36 Frequently Asked Questions In Quantitative Finance
How is Risk Defined in Mathematical
Terms?
Short Answer
In layman’s terms, risk is the possibility of harm or loss.
In finance it refers to the possibility of a monetary loss
associated with investments.
Example
The most common measure of risk is simply standard
deviation of portfolio returns. The higher this is, the
more randomness in a portfolio, and this is seen as a
bad thing.
Long Answer
Financial risk comes in many forms:
- Market risk: The possibility of loss due to movements
in the market, either as a whole or specific
investments
- Credit risk: The possibility of loss due to default on a
financial obligation
- Model risk: The possibility of loss due to errors in
mathematical models, often models of derivatives.
Since these models contain parameters, such as
volatility, we can also speak of parameter risk,
volatility risk, etc.
- Operational risk: The possibility of loss due to
people, procedures or systems. This includes human
error and fraud
- Legal risk: The possibility of loss due to legal action
or the meaning of legal contracts
Before looking at the mathematics of risk we should
understand the difference between risk, randomness
and uncertainty, all of which are important.
