FE507 – 1017

FE507 – 1017Concept of RiskRisksTypes of RisksKnown risks and their managementRisksManagement of risksPrices seem to fluctuate randomlyVolatilityContinues-time rate of returnDescrete-time rate of returnComparing two kind of returns with exampleMore volatile markets have yielded higher returnsAre rates of return normally distributed?Price = Value ?The idea of probabilityInterpretation of the probabilityIdeas from financeThe unpredictability of tomorrow’s prices

Concept of Risk

Expected events are not risks

Risks

Unexpected event
Ignorance of the expected
Surprise
Impossibility of knowing the future

Types of Risks

- Financial prices
- Physical events
Unmeasureable risks
- Investor psychology and irrationality

Known risks
- Encountered by most or all people
- Extent and implications can be modelled
- Can be part of business plan
- Written in your textbooks
Unknown risks
- Encountered by some people, or well described in historical records
- Extent and implications are unclear
  - climate change
  - natural disasters
  - Geopolitics
  - technological disruptions
  - wars
  - …
Unknowable risks
- Not seen in known history
- comet striking the earth
- Covid 19

Known risks and their management

Risks

Market Risk — Diversification
- Risk due to changing market prices and quantities.
Credit risk — Hedging
- Due to default in debt payments
Liquidity risk — Hedging
- Risk of loss in value when trying to buy or sell
Operational risk — Prudence
- Mismanagement
- fraud
- legal mishaps
- operational errors
Funding risk (new)
- inability to find enough cash to prevent insolvency

Management of risks

Diversification
- to reduce market risk
- Diversification of balance sheets and portfolios
Hedging
- to reduce credit and liquidity risk
- Buying insurance
- Hedging
Prudence
- To reduce operational risk and to prepare for unknown risks
- Integrity

Prices seem to fluctuate randomly

Can we know where the market will be next year?

Volatility

Continues-time rate of return

Better for long term
$R_{t} = \ln (\frac{P_{t}}{P_{t - 1}})$

Descrete-time rate of return

R_{t} = \frac{P_{t}}{P_{t - 1}}

Comparing two kind of returns with example

Time (t)	Value (v)
0	100
1	50
2	100

Descrite-return calculation

\begin{matrix} 0 - 1 : \frac{50 - 100}{100} = - 50 % \\ 1 - 2 : \frac{100 - 50}{50} = 100 % \\ total = \frac{- 50 + 100}{2} = 25 % ???? \end{matrix}

Continues-return calculation

r e t u r n = l n \frac{100}{100} = 0 %

lie with statistics

More volatile markets have yielded higher returns

Required rate of return on risky asset = risk-free rate of return + risk premium

R (9.6%) = 3.3 % + 6.3 %

More risky asset has higher rate of return

Are rates of return normally distributed?

in the real-life scenario, the rates of return is a fat-tailed density distribution.

Price = Value ?

Prices of the US equities in the market is much higher than the US GDP

The idea of probability

Interpretation of the probability

Objective interpretation:

Counting of outcomes based on experiments or empirical data.

Subjective interpretation:

Subjective estimate of the likelihood of future event.

Frequency + belief:

Empirical counting modified with subjective believes ( statistics + analysis )

Ideas from finance

The unpredictability of tomorrow’s prices