Before entering risk theory fully, we must understand that it is the financial markets, and how they behave in the face of the different economic factors that affect them, including the behavior of the participants in those markets and their interests when “acting “On them.
We will start the essay by giving a definition of the financial market: a financial market is a mechanism that allows economic agents to exchange money for securities or commodities. In general, any commodity market could be considered as a financial market if the buyer’s purpose is not the immediate consumption of the product, but the delay in consumption over time (1) –
Based on this definition we can infer that financial markets are the places where a group of people meet in a certain space of time, in order to be able to satisfy their needs to exchange values (money or raw material), in order to obtain profit. Financial markets are influenced by both their participants and external economic factors.
Within any financial market there is a certain degree of uncertainty when carrying out any kind of transaction, that is why its participants carry out studies of similar past situations, in order to have a notion, not always correct, of the possible outcome “outcome “Of that situation. If there is an occasion where the market does not present any unexpected situation and there is absolute knowledge of the internal and external factors, all participants should obtain the same profit, however, from our point of view, this would be very unlikely , Since the participants are human beings, who have been exposed to different situations throughout their lives, and who also have different points of view of the same situation, so it is very unlikely that everyone will get the same result. In fact, there is a whole branch of financial knowledge called “Behavioral Finance”, where it establishes the importance of the different attitudes manifested by the different economic agents, which ultimately determines the possibility of experiencing losses or gains.
In order to reach a concept of risk we will study two authors, who have influenced the economic and financial world up to the present time:
The first Frank Knight: who defines the risk from the competitive and objective perspective, is why within his manuscripts is evidenced his belief in relation to which the propositions have intrinsic probabilities of being true or false. Knight distinguished the odds in two ways:
– The A prior probabilities derived from homogeneous symmetries such as those that present the six sides of a given
– The statistical probabilities obtained through the analysis of a homogeneous historical data.
Knight tells us that in order to distinguish between the uncertainty that can be quantified and the other uncertainty, where we do not know how to measure it, we must speak of risk in the first case and of uncertainty – in the second case. In other words Knight rather than giving a definition of risk, makes a distinction between what he considers risk and his point of view of uncertainty, where risk is related to objective probabilities and uncertainty is related to subjective probabilities. In addition, the author considers that the different observers of the situations necessarily suffer from ignorance, and that this ignorance may be inherent to the person or based on the facts. To understand this strange distinction, let us think of an inherently ignorant person who does not know the proportion of red and black balls in an urn, and another person who, in fact, knowing the correct proportion, imagine from 3 to 1, still remains ignorant of which ball can come out Of the ballot box.
The other author is John Maynard Keynes: whose main work was directly related to the economy, also looked for a definition of risk which unlike of the one of Knight, was based on that the probabilities do not apply to a proposition but to a pair of propositions , Which are described as follows:
– A proposition is known to be true or false
– The second proposition is derived from the first.
In this way, Keynes’s interpretation of probability is objective, since it determines that the relations of probabilities are rationally established, in other words, if two individuals are presented with the same evidence of a proposition, they must assign the Same probability based on facts. This is true if and only if both act strictly attached to the laws of logic.
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Like Knight, Keynes considered that, in some situations of uncertainty, objective probabilities could not be assigned. Keynes’s interpretation of probability is “as a guide” to Knight’s distinction between risk and uncertainty. For Knight, propositions should be categorized as risks or uncertainties; According to Keynes is more complicated, since the propositions must be categorized in pairs.