Revision Part 1: Money and
Banking
• Money: anything that is accepted generally
in payment for goods and services
• Functions: unit of account, medium of
exchange and store of value
• Finance: all activities related to money
• Financial system: all financial transactions
between the participants in the economy
• Two ways to channel fund in financial
system: indirect and direct
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Indirect and direct finance
• Indirect finance related to the way to channel
fund through financial intermediaries
• Direct finance related to the way to channel
through financial market
• Indirect finance is much more important than
direct finance:
• + Transaction costs
• + The risk reduction: asymmetric information
problems; free rider; principal-agent…
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Direct finance: financial markets
• Financial markets: the place to buy/sell the
financial instruments
• Structure of financial markets:
• + Based on term: money markets vs capital
markets
• + Based on the characteristics of
instruments: debt markets vs equity
markets
• + Based on the way of transaction: primary
vs secondary markets
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Direct finance: financial markets
• Financial instruments traded in financial
markets:
• + Money markets: T-bills, CDs, NCDs, CPs,
BAs, Repos…
• + Capital markets: Stocks, bonds,
mortgages…
• Explain why stocks and bonds issuance is
not the primary way to raise fund
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Indirect finance
• Expertise; economy of scale -> lowering of
transaction costs and risks; the increasing
of efficiency
• Financial institutions:
• + Banking systems: commercial banks;
mutual saving banks; credit unions; Saving
and Loans associations..
• + Nonbank institutions: Insurance
companies; finance companies; securities
companies; mutual funds…
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Commercial banks
• Functions: doing payments transactions;
supplying the financial services; money
creation
• Bank balance sheet
• + Asset items: uses of the funds
• + Liabilities items: sources of the funds
• Activities: borrow and lend
• Objectives: making profits
• Bank management: liquidity risk; credit risk;
interest rate risk..
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Central banks
• Objectives: macroeconomics development;
monetary policies (price stability; high employment
targets..)
• Operation targets -> Intermediate targets -> Final
targets
• Functions: issue banknotes; in charge of monetary
policies; lender of last resorts…
• Understand the central bank balance sheet
• The way central banks change the reserves of
commercial banks
• Examples on the central banks model: FED; ECB;
BOE; BOJ
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Lecture 6
Risk, Uncertainty, Probability, and Luck
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Content
6.1. An overview of risk
6.1.1. The definition of risk
6.1.2. Risk Measures
6.2. Randomness, Probability and Luck
6.2.1. Randomness
6.2.2. Probability
6.2.3. Luck
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6.1. An overview of risk
6.1.1. Definition
Risk is a term in accounting and finance
used to describe the uncertainty that a
future event with a favorable outcome will
occur.
In other words, risk is the probability that
an investment will not perform as expected
and the investor will lose the money
invested in the project.
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6.1. An overview of risk
6.1.1. Definition
Risk is the possibility of Profit and Loss (P&L)
being different from what is expected or
anticipated; risk is uncertainty or
randomness measured by the distribution of
future Profit and Loss.
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6.1. An overview of risk
Risk combines both the uncertainty of
outcomes and the utility or benefit of
outcomes.
For financial firms, the “future outcomes”
are profits – future outcomes are
summarized by P&L, and the uncertainty
in profits is described by the distribution
or density function.
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6.1. An overview of risk
Quantitative risk measurement focuses first
and foremost on the P&L distribution.
Consider a very simple business – flip a coin
and win $10 if heads, lose $10 if tails. The
P&L distribution will look like that in Figure
1: 1/2 probability of losing $10 and 1/2
probability of winning $10.
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Figure 2.1: P&L from Coin Toss Bet
and Hypothetical Yield Curve Strategy
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Panel A: With Unique Risk Ranking
(the same mean)
Distribution F has lower dispersion and
density function that is “inside” G.
Distribution G will be considered worse
and thus more risky by all risk-averse
investors.
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Panel B: Without Unique Risk Ranking
(with different mean)
H with less dispersion but lower mean
and K with more dispersion but higher
mean.
Some investors may prefer H while others
prefer K, but there is no unique ranking of
which is “riskier”.
To rank distributions and properly define
risk, preferences must be introduced.
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“Risk” vs “Uncertainty”
or “Ambiguity”
The distinction between “risk” and
“uncertainty” is usually attributed to Knight
(1921). It is often argued that “ uncertainty”
or “ambiguity” is inherently distinction from
“risk” in the sense that people behave
differently in the face of “ambiguity” than
they do when confronted with computable or
known probabilities (risk). It is argued that
there is “ambiguity aversion” separate from
“risk aversion”.
