Risk

Question 1

What is risk?

Answer 1

= The probability of something happening which results in a loss or some degree of damage

Question 2

What is risk aversion?

Answer 2

= The dislike of bad things more than the like of good things

• Models of risk aversion are developed using the concept of utility (subjective measure of a persons well-being/satisfaction)
• Explains insurance, diversification, risk/return trade off etc.

Question 3

Key aspects of utility

Answer 3

• Utility is subject to the law of diminishing marginal utility
  meaning the utility curve gets flatter as wealth increases
• Due to this the utility lost is more than the utility gained indicating that people are risk averse

Question 4

What is insurance?

Answer 4

= Someone facing risk pays an insurance company to accept all or part of that risk

• Each insurance contract is a gamble as most people don’t actually make claims on their policies
• Does not eliminate risk just spreads it around more efficiently

Question 5

Problems insurance companies face:

Answer 5

1. Adverse selection
   - A high-risk person is more likely to take out insurance than a low-risk one
2. Moral hazard
   - After people purchase insurance they have less incentive to be careful

Question 6

What is diversification of idiosyncratic risk?

Answer 6

= The reduction of risk by replacing a single big risk with a larger number of small ones

• Used for share portfolios. The more shares, the lower the risk
• Measured using standard deviation
• Impossible to eliminate completely

Question 7

What is the trade-off between risk and return?

Answer 7

= When allocating their saving people need to decide how much risk they are willing to undertake to earn a higher return

Question 8

What is asset valuation?

Answer 8

= What determines the price of a share or stock

- Fundamentally S+D but need to consider underlying WTP

Question 9

What is fundamental analysis?

Answer 9

=The detailed analysis of a company to determine if it is undervalued, overvalued or fairly valued
- Helps people decide what shares to buy to get the most value for money

Question 10

What is the efficient market hypothesis?

Answer 10

= The theory that asset prices reflect all publically available information about the value of that asset

• As supply and demand set the market price it should reflect the number of people who want to buy it
• At any moment in time market price is the best guess about a company’s value based on available info and it should be impossible to predict what the future is

Question 11

What are bubbles of speculation?

Answer 11

• Rising prices due to speculation about what others will think the asset is worth in future
• Price becomes detached from the fundamentals and starts to become contingent on what people assume it will be in future which is impossible to accurately predict leading to irrational waves of optimism and pessimism
• Price rise will come to an end suddenly and fall abruptly

Question 12

How reliable is EMH?

Answer 12

• It is based on the assumption that those who act rationally > those who do not
• Can be a time lag between changes in market price to reflect an assets value
• Proves markets cannot be beaten and any attempts to do so will fail

Question 13

What is Minsky’s financial instability hypothesis?

Answer 13

= That markets will always move to an equilibrium position and stay there

• External factors only affect the commodities or goods markets
• Financial markets are driven by internal forces based upon supply and demand

Question 14

Implications of market irrationality?

Answer 14

• Keynes believed market prices were driven by the ‘aminal spirits’ of investors which cause irrational waves of optimism and pessimism
• Impossible to know correct valuation of a company and if market was irrational a rational person could extort this