Module: | MODULE B: RISK MANAGEMENT
Q257: Consider the following statements regarding volatility and expected earnings in the context of financial risk:
1. Financial risk is solely concerned with the probability of actual earnings falling below the expected earnings, completely ignoring any potential upside.
2. Volatility captures the fluctuation of actual returns around the expected return, representing both potential unexpected gains and unexpected losses.
3. A banking portfolio with absolutely zero volatility in its historical returns is considered to have the highest theoretical risk premium.
Which of the statements given above is/are correct?
2. Volatility captures the fluctuation of actual returns around the expected return, representing both potential unexpected gains and unexpected losses.
3. A banking portfolio with absolutely zero volatility in its historical returns is considered to have the highest theoretical risk premium.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is incorrect: Financial risk is not exclusively about downside risk (losses). Risk represents the total variation or standard deviation from the expected outcome.
It encompasses both the probability of actual earnings falling below expectations (downside risk) and the probability of them exceeding expectations (upside risk). Statement 2 is correct: Volatility is the core statistical metric used to capture this total fluctuation of actual returns around the expected mean, accounting for both potential gains and losses.
Statement 3 is incorrect: A portfolio with zero volatility (like short-term sovereign treasury bills) carries essentially zero market risk.
Consequently, investors demand no risk premium for it.
The risk premium is the extra yield demanded for taking on higher volatility; therefore, zero volatility equals a zero risk premium, not the highest.
It encompasses both the probability of actual earnings falling below expectations (downside risk) and the probability of them exceeding expectations (upside risk). Statement 2 is correct: Volatility is the core statistical metric used to capture this total fluctuation of actual returns around the expected mean, accounting for both potential gains and losses.
Statement 3 is incorrect: A portfolio with zero volatility (like short-term sovereign treasury bills) carries essentially zero market risk.
Consequently, investors demand no risk premium for it.
The risk premium is the extra yield demanded for taking on higher volatility; therefore, zero volatility equals a zero risk premium, not the highest.