Uncertainty

Risk - situation in which the likelihood of each possible outcome is known or can be estimated and no single possible outcome is certain to occur. A probability is a number between 0 and 1 that indicates the likelihood that a particular outcome will occur. Degree of risk: Probability: likelihood (0-1) that a particular outcome will occur. Frequency: historical pattern of outcomes; estimated probability = n/N. Subjective probability: best estimate. Probability distribution: shows probability of each possible outcome. When outcomes are mutually exclusive & exhaustive, probs must sum to 100%. Expected value: (or profit, or cost) Multiply each possible value by its probability & add = amount youd earn (or pay) on average over many repetitions. e.g. concert promoter No rain: profit = $15 000 Rain: loss = - $5000; chance of rain = 50% EV = [Pr(no rain) x V(no rain)] + [Pr(rain) x V(rain)] = [ x $15000] + [ x -$5000] = $5000

(With perfect weather prediction: EV = [ x 15 000] + [ x 0] = $7500.) Measures of risk: variance & standard deviation (reflect spread of prob distribution) Variance (2): probability-weighted avg of the squares of the diffs between observed outcomes and EV. 2 = [Pr(no rain) x (Value(no rain) EV)2] + [Pr(rain) x (Value(rain) EV)2] = [ x (15 5)2] + [ x (-102] = 100 Standard deviation (): square root of the variance. E.g. above, = 10. Smaller or 2 smaller risk.

Attitudes to risk: extend utility max model (Ch 4) to show how attitudes to risk affect choices. Most people dont just max EV; rational person maxs expected utility (EU): probability-weighted average of the utility from each possible outcome. EU = [Pr(no rain) x U(Value(no rain))] + [Pr(rain) x U(value(rain))] = [ x U($15)] + [ x U(-$5)] Classify people i.t.o. willingness to take a fair bet: bet with EV = 0. e.g. heads or tails on a coin (win or lose R1) EV = [ x (R1)] + [ x (R1)] = 0. (Contrast: unfair bet e.g. pay R1 if tails, win R2 if heads: EV = [ x (R1)] + [ x (R2)] = 50c.) Unwilling to take a fair bet = risk averse; indifferent = risk neutral; willing = risk preferring.

Utility / wealth function for risk averse person.

Initial wealth = $40 (d); U = 120. Do nothing keep that U with certainty. Buy a vase may be valuable Ming, may be fake. If real, wealth = $70; if fake, $10. Prob. its real = 50%. EV = ( x $10) + ( x $70) = $40 (fair bet).

If vase real, U($70) will be 140, point c. If fake, U($10) = 70, point a. EU = [ x U($10)] + [ x U($70)] = [ x 70] + [ x 140] = 105 (at b midpoint of chord between a & c) U from certain wealth (120 at d) > EU from risky activity (105 at b) do not buy vase. Risk premium: amount a risk averse person would pay (or forgo) to avoid taking a risk. (Risk averse person needs a sufficiently higher EV to persuade them to take the risk.)

Risk neutrality: panel (a): person has constant marginal U of wealth. Indifferent between buying vase & not, if theres a 50% chance its real: Actual U with certain wealth = U($40) = 105; EU from buying = 105. Choose option with highest EV; risk premium = 0. Risk preference: panel (b): increasing MU of wealth; willing to take a fair bet. Actual U from certain wealth = 82; EU from buying = 105. Negative risk premium (willing to pay for the right to make a fair bet).

Gambling: Most of us are risk averse, so why make unfair bets? 3 main reasons: Entertainment / pleasure Fun element > financial risk & expected loss (unlike having no insurance) Utility / wealth curves with risk-averse & risk-preferring regions Shape of U curve see Figure p586 / 584 Get subjective probabilities wrong (Dont realize its an unfair bet)

*W 1 W 3: risk averse *W 3 W 5: risk preferring Avoiding risk Abstain from risky activities Obtain info Diversify Insurance

Depends on correlation: Negatively correlated: if A occurs, likelihood of B is lower; Uncorrelated / independent: outcome of A has no relationship to outcome of B; Positively correlated: if A occurs, likelihood of B is higher. Diversification can eliminate risk if 2 events are perfectly negatively correlated: e.g. 2 cos competing for govt contract; buy shares in either firm for R20. If co. wins, share value goes up to R40; if loses, value falls to R10.

If you buy 2 shares in the same firm: EV = [ x R80] + [ x R20] = R50 Variance = [1/2 x (80 50)2] + [1/2 x (20 50)2] = R900 If you buy one share in each, your 2 shares will be worth R50 no matter who wins, & variance = 0. Diversification reduces risk if 2 events are imperfectly negatively correlated, uncorrelated, or imperfectly positively correlated the more negatively correlated, the more diversification reduces risk. (Does not reduce risk if 2 events are perfectly positively correlated.) Unit trusts (mutual funds) Comprise shares in a range of cos with imperfectly correlated performance; reduce random, unsystematic risk (but not systematic risk, i.e. movements in all share prices as economy shifts). Insure Anyone risk averse is willing to pay a risk premium. So pay the insurance co. in good state of nature, & theyll transfer funds to you in bad state of nature.