Chapter 7 Flashcards

1
Q

Describing Risk

To measure risk we must know:

Interpreting Probability

  • –*
  • –*
  • *
A

Describing Risk

To measure risk we must know:

  1. All of the possible outcomes
  2. The probability or likelihood that a given outcome will occur

Interpreting Probability

  • – Objective probability*
  • Observed frequency of past events
  • – Subjective probability*
  • Perception that an outcome will occur
  • Influenced by different information or different abilities to process the
    same information – based on judgment or experience
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2
Q

2 measures to help describe and compare risky choices

      • measures the
    • Example: Investment in offshore drilling exploration: 2 possible outcomes
      • Success – the stock price increases from $30 to $40/share
      • Failure – the stock price falls from $30 to $20/share
      • Objective Probability
        • 100 explorations: 25 successes and 75 failures
        • Probability of success = and probability of failure =
        • EV = formula = + =

Variability

  • Extent to which
  • How much
    • Example: Suppose you are choosing between two part-time sales jobs that have the same expected income ($1,500) (table image)
    • Greater variability from expected values signals
    • Variability comes from
    • Difference between
    • Calculating Deviation in example
    • take
    • and then to calculate
      • σ =
    • σ1= =
A

2 measures to help describe and compare risky choices

  1. Expected value
    • Probability-weighted average of the payoffs or values associated with all
      possible outcomes
      • measures the central tendency; the payoff or value expected on average
    • Example: Investment in offshore drilling exploration: 2 possible outcomes
      • Success – the stock price increases from $30 to $40/share
      • Failure – the stock price falls from $30 to $20/share
      • Objective Probability
        • 100 explorations: 25 successes and 75 failures
        • Probability of success = 0.25 and probability of failure = 0.75
        • EV = Pr(success)(value of success) + Pr(failure)(value of failure)= 0.25($40/share) + 0.75($20/share) = $25/share

Variability

  • Extent to which possible outcomes of an uncertain event differ
  • How much variation exists in the possible choices
    • Example: Suppose you are choosing between two part-time sales jobs that have the same expected income ($1,500) (table image)
    • Greater variability from expected values signals greater risk
    • Variability comes from deviations in payoffs
    • Difference between expected payoff and actual payoff
    • Calculating Deviation in example
    • take expected payoff: 2000 for job 1outcome 1 and substract actual payoff E(x1) 1500 so deviation = 1500
    • and then to calculate σ(standard deviation) you take those deviations for each job , square them and multiply by theres probabilities
      • σ = racine(Pr (X − E(X ))^2 + Pr (X − E(X ))^2)
    • σ1= racine((5. 250,000) +(5. 250,000) =500
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3
Q

Preferences toward risk

  • Utility function:
  • Marginal utility:
  • Expected utility:
  • Expected utility(Image):where, i
A

Preferences toward risk

  • Utility function: Assigns a level of utility to each possible market basket.
  • Marginal utility: the additional satisfaction obtained by consuming an additional amount of a good.
  • Expected utility: Sum of the utilities associated with all possible outcomes, weighted by the probability that each outcome will occur.
  • Expected utility(Image):where, u(Xi) is the utility one obtains with outcome Xi
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4
Q

Different preferences towards risk:

  • Risk-averse:
  • Risk neutral:
  • Risk loving:
A

Different preferences towards risk:

  • Risk-averse:Condition of preferring a certain income to a risky income with the same expected value.
  • Risk neutral: Condition of being indifferent between a certain income and an uncertain income with the same expected value.
  • Risk loving: Condition of preferring a risky income to a certain income with the same expected value.
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5
Q

Risk Premium

Risk Premium:

A

Risk Premium

Risk Premium: The risk premium is the maximum amount of money that a risk-averse person will pay to avoid taking a risk.

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6
Q

For a risk-averse person:

  • The steeper the indifference curve,
  • Each individual has
A

For a risk-averse person:

  • The steeper the indifference curve, the more risk-averse this person is, vice versa.
  • Each individual have infinite number of indifference curves, and each indifference curve represents at a given utility U, the combination between risk of the income and expected income.
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7
Q

Reducing risk

  1. : practice of
    • Negatively correlated variables:
    • Positively correlated variables:
  2. …:
    • The law of large number:
    • Actuarial fairness:
  3. The value of information:
A

Reducing risk

  1. Diversification: practice of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related. One can reduce risk through diversification. (e.g. mutual fund: an organization that pools funds of individual investors to buy a large number of different stocks or other financial assets.)
    • Negatively correlated variables: Variables having a tendency to move in opposite directions.
    • Positively correlated variables: variables having a tendency to move in the same direction.
  2. Insurance: Buying insurance assures a person of having the same income whether or not there is a loss. For a risk-averse consumer, the guarantee of the same income regardless of the outcome generates more utility than would be the case if that person had a high income when there was no loss and a low income when a loss occurred.
    • The law of large number: Although single events may be random and largely unpredictable, the average outcome of many similar events can be predicted. (e.g. tossing a coin 100 times)
    • Actuarial fairness: A situation in which an insurance premium is equal to the expected payout
  3. The value of information: Difference between the expected value of a choice when there is complete information and the expected value when information is incomplete.
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8
Q

The Demand for risky Assets

  1. Asset: something that
    • Risky asset:
    • Riskless (risk-free) asset:
  2. Asset Returns:
    • Real return:
    • Expected return:
    • Actual return:
A

The Demand for risky Assets

  1. Asset: something that provides a flow of money or services to its owner.​
    • Risky asset: Asset that provides an uncertain flow of money or services to its owner
    • Riskless (risk-free) asset: Asset that provides a flow of money or services that is known with certainty
  2. Asset Returns: total monetary flow of an asset as a fraction of its price; asset return can be positive or negative
    • Real return: nominal return less the rate of inflation.
    • Expected return: return that an asset should earn on average;
    • Actual return: return that an asset actually earns.
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9
Q
A
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10
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11
Q
A
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