FRM Powerpoints 2011 Unit IA What is Risk

FRM Powerpoints 2011 Unit IA What is Risk - I. Concepts of...

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I. Concepts of Risk Management A. What is Risk?
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Version: January 3, 2011 Unit I.A p. 2 of 33 “In order to understand risk, we must first define risk. George Costanza “The Fatigues” Seinfeld October 31, 1996
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Version: January 3, 2011 Unit I.A p. 3 of 33 Definition o Risk is the potential that an event will have an outcome different from the outcome that is expected to occur. o Example. Suppose you expect that n the stock market will increase 10% in one year n you will make a B in this course o Risk deals with unexpected outcomes
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Version: January 3, 2011 Unit I.A p. 4 of 33 Definition o Good risk vs. bad risk o Skewed outcomes o Sometimes there are no bad outcomes o Our interest is in situations with at least one undesirable outcome o Better definition: Risk is the exposure to an event in which the outcomes are uncertain and at least one of the outcomes is undesirable relative to at least one other outcome.
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Version: January 3, 2011 Unit I.A p. 5 of 33 Elements of a Definition of Risk o Exposure to an Event n Some exposures can be avoided n But avoidance can mean avoidance of opportunity n Degrees of exposure o Uncertain outcomes n No risk if the outcome is known
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Version: January 3, 2011 Unit I.A p. 6 of 33 Probability as a Useful but (Sometimes) Misleading Measure of Risk o Probability: a measure of the relative likelihood of occurrence of the outcome of an event o Relative frequency o Quantifies risk but is not the risk itself o Can be misleading
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Version: January 3, 2011 Unit I.A p. 7 of 33 Probability as a Useful but (Sometimes) Misleading Measure of Risk o Gerd Gerzenzee has studied these phenomena in his book Calculated Risks . One out of 100 forty-year old women has breast cancer. Mammography is used to detect the presence of suspicious tissue. A positive mammogram usually leads to a biopsy. But mammography is imperfect and will detect 90% of breast cancers though it will indicate the presence of cancer 9% of the time in women who do not have cancer. A 40-year old woman gets a positive mammogram. What is the probability she has breast cancer? Gergenzee gave 48 physicians this scenario and asked them this question. The median estimate was 70%. A third estimated more than 90%. What is the correct answer?
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Version: January 3, 2011 Unit I.A p. 8 of 33 Probability as a Useful but (Sometimes) Misleading Measure of Risk 10,000 40-year old women 100 (1%) with BC 9,900 (99%) without BC 90 (90%) have + MM 10 (10%) have - MM 891 (9%) have + MM 9,009 (91%) have - MM Probability = 90/(90 + 891) = 0.092
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Version: January 3, 2011 Unit I.A p. 9 of 33 Probability as a Useful but (Sometimes) Misleading Measure of Risk Another situation: A cholesterol-lowering drug is advertised as giving a 22% reduction in heart attacks for people with high cholesterol. What does this mean? Most people think that of 1,000 people with high cholesterol, 220 will not
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FRM Powerpoints 2011 Unit IA What is Risk - I. Concepts of...

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