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Understanding Risk
Understanding Risk
Defining Risk
Risk is a measure of uncertainty about the
possible future pay offs of an investment. It is
measured over some time horizon, relative to a
benchmark.
•Risk is a measure that can be quantified.
Uncertainties that are not quantifiable cannot be
priced.
Understanding Risk
• Risk arises from uncertainty about the future.
Measuring Risk
Measuring risk is crucial to understanding
the financial system.
Understanding Risk
Measures of Risk
•A risk-free asset is an investment whose future value, or
payoff, is known with certainty.
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•Risk increases when the spread (or range) of possible
outcomes widens but the expected value stays the same.
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Understanding Risk
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•Variance and standard Deviation:
One measure of risk is the standard deviation of
the possible payoffs.
It takes several steps to compute the variance
of an investment.
The Standard deviation is the (positive) square root
of the variance or:
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•Value at Risk
A second measure of risk is value at risk, the
worst possible loss over a specific time horizon,
at a given probability.
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Understanding Risk
Understanding Risk
Sources Of Risk
• Idiosyncratic Risk:
it’s specific to a
particular
business or
circumstance.