chap005 - Chapter 5 Understanding Risk Chapter Overview...

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Chapter 5 Understanding Risk Chapter Overview This chapter covers how to measure risk and assess whether it will increase or decrease. It also develops an understanding of why changes in risk lead to changes in the demand for particular financial instruments and to corresponding changes in the price of those instruments. Reading this chapter will prepare students to: Define risk. Explain how risk is measured. Assess the impact of risk on investors with different risk tolerances. Distinguish between idiosyncratic and systematic risks. Important Points of the Chapter Every day we make decisions involving risk; making any decision that has more than one possible outcome is similar to gambling in that a sum of money is involved and the outcomes are uncertain. The tools used to measure risk were originally developed to analyze games of chance. Applying these rules of probability help us understand the possibility of various occurrences and allow us to make better choices. While risk cannot be eliminated, in many cases it can be effectively managed. Risk also creates opportunities; people are compensated for assuming risk. In order to calculate a fair price for transferring risk from one person to another requires being able to measure risk. Application of Core Principles Principle #2: Risk (page 90) People require compensation for taking risks, and without the capacity to measure risk we could not calculate a fair price for transferring risk from one person to another, nor could we price stocks, bonds and insurance. Principle #1: Time (page 91) Risk is measured over a time horizon. In most cases, the risk of holding an investment over a short period is smaller than the risk of holding it over a long one, but there are important exceptions that will be discussed in a later chapter. Principle #2: Risk (page 100) Adjustable rate mortgages are riskier to the borrower because the rates on such mortgages go up and down. Lower monthly payments come with added risk, which is another way to compensate borrowers for taking on the added risk. Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 56
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Chapter 5 Understanding Risk Principle #2: Risk (page 102) The riskier an investment, the higher the compensation that investors require for holding it—i.e., the higher the risk premium. Teaching Tips/Student Stumbling Blocks Appendix 5A of the chapter provides a “quick quiz” to help students determine their risk tolerance. Using and discussing the quiz might be a good way to begin this material. If you have not already done so, it will be helpful to find out if the students in your class have already taken a course in statistics or not. This will help you plan how you will cover the material in this chapter on the mean, expected value, variance, and standard deviation.
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