Risk and Uncertainty for Fun and for Profit Risk = “Objective Uncertainty” –You know the probabilities of all the outcomes Uncertainty = “Subjective Uncertainty” –You don’t know the probabilities of the outcomes Ambiguity –You don’t know all the outcomes

Our Objective Understand securitization –Selling shares in risky ventures Understand insurance –Placing losing bets Understand futures markets –Lock in current prices –Offset potential losses

How to Decide Maximize Expected Monetary Value (EMV) –The house does –You’ll win on average –You’ll win in the long – run –… but you may not survive the long – run EMV = p 1 X 1 + p 2 X 2 + … + p n X n

How to Decide Maximize Expected Utility (EU)  same as EMV when risk – neutral –But most folks are risk – averse –Some folks are risk – seeking EU = p 1 U(X 1 )+ p 2 U(X 2 )+ … + p n U(X n ) Must elicit decision – maker’s utility function

Reasons it won’t work …well Framing effects –Zero illusion Subjective uncertainty Ambiguity Certainty effect –Mean/variance tradeoff Overweight small probabilities: go for broke! Portfolio effects –Utility of gamble depends on what else you own Temporal resolution of uncertainty –When you learn outcome matters Uncertainty hurts Decision – maker doesn’t bear all risks Ignore these and proceed!