CH 5 - Understanding Risk I Intro a Risk cannot be avoided...

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Understanding Risk I. Intro a. Risk cannot be avoided b. Everyday decisions involve financial and economic risks i. How much car insurance should I buy? ii. Should I refinance my mortgage now or later? c. We must have the capacity to measure risk to calculate a fair price for transferring risk II. Outline a. In this chapter we will: i. Learn to measure risk and assess whether it will increase or decrease ii. Understand why changers in risk lead to changes in the demand for a particular financial instrument iii. Understand why change in risk lead to corresponding change in the price of those instruments. III. Defining Risk a. According to the dictionary, risk is “the possibility of loss or injury” b. For outcomes of financial and economic decisions, we need a different definition i. Risk is a measure of uncertainty about the future payoff to an investment, measured over some time horizon and relative to a benchmark ii. Risk 1. Risk is a measure that can be quantified a. The riskier the investment, the less desirable and the lower the price 2. Risk arises from uncertainty about the future a. We do not know which of many possible outcomes will follow in the future 3. Risk has to do with the future payoff of an investment a. Must imagine all the possible payoffs and the likelihood of each 4. Definition of risk refers to an investment or a group of investments a. Investment described very broadly 5. Risk must be measured over some time horizon a. In general, risk over shorter periods is lower 6. Risk must be measured relative to some benchmark - not in isolation a. A good benchmark is the performance of a group of experienced investment advisors or money managers IV. Measuring Risk a. We must become familiar with the mathematical concepts useful in thinking about random events b. In determining expected inflation or expected return, we need to understand expected value.

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Understanding Risk i. The investments return out of all possible values V. Possibilities, Probabilities, and Expected Value a. Probability theory states that considering uncertainty requires: i. Listing all the possible outcome ii. Figuring out the chance of each one occurring b. Probability is a measure of the likelihood that an event will occur i. It is always between zero and one ii. Can also be stated as frequencies c. We can construct a table of all outcomes and probabilities for an event, like tossing a fair coin
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This note was uploaded on 03/02/2011 for the course ECON 121 taught by Professor Labadie during the Spring '10 term at GWU.

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CH 5 - Understanding Risk I Intro a Risk cannot be avoided...

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