© The McGraw-Hill Companies, 2008 Chapter 13 Risk and information David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

© The McGraw-Hill Companies, 2008 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.

© The McGraw-Hill Companies, 2008 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.

© The McGraw-Hill Companies, 2008 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.

© The McGraw-Hill Companies, 2008 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.

© The McGraw-Hill Companies, 2008 Example of diversification

© The McGraw-Hill Companies, 2008 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.

© The McGraw-Hill Companies, 2008 Behavioural Finance Empirical evidence in support of efficient markets is mixed. Behavioural finance links finance, economics and psychology Bounded rationality leads to people to make decisions using heuristics These decisions are often biased and irrational

© The McGraw-Hill Companies, 2008 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 onto somebody else. A speculator –temporarily holds an asset in the hope of making a capital gain.