Topic 3 - Measures of Risk

• Risk


  The possibility of loss or injury
• Risk (financial)

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

  • It can be quantified
  • It arises from uncertainty about the future
  • It has to do with the future payoff of an investment
  • It must be assessed over some time horizon
  • It must be measured relative to some benchmark

  
• Probability


  A measure of the likelihood that an event will occur, between 0 and 1
• Expected value

  The mean - the sum of their probabilities multiplied by their payoffs
• Using percentages allows comparison of returns regardless of the size of initial investment
• Variance


  The average of the squared deviations of the possible outcomes from their expected value, weighted by their probabilities
• Standard deviation


  A measure of risk that deals in normal units, not squared units
• Value at Risk (VaR)


  The worst possible loss over a specific horizon at a given probability
• Risk aversion


  Most people do not like risk and will pay to avoid it
• Risk premium


  The compensation investors required to hold the risky asset
• Idiosyncratic risk

  Risks affecting a small number of people but no one else
• Systematic risk

  Risks affecting everyone
• Reducing risk through diversification

  1. Hedging - making two investments with opposing risks

  2. Spreading - finding investments with unrelated payoffs
• The more independent sources of risk you hold in your portfolio, the lower your overall risk