Behavioral finance FAQ / Glossary (Risk)

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This is a separate page of the R section of the Glossary

 

Dates of related message(s) in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

(Financial) Risk


 

00/9i,10d - 01/4i,9i - 02/10i ,11i
- 03/1i,9i - 04/1i,10i
- 05/1i,6i,8i
- 07/1i - 08/3i + see uncertainty,
volatility, semi-volatility, stochastic,
random, probability, distribution

Risk as arithmetic

Definition (general):

A risk is a random event

That could bring a damage

And which occurrence can be quantified in

* Its frequency

* The size of the loss it could bring.


In other words, a risk can be measured, or at least
estimated,thanks to a probability law or statistical
pattern
, at the difference of a pure uncertainty
(see that word).

Definition (financial):

When money is involved (financial risk), risk is a
quantified loss possibility that
can affect an asset value or a financial operation
.

The old china from aunt Martha might break !

The menace addressses usually a downside price possibility but also, in
some operations - short selling - for example, an upside price possibility.

A coffee break before going on:
     contemporaneous attempts to tame risk

To buy and to sell risk.

Modern finance has packaged risk into mathematical objects,
based on purportedly measurable and objective probabilities.

One purpose is to change it from a nuisance to a
tradable commodity / asset..

A good intention, don't you think: transferring the risk to
somebody happy to take it... for a price. But are good
intentions always so good (see below)?


Beware, the tradable package can have some leaks,
    and get sometimes punctured.

Also, a risk-based financial instrument might not be
transparent
about what is stacked inside.
Opaque financial jars! True science or esoteric rites playing
on gullibility?

The nuisance might reappear in an unexpected way. The
idea
that financial risk can be fully mastered, nearly
eliminated, by sophisticated methods has been proved
illusory
.

That was was seen in the 2007 - .... financial crisis, because of
a misuse, even a delinquent use, of financial techniques such as
debt securitization and credit derivatives, encouraged by a lax
monetary policy (near-free money).


To play on the paradox, those flaws in the system

(and in some theoretical rationalizations) clarify things:

They show that risk can survive in its rawest form:
uncertainty.

Yes, social, economic and financial life (and life in
general) will keep being an adventure, as risk (and
uncertainty, its cousin) will survive whatever is
tried to
:

Imprison risk in bottles of highly mathematically

packaged products  of financial engineering.

They might fly well, but also explode in flight.

Or avoid it by using an illusory and regressive (but
    politically correct) "precautionary principle", or a

range of bureaucratic rules that replace anticipation,
intelligence, independence and courage by those in
charge of monitoring.

Risk and finance

Risk is the game.

Risk, as the possibility of a monetary loss, applies, among other economic
fields,to financial assets and operations.


All assets are risky, in the sense that their price and
return tend to
vary more or less dangerously.

Thus the two mainfinancial valuation parameters are
summed up in the risk / return duet.

A financial risk can be understood either as:

The probability (x %) of a negative outcome (see probability,
   
random, distribution).

There can be some illusion here.  Contrarily to the platitude,
finance is not a "casino" (a strictly organized place in which
probabilities  are known with certainty).

In finance, probabilities, even when presented as scientific, are
just tentatively deduced
, usually from past statistics,
whatever those data are worth as regards the future.


Or the "mathematically expected" loss

(the monetary sum of the amounts of possible future losses
each one being multiplied by its probability
)

to be compared of course to the expected gains, using the same
calculation formula.


Or the maximum possible loss (for ex. a 100% fall in asset prices,

Or the maximum acceptable loss to avoid "total ruin"

Asset markets, and assumptions
     about financial risk in those markets

Chance encounters!

The market risk is supposed to be known
...until you meet it in person.

To buy or sell an asset is to buy or to sell
an expectation of risk and return.

Normally, when you buy capital properties, their present state is only an
aspect.

What you buy actually are:

The future revenues you expect from those assets, including their future
    resale value,

And the risks of loss they entail.

Assets prices are supposed to mirror the average expectations by all
players.

Also, asset price variations are supposed to measure how those average
expectations evolve.

That risk / reward ratio is supposed to help in building models of asset
pricing, trading or portfolio diversification.

For this purpose, two assumptions are used
about financial markets:

A supposed correlation between an asset's risk  
    and its return
(higher risk = higher return, see risk premium).

The idea that risk is well-known statistically  (using volatility as
    a proxy for 
risk, as shown below).

This is at least partly an illusion that relies too much on standard
distribution laws, while real market data distributions show many
distortions.

It neglects also the fact that uncertainty (non quantified risk) exists
in all human and social activities as well as in the future value of
assets.

Asset risk parameters

Volatility as a practical, but reductive, heuristic

The asset risk parameters differ according to what the financial models is used
for.

But most of them use stochastic (see that word) financial calculations. Their
main (and not always right) assumption is that risk is a purely random
phenomenon, obeying clear random laws.

Here are the most usual financial market risk parameters:

A common (but far from reliable) risk quantification criterion 

for asset prices is past volatility.

The use of historical volatility as a proxy for risk is an heuristic
(= simplification).
Thus, it might be illusory and verge on a numeracy bias
(see that word).

It is not fully rational to to extrapolate future risk from data
on
previous risk, whatever those data are: historical
randomness,
past mean-variance, beta...

Also the tenet under which the risk / volatility follows a standard
random law underestimates the risk. It neglects distributions
anomalies

(fat tails, clusters, asymmetries...) and extreme scenarios, that
only the human mind can imagine as they do not appear in past
statistics.


Another approach is to take the absolute maximum price variation
    seen in the
past (extreme risk).

This is closer to the full real risk, but the numeracy bias can
strike here also (see law of "small numbers", "fat tails",
"extreme (risk)").


An intermediate solutions is to use a "VaR / Value at risk" model.


Another one is to focus on downside volatility
   (Sortino ratio)


Last but not least, the CAPM (see that acronym) offered its magical
    toolbox with the systematic / specific risk parameters (see
    article below).

But is risk only a matter of parameters?


Of course, the base rate probabilities (see that pharase) should always
kept in mind when past data exist and are reliable. But be conscious that a
cozy measurable "risk" drawn from past figures might give a false
certainty
.


The danger might strike when the current situation  does not fit past
cases
, something which happens often in evolutionary systems (see
dynamical systems) where uncertainty dominates.
Also do not exclude extreme risks never seen or rarely seen  before
which therefore do not really appear
in limited satistics but which
consequences could be dramatic.

What is at play is real uncertainty, given the

     whole range of scenarios of good
     and bad
events that can be built.

Be the scenarist!

Past statistics are crucial, but project you mind into the future.

This is where risk resides, sorry for the platitude!

(Related topics)

(Small) Risk

See rare events

(Specific / systematic) Risk

See risk, beta, CAPM

According to the CAPM (see that acronym),

The systematic risk is the risk, measured by the beta

coefficient (see that word), that is correlated to the whole
market (market index) risk.

It can be reduced by acquiring a portfolio that represents closely
enough the whole market efficient diversification).

    The specific risk is the portion of risk of the individual
       asset that is
not correlated
to the market portfolio.

Risk attitude, aversion, preference, profile...

See specific page

Risk perception, perceived risk

See specific page

Risk premium, risk premia puzzle

See specific page

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This page last update: 14/07/15   

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