returns over those with similar expected returns but greater uncertainty, reflecting a preference for stability and predictability.
What is the relationship between risk and the risk premium?
he riskier an investment is perceived to be, the higher the risk premium investors will demand as compensation for holding that asset, reflecting the additional risk they are taking on.
What does the risk premium represent?
The risk premium is the additional return or compensation investors require to hold a risky asset compared to a risk-free asset, reflecting the perceived level of risk associated with the investment.
How can risks be classified into two main groups?
Risks can be categorized as idiosyncratic (diversifiable) risks, affecting only a small number of people or entities, and systematic (undiversifiable) risks, impacting everyone.
What are idiosyncratic risks?
Idiosyncratic risks are specific to individual entities or sectors and can be further classified into two types: (1) risks that may benefit one sector of the economy while harming another, and (2) risks unique to one person or company and not applicable to others.
Can you provide an example of an idiosyncratic risk benefiting one sector but harming another?
Yes, an increase in oil prices may be detrimental to the automobile industry due to higher production costs but beneficial to the energy sector, leading to increased revenues.
How can risk be reduced in investment portfolios?
Risk can be reduced through diversification, which involves holding multiple investments to spread risk across different assets and reduce idiosyncratic risk.
What is the principle behind diversification?
Diversification involves holding more than one risk at a time to reduce the impact of individual risks on an investment portfolio.
How does hedging help in risk reduction?
Hedging is a strategy used to reduce idiosyncratic risk by making investments with opposing risks, thereby offsetting potential losses in one investment with gains in another.
What is spreading in the context of risk management?
Spreading is a strategy for reducing idiosyncratic risk by investing in assets that are unrelated or have low correlation, thereby minimizing the impact of adverse events on the overall portfolio.
How does hedging eliminate risk entirely?
By investing half of the capital in each of two stocks with opposing risks, hedging can eliminate risk entirely, as the variability in the returns of one investment is offset by the stability in the returns of the other.
What is the alternative to hedging when investments are not predictable?
he alternative to hedging is spreading risk around by investing in assets whose payoffs are unrelated, thereby diversifying the investment portfolio.
What is the basis for diversification through the spreading of risk?
Diversification through spreading risk is akin to the principles of insurance, where the pooling of independent risks leads to reduced overall risk and increased stability in the face of uncertainties.
what is wealth
the total resources owned by the individual, including all assets
