8/29/2016

What is Risk?
Risk exists whenever the consequences of a
decision are uncertain
A state of nature is one possible way in which
events relevant to a risky decision can unfold
To analyze a risky decision, begin by
describing every state of nature
Once someone makes a choice, she
experiences only one state of nature

Choices Involving Risk

Cant experience more than one state because each

state is described in a way that rules out the others
McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Describing Risk
Interpreting Probability
1. Objective Interpretation
Based on the observed frequency of past
events

2. Subjective Interpretation
Based on perception that an outcome will occur

11-2

Uncertain Payoffs
Risky choices often have financial consequences,
payoffs
Payoffs can be positive (gains) or negative (losses)
The probability distribution of a set of payoffs gives
the likelihood that each possible payoff will occur
To determine the average gain or loss from a risky
choice, can calculate its expected payoff
Expected payoff of a risky financial choice is a
weighted average of all the possible payoffs, using the
probability of each payoff as its weight

Chapter 5

11-4

8/29/2016

Expected Value An Example

Investment in offshore drilling
exploration:
Two outcomes are possible

Expected Value An Example

Objective Probability

Success the stock price increases from

$30 to $40/share
Failure the stock price falls from $30 to
$20/share

100 explorations, 25 successes and 75

failures
Probability (Pr) of success = 1/4 and the
probability of failure = 3/4

Chapter 5

Chapter 5

Expected Value An Example

EV Pr(success )(value of success)
Pr(failure )(value of failure)
EV 1 4 ($40/share ) 3 4 ($20/share )

Expected Value
In general, for n possible outcomes:
Possible outcomes having payoffs X1, X2,
, Xn
Probability of each outcome is given by Pr1,
Pr2, , Prn

E(X) Pr1X1 Pr2 X 2 ... Prn X n

EV $25/share
7

Chapter 5

Chapter 5

8/29/2016

Variability

Variability An Example

Gauge financial risk by measuring the

variability of gains and losses

Suppose you are choosing between two

part-time sales jobs that have the same
expected income ($1,500)
The first job is based entirely on
commission
The second is a salaried position

Generally, variability is low when range of likely

payoffs is narrow and high when range of likely
payoffs is wide

Often, economists measure the variability of a

risky financial payoff by calculating variance or
standard deviation

10

11-9

Variability An Example
There are two equally likely outcomes in
the first job: $2,000 for a good sales job
and $1,000 for a modestly successful
one
The second pays $1,510 most of the time
(.99 probability), but you will earn $510 if
the company goes out of business (.01
probability)
11

Chapter 5

Chapter 5

Variability An Example
Outcome 1

Outcome 2

Prob.

Income

Prob.

Income

Job 1:
Commission

.5

2000

.5

1000

Job 2:
Fixed Salary

.99

1510

.01

510

Chapter 5

12

8/29/2016

Variability An Example
Income from Possible Sales Job
Job 1 Expected Income

E(X1 ) .5($2000) .5($1000) $1500

Variability
While the expected values are the same,
the variability is not
Greater variability from expected values
signals greater risk

Job 2 Expected Income

E(X2 ) .99($1510) .01($510) $1500

13

14

Chapter 5

Chapter 5

Variability An Example
Deviations from Expected Income ($)
Outcome Deviation Outcome Deviation
1
2

Job
1

$2000

$500

$1000

-$500

Job
2

1510

10

510

-900

Chapter 5

Variability
Average deviations are always zero so
we must adjust for negative numbers
We can measure variability with
standard deviation
The square root of the average of the
squares of the deviations of the payoffs
associated with each outcome from their
expected value

15

16

Chapter 5

8/29/2016

Variability

Standard Deviation Example 1

The standard deviation is written:

Deviations from Expected Income ($)

Outcome Deviation Outcome Deviation
1
2

Pr1X1 E( X ) Pr2 X2 E( X )
2

Job
1

$2000

$500

$1000

-$500

Job
2

1510

10

510

-900

17

Chapter 5

18

Chapter 5

Standard Deviation Example 1

Standard Deviation Example 1

Standard deviations of the two jobs

are:
2
2

Job 1 has a larger standard deviation

and therefore it is the riskier alternative
The standard deviation also can be used
when there are many outcomes instead
of only two

Pr1 X 1 E ( X ) Pr2 X 2 E ( X )
1 0.5($250,000) 0.5($250,000)
1 250,000 500
2 0 .99 ($ 100 ) 0 .01($ 980 ,100 )
2 9,900 99 .50
19

Chapter 5

20

Chapter 5

8/29/2016

Decision Making
Consider these two jobs:
Job 1: expected income $1,600 and a
standard deviation of $500
Job 2: expected income of $1,500 and a
standard deviation of $99.50

21

Chapter 5

Decision Making
Which job should be chosen?
Depends on the individual
Some may be willing to take risk with higher
expected income
Some will prefer less risk even with lower
expected income

Consider another situation

Deviations from Expected Income ($)
Outcome Deviation Outcome Deviation
1
2

Job
1

$2100

$500

$1100

-$500

Job
2

1510

10

510

-900

Chapter 5

22

Risk Aversion
A person is risk averse if, in comparing a
riskless bundle to a risky bundle with the
same level of expected consumption, he
prefers the riskless bundle
Risk averse individuals do not avoid risk at
all costs
Usually willing to accept some risk provided
they receive adequate compensation in the
form of higher expected consumption

