risk
Post on 14-Nov-2014
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Riskjuliohuato@gmail.com
Goals: To learn about… The effect of uncertainty in our
economic life Ways in which risk can be estimated Our attitudes towards risk The different sources of risk The ways in which manage our
economic risk
Uncertainty Kenneth J Arrow: “Uncertainty is our relative
ignorance about the future effects of our current choices -- the more so, the further removed the effects are from these choices.”
We are ignorant about how the world and our society functions (economics barely makes a dent), ultimately because our productive powers are finite
On top of our regular ignorance vis-à-vis the rest of nature, uncertainty about our own social life is self-referential – it depends on how we deal with our own uncertainty (chicken-and-egg).
Risk In economics and finance, we usually
think of risk as: The economic effect (benefits/costs) of
our uncertainty One usual way in which risk is quantified
in economics and finance is as the variability in payoffs
Probability & Statistics Probability is a mathematical theory
about our cognitive behavior in the face of uncertainty
Statistics is a set of techniques that use probability theory (and other assumptions) to extract knowledge from data (observations)
Possibilities, Probabilities, and Expected Value We can construct a table of all outcomes
and probabilities for an event, like tossing a fair coin.
Lottery AFlip a ‘fair’ coin:
If heads, you receive $1: If tails, you receive $1: The expectation (or expected value or
mean or average) payoff of this lottery is:
In general:
Lottery BFlip the same ‘fair’ coin:
If heads, you receive $0: If tails, you receive $2: The expectation (or expected value or
mean or average) payoff of this lottery is:
Lottery CFlip the coin again:
If heads, you give $1: If tails, you receive $3: The expectation (or expected value or
mean or average) payoff of this lottery is:
The 3 lotteriesLotto x bar Range:
max(x)-min(x)
A $1 $0
B $1 $2
C $1 $4
With which lottery do the effects of your uncertainty feel more painful?
Risk aversionPeople prefer a certain payoff to an uncertain one
In a market system, people trade off risk for reward
Statistics Let be the “payoff,” i.e. the economic costs of
benefits of a choice, e.g. acquiring an asset). We already know how to compute the expectation: Range of payoff: Variance of payoff:
+…+ Standard deviation of payoff: Coefficient of variation of payoff:
Exercise Calculate the variance, standard deviation, and
coefficient of variation of the lotteries above.
Exercise Calculate the variance, standard deviation, and
coefficient of variation of the lotteries above. A)
.
Exercise Calculate the variance, standard deviation, and
coefficient of variation of the lotteries above. A)
. B)
.
Exercise Calculate the variance, standard deviation, and
coefficient of variation of the lotteries above. A)
. B)
. C)
.
Risk in economics & finance Usually, we think of risk as a measure of
uncertainty about the future payoff to a bond over a time period and compared to a benchmark
The benchmark is usually a hypothetical risk-free bond
Again, in a market system with prevailing risk aversion, there is a tradeoff between risk and reward
The use of probability theory requires that we envision all possible scenarios (“states of the world”) and their likelihood
Sources of RiskAll risks can be classified into two groups:1. Those affecting a small number of
people but no one else:idiosyncratic or unique risks
2. Those affecting everyone:systemic, systematic, economy-wide, or
macro risks
Sources of RiskIdiosyncratic risks can be classified into two extreme types:
1. A risk is bad for one sector of the economy but good for another.
2. Unique risks specific to one person or company and unrelated to others.
Dealing with riskRisk can be reduced through: Hedging: building a portfolio with assets
that have offsetting payoffs Diversification: randomly adding more
assets to one’s portfolio, since the additional assets are unlikely to have payoffs that move exactly like those already in the portfolio
Hedging Risk• Hedging is the strategy of reducing
idiosyncratic risk by making two investments with opposing risks.• If one industry is volatile, the payoffs are
stable.• Let’s compare three strategies for
investing $100:• Invest $100 in GE.• Invest $100 in Texaco.• Invest half in each company.
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Spreading Risk You can’t always hedge as investments
don’t always move in a predictable fashion.
The alternative is to spread risk around. Find investments whose payoffs are
unrelated. We need to look at the possibilities,
probabilities and associated payoffs of different investments.
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Spreading Risk The more independent sources of risk
you hold in your portfolio, the lower your overall risk.
As we add more and more independent sources of risk, the standard deviation becomes negligible.
Diversification through the spreading of risk is the basis for the insurance business.
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We learned about… Uncertainty and its economic effect: risk Estimating risk by measuring the variation of payoffs
to our assets Risk aversion and the tradeoff between risk and
reward in a market system Idiosyncratic (unique) risk and systemic (macro) risk How hedging (if there are assets with contrarian
payoffs) and diversification (spreading risk around) lowered idiosyncratic risk
In our next session, we will study how the risk premium on bonds can be estimated (under certain assumptions)
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