Read the summary and the most important questions on Risk management and financial institutions | 9780138006174 | John Hull.

• 1 Introduction

• 1.1 LECTURE SHEETS SUMMARY LESSON 1&2

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• What is risk? (definition restricted to economics and finance)

  the probability that an actual return (or loss) on an investment/financial decision will be lower (or higher) than the expected return (or loss).

• Can we always quantify financial risks?

  No, because of Knightian uncertainty (from Frank Knight). This is uncertainty that we cannot measure, calculate or estimate. 

• What's the practical use of a risk measure?

  A risk measure is meant to determine the amount of an asset (or set of assets) to be kept in reserve. The aim of a reserve is to guarantee that the presence of capital that can be used as a (partial) cover if the risky event manifests itself, generating a loss.

• Denote the formula for the SD of a combined portfolio consisting of 2 investments.

  sigma(portfolio) = sqrt ( w1^2*sig1^2 + w2^2*sig2^2 + 2*rho1,2*w1*w2*sig1*sig2 )

• What does the efficient frontier represent?

  The EF represents all portfolios that maximize the E[R] and minimize sigma[R], thus dominating all other portfolios. The portfolios on the EF are convex linear combinations of all the portfolios of the economy.

• Give an example of a risk free invesment and explain why we call it 'risk free' and the difference between a risky investment. 

  An example of a risk free investment is a German federal bond (the bund). It's risk free because it guarantees a constant return (the risk free rate). The difference between the bund and a risky investment is that a risky investment has a higher expected return, but there's a chance it will generate a loss. The lower risk free return is 'sure'.

• How do we get from the efficient frontier to the new efficient frontier and what is represented by the touch point?

  We add the Risk-free rate to the graph and then we draw a tangent line from this point to the EF. The point where the two meet represents the market portfolio.

• Which is a straight line: The new efficient frontier or the efficient frontier and why?

  The NEF is a straight line. This is because we draw a tangent line from the risk-free rate to the EF and beyond, because now investors can choose the most rewarding portfolio combination in terms of the SD and return.

• What is the capital asset pricing model and give the formula's with and without alpha.

  It's a model used to determine the theoretically appropriate required rate of return of an asset, if the asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk.

  E[R] = alpha + beta*R(M) + epsilon

  E[R] = (1-beta)*R(F) + beta*E[R(M)]

  where beta*R(M) is known as systematic risk (SR) and epsilon is called the non-systematic/idyosincratic risk (IR).

• Explain the difference between systematic risk and non-systematic/idyosincratic risk.

  IR can be controlled with diversification, but SR depends on the economy as a whole and can therefore not be diversified. E.g. a risk-averse investor will require extra returns to compensate for SR.