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

15.2

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

15.3

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.

15.4

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

15.5

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

15.6

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.

15.7

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.