Chapter 2

Risk: An Introduction

Tzu-hsia said, “Learn widely and be steadfast in your purpose, enquire earnestly and reflect on what is at hand, and there is no need for you to look for benevolence elsewhere.”

Confucius, The Analects

2.1. WHAT IS RISK?

We can define risk in many ways, including as the possibility of uncertain change, particularly a change for the worse. From a financial perspective that means that there is a chance of suffering an economic loss. When investors talk of individual security risk, they may be thinking of the risk of a corporate bond defaulting, or of a stock price declining. When referring to portfolios, risk is usually taken to mean that there is a chance of some return objective not being met. That objective can be an absolute return target, such as an annual return of 10%, or it could mean “not losing money,” that is, maintaining the current dollar value of the portfolio. Alternatively, for a pension fund with defined future liabilities to be met, it could be a relative return requirement—for instance, that the portfolio assets match the portfolio liabilities over time. With an absolute return requirement, the return objective is known, with certainty, in advance. With a relative return requirement, such as meeting or exceeding a benchmark return, the constraint on performance is known in advance with certitude, but the return objective is unknown.

Some risks can be determined quantitatively, as we shall explore in later chapters. For example, ...

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