Week 2a

Question 1

what is risk in economics

Answer 1

Risk is a measure of uncertainty about the future payoff to an investment,
assessed over some time horizon and relative to a benchmark.

Question 2

what happens to the price when the investment is riskier

Answer 2

the investment is less desirable hence the price is lower

Question 3

how is risk related to investment

Answer 3

Risk refers to the uncertainty of future outcomes, particularly in terms of potential losses or negative impacts on investments.

Question 4

how can risk be quantified

Answer 4

Risk can be quantified by assessing the probability and magnitude of potential losses associated with an investment.

Question 5

What contributes to the emergence of risk in investments?

Answer 5

Risk arises from uncertainty about future outcomes, where the exact outcome among many possibilities is unknown.

Question 6

Why is it essential to consider the future payoff when evaluating risk?

Answer 6

Evaluating risk requires considering all potential future payoffs and their likelihoods to understand the variability in investment outcomes.

Question 7

Can risk be assessed over any time horizon?

Answer 7

Yes, risk must be evaluated over a specific time horizon, with shorter periods generally associated with lower risk.

Question 8

How should risk be measured?

Answer 8

Risk should be measured relative to a benchmark or reference point, such as the performance of experienced investment advisors or comparable investments.

Question 9

what does probability theory state that considering uncertainty requires

Answer 9

listing all the possible outcomes
figuring out the chance of each one occurring

Question 10

what is true about probability

Answer 10

its always between 0 and 1
can also be stated as frequencies

Question 11

what is the expected value

Answer 11

Expected value is the mean : the sum of their probabilities multiplied by
their payoffs.

Question 12

How does the range of potential outcomes relate to risk?

Answer 12

The wider the range of possible outcomes, the greater the perceived risk associated with an investment.

Question 13

What is a risk-free asset?

Answer 13

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.

Question 14

Why is measuring the spread important in assessing risk?

Answer 14

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.

Question 15

what is the variance

Answer 15

The variance is the average of the squared deviations of the possible
outcomes from their expected value, weighted by their probabilities

Question 16

what are the steps to calculate the variance

Answer 16

1. compute expected value
2. subtract expected value from each of the possible payoffs and square the result
3. multiply each result time the probability
4. add up the results

Question 17

Why is standard deviation considered more useful than variance?

Answer 17

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.

Question 18

How can standard deviation be converted into a percentage?

Answer 18

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.

Question 19

Why is comparing investments based on standard deviation helpful?

Answer 19

Comparing investments based on standard deviation enables investors to assess the relative level of risk associated with each investment, aiding in decision-making.

Question 20

When given a choice between two investments with equal expected payoffs, what is the usual preference?

Answer 20

Given equal expected payoffs, investors typically prefer the investment with the lower standard deviation, as it signifies lower variability and perceived risk.

Question 21

what is VAR value at risk

Answer 21

The worst possible loss over a specific horizon at a
given probability.

Question 22

what question does VAR provide the answer for

Answer 22

how much will I lose if the worst possible
scenario occurs

Question 23

Why do most people prefer to avoid risk?

Answer 23

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.

Question 24

How does risk aversion influence investment choices?

Answer 24

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.

Question 25

What is the relationship between risk and the risk premium?

Answer 25

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.

Question 26

What does the risk premium represent?

Answer 26

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.

Question 27

How can risks be classified into two main groups?

Answer 27

Risks can be categorized as idiosyncratic (diversifiable) risks, affecting only a small number of people or entities, and systematic (undiversifiable) risks, impacting everyone.

Question 28

What are idiosyncratic risks?

Answer 28

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.

Question 29

Can you provide an example of an idiosyncratic risk benefiting one sector but harming another?

Answer 29

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.

Question 30

How can risk be reduced in investment portfolios?

Answer 30

Risk can be reduced through diversification, which involves holding multiple investments to spread risk across different assets and reduce idiosyncratic risk.

Question 31

What is the principle behind diversification?

Answer 31

Diversification involves holding more than one risk at a time to reduce the impact of individual risks on an investment portfolio.

Question 32

How does hedging help in risk reduction?

Answer 32

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.

Question 33

What is spreading in the context of risk management?

Answer 33

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.

Question 34

How does hedging eliminate risk entirely?

Answer 34

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.

Question 35

What is the alternative to hedging when investments are not predictable?

Answer 35

he alternative to hedging is spreading risk around by investing in assets whose payoffs are unrelated, thereby diversifying the investment portfolio.

Question 36

What is the basis for diversification through the spreading of risk?

Answer 36

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.

Question 37

what is wealth

Answer 37

the total resources owned by the individual, including all assets