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Measuring Risk
• Elements
Distribution/probability
Expected value
Variance & standard deviation
Probability
• Likelihood of an event
• Between 0 and 1
• Probabilities of all possible
outcomes must add to 1
• Probabilities distribution
All outcomes and their
associated probability
Example: coin flip
• Possible outcomes?
2: heads, tails
• Likelihood?
50% or .5 heads; 50% or .5 tails
.5+.5 =1
Expected value
• i.e. mean
• Need probability distribution
• Center of distribution
EV
= sum of (outcome)(prob of outcome)
Or if n outcomes, X1, X2, . . .,Xn
n
EV X i Pr( X i )
i 1
For a financial asset
• Initial investment:
$1000
Investment 1
Payoff (gross) Return Probability
$500 -50% 0.2
$1,000 0% 0.4
$1,500 50% 0.4
• (500 -1100)2(.2) +
(1000-1100)2(.4) +
(1500-1100)2(.4)
= 116,000 dollars2 = variance
• Standard deviation = $341
Investment 2
• (800 -1100)2(.25) +
(1000-1100)2(.35) +
(1375-1100)2(.4)
= 56,250 dollars2 = variance
• Standard deviation = $237
• Lower std. dev
Small range of likely outcomes
Less risk
Alternative measures
• Skewness/kurtosis
• Value at risk (VaR)
Value of the worst case scenario
over a give horizon, at a given
probability
Import in mgmt. of financial
institutions
Risk aversion
• Idiosyncratic risk
aka nonsytematic risk
specific to a firm
can be eliminated through
diversification
examples:
-- Safeway and a strike
-- Microsoft and antitrust cases
• Systematic risk
aka. Market risk
cannot be eliminated through
diversification
due to factors affecting all assets
-- energy prices, interest rates,
inflation, business cycles
Diversification
systematic
risk
# assets