Chapter 17 - Uncertainty Flashcards
Someone who is risk neutral has a …
constant marginal utility of wealth: Each extra dollar of wealth raises utility by the same amount as the previous dollar.
In general, a risk neutral person chooses the option with the…
highest expected value, because maximizing expected value maximizes utility.
An individual with an increasing marginal utility of wealth is …
risk preferring: willing to take a fair bet
Fair Bet
A wager with an expected value of zero
Risk Averse
unwilling to make a fair bet
Risk Neutral
Indifferent about making a fair bet
Risk Preferring
Willing to make a fair bet
Risk Premium
The amount that a risk averse person would pay to avoid taking a risk
A person whose utility function is concave picks…
the less risky choice if both choices have the same expected value
How can we classify people’s risk preference?
Their willingness to make a fair bet
Holding the expected value constant, the smaller the standard (or variance)
the smaller the risk
Instead of describing risk using variance…
they report it based on standard deviation which is the square root of the variance
A probability is
a number between 0 and 1 that indicates the likelihood that a particular outcome will occur
Investing Under Uncertainty
Whether people make an investment depends on the riskiness of the payoff, the expected return, attitudes toward risk, the interest rate, and whether it is profitable to alter the likelihood of a good outcome
Behavior Economics of Risk
Because some people do not choose among risky options the way that traditional economic theory predicts, some researchers have switched to new models that incorporate psychological factors
Avoiding Risk
People try to reduce their overall risk by not making risky choice, taking actions to lower the likelihood of a disaster, combining offsetting risks, insuring, and in other ways.
Degree of Risk
Probabilities are used to measure the degree of risk and the likely profit from a risky undertaking
Decision Making Under Uncertainty
Whether people choose a risky option over a non-risky one depends on their attitudes toward risk and on the expected payoffs of each option
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
The simplest way to avoid risk is to …
abstain from optional risky activities
Diversification can eliminate risk if…
two events are perfectly correlated
The extent to which diversification reduces risk depends on…
the degree to which various events are correlated over states of nature
The degree of correlation ranges from …
negatively correlated to uncorrelated to positively correlated
If you know that the first event occurs,
you know that the probability that the second event occurs is lower if the events are negatively correlated and higher if the events are positively correlated
The outcomes are independent or uncorrelated if…
knowing whether the first event occurs tells you nothing about the probability of the second event occurring
Diversification reduces risk even if the two events are …
imperfectly negatively correlated, uncorrelated, or imperfectly positively correlated.
The more negatively correlated two events are..
the more diversification reduces risk
