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The Changing Concept of Financial Risk

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  • CORNELIS A. LOS

    (Kent State University)

Abstract

The recent rapid accumulation of anomalous empirical research results has made clear that the classical definition of financial risk based on asset classes only is ready for a epistemological change. Currently, the definition of financial risk suffers from three major deficiencies: (1) financial risk is insufficiently measured by the conventional second - order moments; (2) financial risk is assumed to be stable and all distribution moments are assumed to be time-invariant; and (3) pricing observations are assumed to exhibit only serial dependencies, which can be simply removed by simple inverse transformations, like the geometric Brownian motion, Markov, ARIMA, or (G)ARCH models. But (1) higher - order moments are acknowledged by experienced traders to be influential in asset and derivative valuations; (2) distributions of returns are observed to be nonstationary; and (3) difficult to observe long term dependencies have surprised many risk managers. Based on accumulated empirical evidence, a new funtional definition of financial risk that takes account of asset classes, time and time horizons is required to fully capture the concept as required in the empirical financial markets.

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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0409034.

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Date of creation: 13 Sep 2004
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Handle: RePEc:wpa:wuwpfi:0409034

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Keywords: Risk;

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References

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  1. Schwert, G William, 1989. " Why Does Stock Market Volatility Change over Time?," Journal of Finance, American Finance Association, vol. 44(5), pages 1115-53, December.
  2. Fama, Eugene F, 1991. " Efficient Capital Markets: II," Journal of Finance, American Finance Association, vol. 46(5), pages 1575-617, December.
  3. Cornelis A. Los, 2004. "Nonparametric Efficiency Testing of Asian Stock Markets Using Weekly Data," Finance 0409033, EconWPA.
  4. French, Kenneth R. & Roll, Richard, 1986. "Stock return variances : The arrival of information and the reaction of traders," Journal of Financial Economics, Elsevier, vol. 17(1), pages 5-26, September.
  5. Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
  6. James Tobin, 1956. "Liquidity Preference as Behavior Towards Risk," Cowles Foundation Discussion Papers 14, Cowles Foundation for Research in Economics, Yale University.
  7. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. " Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-32, December.
  8. Stulz, René M., 1984. "Optimal Hedging Policies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(02), pages 127-140, June.
  9. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
  10. Fama, Eugene F, 1970. "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, American Finance Association, vol. 25(2), pages 383-417, May.
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Cited by:
  1. Cornelis A. Los, 2005. "The Degree of Stability of Price Diffusion," Finance 0508006, EconWPA.

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