Uncertainty

Question 1

Expected value

Answer 1

The average outcome from an uncertain gamble

Question 2

Fair gamble

Answer 2

Gamble with expected value of 0

Question 3

Risk aversion

Answer 3

The tendency of people to refuse to accept fair gambles

Question 4

Risk neutral

Answer 4

Willing to accept any fair gamble

Question 5

Fair insurance

Answer 5

Insurance for which the premium = expected value of the loss

Question 6

Unfair insurance

Answer 6

No insurance company can afford to sell insurance at actuarily fair premiums
Have to pay benefits etc so rates are higher than fair

Question 7

What will risk averse individuals do with insurance

Answer 7

Risk averse individuals will always buy insurance against risky outcomes unless insurance premium>expected value of loss by too much

Question 8

3 types of factors that may result in high premiums therefore some risks = uninsurable

Answer 8

1) risk = too unique/difficult to evaluate = insurer can’t set premium level
(Fair premiums needs risky situation to be frequent enough to estimate expected value of loss)

2) adverse selection - individuals may know more about likelihood of loss than insurer = insurer pays out more in losses than expected

3) behaviour of individuals after they’re insured may affect possibility for insurance leverage
- -> moral hazard

Question 9

Divrsifying

Answer 9

Decrease risk by spreading risk among several alternatives rather than only choosing one

Question 10

Example of diversifying

Answer 10

Binomial distribution

£1000 to bet on fair coin flips and returns have binomial distribution
Bet £1000 on single flip = 50% chance lose entire income
Bet £500 on 2 flips = 25% chance
Expected value is same 0 therefore better to be risk averse

More diversification = less risk

Question 11

CAPM

Answer 11

Capital asset pricing model

Income optimally diversity therefore assets = priced on risk that can’t be diversed away from market risk

Question 12

Flexibility

Answer 12

Allows to adjust initial decision depending on how future unfolds

Question 13

Option contract

Answer 13

Financial contract offering the tight but not the obligation to buy/sell an asset over a specified period

Question 14

Real option

Answer 14

Option arising in a setting outside of finance

Involves the allocation of tangible resources

Question 15

Attributes of options

Answer 15

1. Specification of the underlying transaction
   - what’s being bought/sold, at what price etc
   - stock option = contract specifies which company’s stocks are involved how many shares are transacted at what price
   - real option = 2-in-1 coat, underlying transaction = conversion parka to windbreaker
2. Definition of the period during which the option may be exercised
   - e.g. Might expire after 2 years
3. Price of an option
   - determined by 1) expected value of underlying transaction 2) variability of the value of the transaction 3) duration - longer the better
   - options can be used to help risk averse people mitigate uncertainty
   - adding more options can never harm an individual decision maker because the extra options can be ignored

Question 16

Information

Answer 16

Full info = perfectly predict future = no uncertainty = no risk

People = willing to pay to gain more info about future
- more uncertain the situation, the more valuable the info

Info = valuable to risk neutral and risk averse people

Financial markets allow people to choose the risk return combination that max their utility
- these markets therefore provide evidence on how risk priced

Question 17

Probability

Answer 17

Relative frequency with which an event occurs