23

Chapter 5

11-24

8/29/2016

Certainty Equivalence

Risk Premium

The certainty equivalent of a risky bundle is

the amount of consumption which, if provided
with certainty, would make the consumer
equally well off
For a risk-averse person, the certainty
equivalent of a risky bundle is always less than
expected consumption

The risk premium of a risky bundle is the

difference between its expected
consumption and the consumers
certainty equivalent
It is the amount by which the consumer is
willing to reduce expected consumption to
eliminate all risk

Providing the same expected consumption with no

risk would make the individual better off

11-25

Expected Utility Functions

Expected Utility and Risk Aversion

Can determine the consumers attitude toward
risk from the shaper of her benefit function,
u(F) (also known as the vNM utility function):

An expected utility function:

Assigns a benefit level to each possible state of
nature based only on what is consumed
Then takes the expected value of those benefits
It is a weighted average of all possible benefit
levels using the probability of each level as its
weight

If u(F) is concave (flattens as F increases), shes

risk averse
If its convex (gets steeper as F increases), shes
risk loving
If its linear, shes risk neutral

The greater the concavity, the greater the risk

aversion
11-27

11-28

8/29/2016

Attitudes towards risk

Consider a lottery:
L = {(p, W1), (1-p, W2)}
Expected value = pW1 + (1 p)W2
The consumer compares
u{pW1 + (1 p)W2}
with
pu{W1) + (1 p)u(W2)

Risk-averse preferences

Risk Aversion
Mathematically, for two possible states of
nature, risk aversion may be stated as
U(1W1 + 2W2) > 1U(W1) + 2U(W2)
Where W1 and W2 are levels of wealth resulting
from possible outcomes 1 and 2, respectively
Weights are probability of wealth levels W1 and
W2 occurring
1 + 2 = 1
Implies diminishing marginal utility of wealth
2U/W2 < 0
As wealth increases, marginal utility of wealth
declines

Certainty Equivalence
Amount of return a household would receive
from a certain outcome so it is indifferent
between a risky outcome and this certain
outcome
Specifically, given two uncertain outcomes
U(C) = 1U(W1) + 2(W2)
Illustrated in next Figure
At a level of utility 1U(W1) + 2U(W2), household is
indifferent between receiving C with certainty or
receiving risky outcome, 1W1 + 2W2

31

32

8/29/2016

Risk aversion and certainty

equivalence

33

Example contd.
Level of guaranteed food consumption that
gives the consumer the same utility as
the risky bundle:
(2/3)(36)0.5 + (1/3)(81)0.5 = (2/3)F0.5 +
(1/3)F0.5 => F0.5 = 7 => F = 49
So the certainty equivalent is 49.
The risk premium is 51 49 = 2

Example
FS = 36, FH = 81, = 2/3 (prob. of sunshine)
The utility function is u = F0.5
Expected consumption is
(2/3)x36 + (1/3)x81 = 51
u(51) = 7.14
Expected utility :
(2/3)(36)0.5 + (1/3)(81)0.5 = (2/3)(6) + (1/3)(9) = 7
Therefore u(51) > (2/3)(FS)0.5 + (1/3)(FH)0.5

Risk Seeking
Mathematically, risk seeking reverses inequality for
risk aversion
For two possible states of nature, risk-seeking
preferences are defined as
U(1W1 +2W2) < 1U(W1) + 2U(W2)

As illustrated in next Figure, for risk-seeking

preferences expected utility function is now convex
Weighted average of wealth levels, W1 and W2, yield a
higher expected utility of wealth, 1U(W1) + 2U(W2),
than utility of expected wealth, U(1W1 + 2W2)

Risk seeking is equivalent to a convex expected utility

function
Implies increasing marginal utility of wealth, 2U/W2 >
0
As wealth increases, marginal utility of wealth
increases
36

8/29/2016

Risk-seeking preferences

Risk Neutrality
Risk-neutral preferences are depicted in
next Figure
Expected utility function is now linear
Weighted average of wealth levels, W1 and W2,
yield same expected utility of wealth, 1U(W1) +
2U(W2), as utility of expected wealth, U(1W1 +
2W2)

Equivalent to a linear expected utility

function
Implies constant marginal utility of wealth,
2U/W2 = 0
37

Risk-neutral preferences

38

Marginal utility is constant at all levels of wealth

Managing Risk - Insurance

Object of risk management is to make risky activities
more attractive by reducing the potential losses while
preserving much of the potential gains
People address a wide range of risks by purchasing
insurance policies
An insurance policy is a contract that reduces the
financial loss associated with some risky event, such as
burglary
The purchaser of an insurance policy is essentially placing
a bet
Having paid M, the premium, the policy holder receives B,
the benefit, if a loss occurs, for a net gain of B M
If a loss doesnt occur the consumer loses the premium M

39

11-40

10

8/29/2016

Other Methods of Managing Risk

Four other strategies for managing risk
Risk sharing involves dividing a risky prospect
among several people
Hedging is the practice of taking on two risky
activities with negatively correlated financial
payoffs
Diversification is the practice of undertaking
many risky activities each on a small scale
People also often try to reduce risk through
information acquisition
11-41

11