In this chapter, we begin studying how to quantify market risk, the risk of loss from changes in market prices, via statistical models of the behavior of market prices. We introduce a set of tools and concepts to help readers better understand how returns, risk, and volatility are defined, and we review some basic concepts of portfolio allocation theory.
The statistical behavior of asset returns varies widely, across securities and over time:
We discuss the relationship between asset prices and risk factors further in Chapter 4. For now, we will be a bit loose and use the terms “asset prices” and “risk factors” synonymously.