Chapter 21

Question 1

random variable

Answer 1

A variable with an uncertain future value

Question 2

expected value

Answer 2

The weighted average of all possible values, where the weights on each possible value correspond to the probbility of that value occurring

Question 3

State of the world

Answer 3

A possible future event

Question 4

Risk

Answer 4

Uncertainty about future outcomes

When the uncertainity is about monetary outcomes, it becomes financial risk

Question 5

financial risk

Answer 5

When uncertainty about monetary outcomes exists

Question 6

expected utility

Answer 6

The expected value of an individual’s total utility given uncertainty about future outcomes

Question 7

premium

Answer 7

A payment to an insurance company in return for the insurance company’s promise to pay a claim in certain states of the world

Question 8

Fair insurance policy

Answer 8

An insurance policy for which the premium is equal to the expected value of the claim

Question 9

Risk-averse

Answer 9

Individuals will choose to reduce the risk they face when that reduction leaves the expected value of their income or wealth unchanged

Question 10

Risk-neutral

Answer 10

A person who is completely insensitive to risk

Question 11

capital at risk

Answer 11

The funds that n insurer places at risk when providing insurance is called the insurer’s capital at risk

Question 12

efficient allocation of risk

Answer 12

An allocation of risk inwhich those who are most willing to bear risk are those who end up bearing it

Question 13

independent events

Answer 13

Two possibl events are independent if each of them is neither more nor less likely to happen if the other one happens

Question 14

diversification

Answer 14

Investing in several different things, so that the possible losses are independent events

Question 15

Share

Answer 15

A company is a partial ownership of that company

Question 16

Pooling

Answer 16

A strong form of diversification in which an investor takes a small share of the risk in many independent events. This produces a payoff with very little total overall risk

Question 17

positively correlated

Answer 17

When each event is more likely to occur if the other event also occurs

Question 18

private information (asymmetric information)

Answer 18

Information that some people have that others do not

Question 19

adverse selection

Answer 19

When an individual knows more about the way things are than other people do.

Private information leads buyers to expect hidden problems in items offered for sale, leading to low prices and the best items kept off the market

Question 20

Screening

Answer 20

Using observable information about people to make inferences about their private information

reduces adverse selection

Question 21

signaling

Answer 21

Revealing private information through actions that credibly reveal what they know

reduces adverse selection

ex. used car companies offering large waranties

Question 22

Reputaiton

Answer 22

Allows an individual to reassure others that he or she isn’t concealing adverse private information

Question 23

Moral hazard

Answer 23

Occurs when an individual knows more about his or her own actions than other people do.

Leads to a distortion of incentives to take care or to exert effort when someone else bears the costs of the lack of care or effort

Question 24

Deductible

Answer 24

An insurance policy is a sum that the insured individual must pay before being compensated for a claim