1297266771182_Chapter5_Instructor_Notes - CHAPTER 5:...

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1 CHAPTER 5: UNDERSTANDING RISK A. T HE B ASICS Core Principle 2, risk requires compensation, is the focus of Chapter 5. Risk is defined as a measure of uncertainty about the future payoff to an investment over a specific time horizon relative to a benchmark. Much of the discussion in the text deals with risk as it applies to financial instruments, though nonfinancial examples are everywhere. For example, you risk being hit by a car crossing the street after class. Two measures of risk are introduced: the variance of the returns on an asset and the value at risk. You probably know the concept of the variance: the sum of probability- weighted squared deviations of all the possible outcomes from the expected outcome. The value at risk is, roughly, the worst-case scenario which occurs with a given probability. And both concepts might be applied to the same issue. For example, monetary policy might primarily focus on output fluctuations (that is, smoothing out the ups and downs of the business cycle or, technically, minimizing the variance of output over time) but also want to avoid a repeat of the Great Depression, a “worst-case” event. The definition of risk also refers to time since, as you learned in chapter 4, time has value (Core Principle 1). For instance, as you save for retirement, you have risk that a low return over roughly a 40-year professional career will leave you with a retirement portfolio that will not support you when you want to retire. This is a concern since funds you invest today may earn high, low, or moderate returns over the period – that’s the uncertainty referred to in the definition of risk. The concept of risk is only half of Core Principle 2. The other half is that risk requires compensation. Suppose you own an insurance agency that issues automobile policies. Some of your clients have never had an accident, while others have had quite a few. Would you charge each type the same premium for a given amount of coverage? Those with many accidents represent, on average, a bigger risk to your company in terms of claims payouts than those with no accidents. So you’d probably charge the reckless drivers higher premiums; risk requires compensation. (If you charged the same premiums to both types, the good drivers would likely find a company that discounts the premiums of drivers with clean accident histories. Then you’d be left with just the reckless drivers.) B. S OLIDIFY Y OUR K NOWLEDGE DISCUSSION/EXTENSIONS OF THE BASICS Review of Basic Statistical Concepts : Risk, both its measurement and many of its applications, is often thought about in terms of basic statistical techniques. One key concept, the variance, is presented in appendix 5B on text page 123 in equation (A4). While we will discuss this concept in a moment, the idea of an expected value is needed
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This note was uploaded on 09/07/2011 for the course ECO 412 taught by Professor Staff during the Spring '05 term at Kentucky.

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1297266771182_Chapter5_Instructor_Notes - CHAPTER 5:...

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