séance 8 - uncertainty and the value of information Flashcards
(30 cards)
how to calculate expected payoff/value?
EV = p1 x V1 + p2 x V2 … (probability x outcome)
what is specific about EV for investors?
it is the same for all investors
how can a fair bet be defined?
a fair bet has an EV=0 (a risky situation that yields a net EV of zero)
who wouldn’t want to take a fair bet?
risk averse individuals, because it is a risky situation that yields EV=0 (risk is bad)
TF: risk neutral individuals are willing to take a fair bet?
T&F: risk neutral individuals are indifferent to risk: indifferent between taking a fair bet or not (indifferent among alternatives with the same expected value
who would want to take a fair bet?
risk seeking/loving individuals are willing to take a fair bet (risk is good)
to base decision upon a bet, what do we consider for risk neutral, averse and seeking individuals?
- neutral: EV
- seeking & averse: EU
what is the difference between EV and EU for investors?
EV is the same for all investors, EU is different for every investor because of different risk attitudes
how do you compute expected utility?
EU = p1 x U(V1) + p2 x U(V2) …
what is an individual’s expected utility?
it is its preference over choices that have uncertain outcomes (gambles)
what is the relation between EU and U(EV) for risk averse ppl?
EU < U(EV)
utility of the gamble < utility of having EV for sure (prefers a sure thing over an uncertain prospect of same expected value)
what is the relation between EU and U(EV) for risk seeking ppl?
EU > U(EV)
utility of the gamble > utility of having EV for sure (prefers risky situation to obtaining the expected value for sure)
what is the relation between EU and U(EV) for risk neutral ppl?
EU = U(EV)
do not care about risk, all that matters is the expected payoff
what can we say about marginal utility of $ of risk seeking ppl?
marginal utility of $ must be increasing: dollar number 100 is more important than dollar number 1
what shape is the utility fct of a risk neutral person?
linear
what shape is the utility fct of a risk seeking person?
U shape
what shape is the utility fct of a risk averse person?
n shape
what are the 2 ways of reducing risk?
- insurance
- diversification
what is the definition of diversification?
making future wealth less uncertain by spreading the risk over several different unrelated investments
when is an insurance policy actuarially fair?
an insurance policy actuarially fair if its cost = the expected loss (EVloss = probability of loss x value of thing)
who would be willing to spend less than the expected loss on insurance? (P
risk seeking
who would be willing to spend more than the expected loss on insurance? (P>expected loss)
risk averse
when should an individual pay for insurance?
should buy insurance when it brings more utility than the gamble
how to compute how much a person is willing to pay for insurance?
- compute EU of the gamble
- find value of X for which U(X) = EU
- amount = value - X
