Risk Finance and Asset Pricing: Value, Measurements, and Markets

CHAPTER 3

Risk Measurement and Volatility

OVERVIEW

Financial practice is embedded in the measurement and the use of data, its interpretation, and its reconciliation with economic theories, trends, and insights that are used for financial decision making. Securities, bonds, and options’ prices as well as financial and economic time series are used in many ways and for many purposes. They may be used to test the validity of financial models, to predict future prices, to reveal financial markets expectations, and so on. The focus of this chapter is on quantitative definitions and measurements of risk using statistical techniques. Our purpose is to familiarize students of financial engineering with these techniques to help them make sense of the extraordinarily abundant and complex financial data that is available from both public and private sources. The chapter’s message is that financial decisions involve information, analysis, and interpretation; and that data contributes to a greater understanding of financial trends and to our ability to forecast the prices of securities and their derivatives and to make educated financial decisions.

RISK, VOLATILITY, AND MEASUREMENT

Finance is about money, expectations, prices, and financial consequences—whether adverse (in which case it is a risk) or not (in which case it is a profitable return). Price may be an insurance premium that an insured pays to an insurer, expressing both the insured’s demand for risk protection and the insurer’s ...