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Chou's SR article - GauravChoudhury(UG03 WHAT IS FINANCIAL...

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Gaurav Choudhury (UG ’03) The Wharton School of Finance and Commerce University of Pennsylvania W H A T I S F F I N A N C I A L I N A N C I A L R R I S K ? R ISK has been know to man ever since he first faced adversity. It is an integral part of the evolution of man. Risk has been encountered primarily in his physical environment, later on in his social environment. With time, risk has evolved alongwith man. The main risk Neolithic man faced was an attack by a wild animal. This was mitigated with the discovery of fire. Note: Mitigated not eliminated. Risk can rarely, if ever, be completely eliminated. This mitigation has now take the form hedging sales of currencies in the future using forward contracts or options. It is risk, but it has changed with man and his society. R ISK is essentially, the probability that the outcome maybe damaging or result in a loss. With risk, the outcomes of an event are thrown open to uncertainty. Tossing a dice, is at a basic level a risky endeavor, that has uncertain outcomes. If you were to be shot depending on the outcome of a dice roll (say prime number you live, non-prime number you die), you would have a 50% chance of survival. A risky outcome with a level of uncertainty involved. W HAT are the standard types of risk? 1. Pure v/s Speculative a. Pure Risk: The situation in which a gain will not occur. The best possible outcome is that of no loss occurring. E.g.: A pilot flying an airplane will be happy with not crashing the airplane. He has not gained anything, but avoiding the catastrophe is the best possible outcome.(This is an extreme example, intended to clarify the concept). b. Speculative Risk: A risk in which either a gain or a loss may occur. E.g.: You commit to sell a bag of wheat 3 months into the future at $10. Three months down if the price of wheat is $5 you make a profit of $5; if it is $15, you incur a loss of $5 by not being able to sell it at the market price. You speculated on the price of wheat 3 months into the future. 2. Diversifiable v/s Non-diversifiable Essentially diversifiable risk is that which can be mitigated through a process of pooling risks. Vice versa for non-diversifiable.
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Gaurav Choudhury (UG ’03) The Wharton School of Finance and Commerce University of Pennsylvania E.g.: This is best exemplified through the theory of portfolio diversification. Buying one stock (portfolio of 1 stock) exposes you to 2 types of risk. Risk of the market (Systematic risk) and risk of the firm specific stock (Non- systematic risk). Increasing the number of stocks in your portfolio would be a form of pooling that mitigates non-systematic risk of the whole portfolio. But the portfolio is implicitly exposed to the systematic risk of the market. R ISK averse individuals tend to be willing to pay the expected value of the loss rather than face the risk of the loss. This can be explained by the fact that the value of the loss, if incurred, is greater than the amount sacrificed by the individual to cover that loss.
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