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“Risk” vs “Uncertainty”
or “Ambiguity”
The following are a few differences between
risk and uncertainty:
In risk you can predict the possibility of a
future outcome, while in uncertainty you
cannot.
Risks can be managed while uncertainty is
uncontrollable.
Risks can be measured and quantified
while uncertainty cannot.
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“Risk” vs “Uncertainty”
or “Ambiguity”
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6.1. An overview of risk
6.1.2. Risk measures
The summary measures that tell us things
about the distribution of future P&L can be
called “ Risk Measures”: numbers that
summarize important characteristics of the
distribution (risk).
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6.1. An overview of risk
6.1.2. Risk measures
The most important characteristic to
summarize is the dispersion or spread of the
distribution.
The standard deviation is the best-known
summary measure for the spread of the
distribution.
For any distribution, the first two features
that are of interest are location, on the one
hand, and scale on the other.
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Standard Deviation
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6.2. Randomness, Probability and
Luck
6.2.1. Randomness
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6.2.1. Randomness
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• Randomness is the lack of pattern or
predictability in events. ... In this
view, randomness is a measure of
uncertainty of an outcome, rather than
haphazardness, and applies to concepts of
chance, probability, and information
entropy.
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Randomness and Probability of
flipping coin
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Random Variables in Finance
• In finance, random variables are widely used
in financial modeling, scenario analysis, and
risk management.
• In financial models, the probabilities of the
variables represent the probabilities of
random phenomena that affect the price of
a security or determine the risk level of an
investment.
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Random Variables in Finance
• For instance, a variable may be applied to
indicate the price of an asset at some point
in the future or signal the occurrence of an
adverse event.
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6.2. Randomness, Probability and
Luck
6.2.2. Probability
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Probability is not intuitive
• What is the probability that if you enter a
room with 20 people, 2 of those 20 will
share the same birthday?
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Probability is not intuitive
If there are 20 people, the probability is over
44 percent.
If there are 56 people, the probability is over
90 percent.
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Probability Paradoxes and
Puzzles: A Long Digression
Random walks
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Probability Paradoxes and
Puzzles: A Long Digression
Random walks
A random walk is clearly related to the
binomial process with probability is 1/2
The random walk hypothesis is
a financial theory stating that stock market
prices evolve according to a random walk (so
price changes are random) and thus cannot
be predicted.
Ex: The price of a stock market index, like the
S&P 500 index.
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Probability Paradoxes and
Puzzles: A Long Digression
Random walks
The changes in stock prices have the same
distribution and are independent of each
other. Therefore, it assumes the past
movement or trend of a stock price or market
cannot be used to predict its future
movement. In short, random walk theory
proclaims that stocks take a random and
unpredictable path that makes all methods of
predicting stock prices futile in the long run.
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Probability Paradoxes and
Puzzles: A Long Digression
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The Monty Hall Problem
Suppose you're on a game show, and you're
given the choice of three doors: Behind one
door is a car; behind the others, goats. You
pick a door, say No. 1, and the host, who
knows what's behind the doors, opens another
door, say No. 3, which has a goat. He then
says to you, "Do you want to pick door No. 2?"
Is it to your advantage to switch your choice?
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• Try playing the game 50 times, using a “pick
and hold” strategy. Just pick door 1 (or 2, or
3) and keep clicking. Click click click. Look at
your percent win rate. You’ll see it settle
around 1/3.
• Now reset and play it 20 times, using a “pick
and switch” approach. Pick a door, Monty
reveals a goat, and you switch to the other.
Look at your win rate. Is it above 50% Is it
closer to 60%? To 66%?
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6.2. Randomness, Probability and
Luck
6.2.3. Luck
• Luck is the irreducible chanciness of life that
remains even after learning all one can
about possible future outcomes,
understanding how current conditions and
exposures are likely to alter future
outcomes, and adjusting current conditions
and behavior to optimally control costs and
benefits.
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6.2. Randomness, Probability and
Luck
6.2.3. Luck
• Luck cannot be “controlled”, but it can be
managed.
• Winning a lottery, being hit by a stray bullet,
or surviving a plane crash, all are instances
of a mundane phenomenon: luck.
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