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24 Cards in this Set
- Front
- Back
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Probability
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relative frequency with which an event occurs
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expected value
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average outcome from an uncertain gamble
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fair gamble
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gamble with an expected value of 0
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risk aversion
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tendency of people to refuse to accept fair gambles
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which gamble to choose
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1. calculate expected utility
2. choose gamble with highest value |
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risk neutral
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willing to accept any fair gamble
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utility of income curve
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y = utility
x = income provides idea of risk aversion less U bends, the less risk averse |
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fair insurance
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insurance for which the premium is equal to the expected value of the loss
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adverse selection
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insuree knows more about expected loss than insurer
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moral hazard
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people behave more recklessly now that insured
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diversification
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the spreading of risk among several alternatives
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flexibility
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allows subject to adjust initial decision depending on future.
options ex. 2 in 1 coat |
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option contract
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financial contract offering the right, but not the obligation, to buy or sell an asset over a specified period of time
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real option
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option arising in a setting outside finance. involves reallocation of tangible resources
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attributes of options
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1. specification - what, price, details
2. definition of period - option may have to be excerised within 2 years 3. the price: explicit - stock might sell for $70. implicit - 2 in 1 sells for 150, parka for 120, implicit price is 30. |
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dimensions of value of underlying transaction
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1. expected value of transaction
2. variability of the value of the transaction generally option is more valuable if underlying conditions are more variable |
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strategic interaction
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economic actors may benefit from having some options cut off
sun tzu army |
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methods for reducing risk
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insurance
diversification flexibility information |
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information
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affected by info costs and info preferences
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market line
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shows relationship between risk and annual returns that an investor can achieve by mixing financial assets
y = annual return x = risk |
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two state model
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x = c1 c = income/consumption
y = c2 a,b,c,d = possible choices / gambles |
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expected utility in two state model
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utility of consumption + probability each state occurs
change in probability shifts indifference curves |
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risk aversion in two state model
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risk averse person has convex indifference curves
greater risk aversion then sharper bend - two states are compliments risk neutral has linear indifference curves - two states are substitutes |
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insurance in two state model
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fairly insured is where highest expected utility curve meets certainty line.
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