Theme 8 - Value of Information

Question 1

What do we use to determine attitude toward risk?

Answer 1

Utility. We compare UE with U(EV)

Question 2

What are the three attitudes toward risk and what characterizes them?

Answer 2

1. Risk averse: U(EV) > EU
   These individuals are unwilling to expose themselves to risk unless the expected payoff is large enough.
2. Risk neutral: U(EV) = EU
   All these investors care about is the expected payoff.
3. Risk lover: U(EV) < EU
   Risk is something they enjoy, to the point of being willing to accept a lower payoff in order to face risk.

Question 3

How do we determine the maximum price an individual is willing to pay (Pmax)? Descripe the Pmax corresponding to different attitudes toward risk.

Answer 3

EU = U[ Value - Pmax ]

Risk averse: Pmax > expected loss

Risk lover: Pmax < expected loss

Risk neutral: Pmax = expected loss

Question 4

Does all information are of equal value?

Answer 4

No. Perfect information is worth more than imperfect information.

Question 5

How do you compute EV and EU?

Answer 5

EV = p1 × V1 + p2 × V2 + …+ pn × Vn

EU = p1 × U(V1) + p2 × U(V2) + … + pn × U(Vn)

Question 6

When do we say a situation is actuarially fair?

Answer 6

When it’s costs are equal to the expected loss.

Question 7

What are the different takeaways on attitude toward risk and insurance?

Answer 7

A risk averse individual is willing to pay a premium greater than the expected loss in order to eliminate the risk completely.

The maximum premium that a risk-seeking individual will be willing to pay will be less than the expected loss.

The maximum premium that a risk-neutral individual will be willing to pay is exactly equal to the expected loss (because only the expected value matters to him or her).

Question 8

How can you reduce exposure to risk?

Answer 8

Diversification

Question 9

Why does the insurance market works?

Answer 9

Because most people are risk averse. Insurance markets work, because insurance companies are risk neutral (they diversify their risk by insuring many people).

Question 10

Does being risk averse mean that you always buy insurance?

Answer 10

No, it just means that you are willing to pay more than the expected loss.

Similarly, being a risk lover does not mean that you never buy insurance, only that you are willing to pay less than the expected loss.

Question 11

How can decision-making can be done?

Answer 11

By using a decision tree.