Risk and Risk Aversion

Question 1

What is a good measure of risk when returns are normally distributed

Answer 1

standard deviation

Question 2

if you have 5 assets and the return of each is normally distributed, what type of distribution will the portfolio have

Answer 2

normal

Question 3

what do we need to consider when assets are not normally distributed

Answer 3

skewness and kurtosis

Question 4

example of skewed data

Answer 4

household incomes
average bunched to the left and a ling tail to the right

Question 5

what is an example of data with kurtosis

Answer 5

great financial crisis booms and busts eg dot com bubble, housing bubble

Question 6

coming up to a bubble, are returns higher or lower

Answer 6

higher

Question 7

what is the pairwise correlation coefficient

Answer 7

looks at how two things move in relation to each other

Question 8

what are some other measures of risk to use when you cannot assume normal distribution

Answer 8

1. Semi Variance
2. Lower Partial Standard Deviation
3. Value at Risk (VaR)
4. Expected Shortfall

Question 9

What is semi variance

Answer 9

just looks at variances below the mean

assumes that returns higher than the mean are a good thing

Question 10

what is lower partial standard deviation

Answer 10

same as semi variance but only counts deviations below the risk free rate

Question 11

what is value at risk

Answer 11

tells us the loss of the very low percentile of the return distribution (left hand tail)

Question 12

who uses value at risk mostly

Answer 12

banks
corporates

Question 13

how is value at risk usually displayed

Answer 13

• Time period
• Probability of occurrence
• Money amount

eg 5% probability of a loss of €190 or more occurring next week

Question 14

what is the expected shortfall also known as

Answer 14

conditional value at risk

Question 15

what is the expected shortfall

Answer 15

focuses on worst case scenario and tells us about it in more detail

Question 16

3 ways to estimate the VAR

Answer 16

1. historical data
2. assume normal distribution for the future
3. Use simulations eg monte carlo

Question 17

what is on the x axis in the risk return space

Answer 17

risk/standard deviation

Question 18

what is on the y axis in the risk return space

Answer 18

return / expected return

Question 19

where does a risk free asset sit in the risk return space

Answer 19

y axis

the risk is 0 but the return will vary

Question 20

what does it mean to say someone is risk neutral

Answer 20

there are two expected outcomes of the same return but different risks

a risk neutral person wouldn’t want to be compensated for this risk

Question 21

example of a risk neutral situation

Answer 21

€100 now

flip a coin. Heads €200, tails nothing

Expected value of both is €100 but scenario 2 has more risk

risk neutral person would not care between the two

Question 22

what is an indifference curve

Answer 22

someone is equally happy along this curve so long as they are compensated for the risk

Question 23

what curves are best

Answer 23

the higher curves
north west