Chapter 15 Coping with risk in economic life

1
Chapter 15Coping with risk in economic life

• David Begg, Stanley Fischer and Rudiger
  Dornbusch, Economics,
• 6th Edition, McGraw-Hill, 2000
• Power Point presentation by Peter Smith

2
Individual attitudes towards risk

• A risk neutral person
• is only interested in whether the odds will yield
  a profit on average
• A risk-averse person
• will refuse a fair gamble
• i.e. one which on average will make exactly zero
  monetary profit
• A risk-lover
• will bet even when a strict mathematical
  calculation reveals that the odds are unfavourable

3
Risk and insurance

• Risk-pooling
• works by aggregating independent risks to make
  the aggregate more certain
• Risk-sharing
• works by reducing the stake
• By pooling and sharing risks, insurance allows
  individuals to deal with many risks at affordable
  premiums.

4
Moral hazard and adverse selection

• Moral hazard
• is the exploiting of inside information to take
  advantage of the other party to a contract
• e.g. if you take less care of your property
  because you know it is insured
• Adverse selection
• occurs when individuals use their inside
  information to accept or reject a contract, so
  that those who accept are not an average sample
  of the population
• e.g. smokers taking out life insurance

5
Portfolio selection

• The risk-averse consumer prefers a higher average
  return on a portfolio of assets
• but dislikes risk.
• Diversification
• is a strategy of reducing risk by risk-pooling
  across several assets whose individual returns
  behave differently from one another.
• Beta
• is a measurement of the extent to which a
  particular share's return moves with the return
  on the whole stock market

6
Efficient asset markets

• The theory of efficient markets
• says that the stock market is a sensitive
  processor of information
• quickly responding to new information to adjust
  share prices correctly
• An efficient asset market already incorporates
  existing information properly in asset prices.

7
More on risk

• A spot market
• deals in contracts for immediate delivery and
  payment
• A forward market
• deals in contracts made today for delivery of
  goods at a specified future date at a price
  agreed today
• Hedging
• the use of forward markets to shift risk on to
  somebody else.
• A speculator
• temporarily holds an asset in the hope of making
  a capital gain.