Transcription of CHAPTER 4 HOW DO WE MEASURE RISK?
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CHAPTER 4 HOW DO WE MEASURE RISK?
1 CHAPTER 4 HOW DO WE MEASURE RISK? If you accept the argument that risk matters and that it affects how managers and investors make decisions, it follows logically that measuring risk is a critical first step towards managing it. In this CHAPTER , we look at how risk measures have evolved over time, from a fatalistic acceptance of bad outcomes to probabilistic measures that allow us to begin getting a handle on risk, and the logical extension of these measures into insurance. We then consider how the advent and growth of markets for financial assets has influenced the development of risk measures. Finally, we build on modern portfolio theory to derive unique measures of risk and explain why they might be not in accordance with probabilistic risk measures. Fate and Divine Providence Risk and uncertainty have been part and parcel of human activity since its beginnings, but they have not always been labeled as such. For much of recorded time, events with negative consequences were attributed to divine providence or to the supernatural.
entitled to three quarters of the pot. In the process, they established the foundations of probabilities and their usefulness not just in explaining the past but also in predicting the future. It was in response to this challenge that Pascal developed his triangle of numbers for equal odds games, shown in figure 4.1:3
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