Risk Preferences Diversification

Financial Markets and Institutions: Lecture 1

Anurag Singh

Instituto Tecnológico Autónomo de México (ITAM)

Spring 2021

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Risk Preferences Diversification

The Course Outline

Introduction and Motivation

Types of Financial Institutions

Risk: Types of Risk and Measuring the Risk

Managing Risk

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Risk Preferences Diversification

The Course Outline

Introduction and Motivation

Introduction to Financial Intermediation: Basic Concepts

Financial Intermediation & Financial Institutions: An Overview

Types of Financial Institutions

Risk: Types of Risk and Measuring the Risk

Managing Risk

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Risk Preferences Diversification

Topic to be Covered Today

Introduction to Financial Intermediation: Basic Concepts

Risk Preferences

Risk Diversification

Riskless Arbitrage

Market Efficiency

Market Completeness

Asymmetric Information
Adverse Selection
Agency and Moral Hazard

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Risk Preferences Diversification

Risk Preference: An Experiment

Assume we roll a dice:

if any of 1, 3, or 5 comes—you get $0
if any of 2, 4, or 6 comes—you get $120
In summary,

The other option is that I give you $60 without playing the lottery
Would you chose the lottery or $60
What would most of the people choose?

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Risk Preference: An Experiment

What does “The Economist” Say About This?

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Risk Preferences Diversification

Risk Preference: An Experiment

What does “The Economist” Say About This?

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Risk Preferences Diversification

Risk Preference: An Experiment

How to analyze the two options

Things we need to know (A Refresher!)

Utility of an expected payoff
Expected Utility
How does the utility function look like? U 0 (W ), U 00 (W )

What is the expected Payoff of the lottery here?

You take the lottery if the utility of an expected payoff < expected
utility of the lottery

You do not take the lottery if the utility of an expected payoff >
expected utility of the lottery

As “the economist” says, most of the people are risk averse and they
do not take the lottery
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Risk Preferences Diversification

Risk Preference
An individual is considered risk neutral if the individual is indifferent
between the certainty of receiving the mathematical expected value of
a gamble and the uncertainty of the gamble itself
U(E {W }) = E {U(W )}

An individual is considered risk-averse if the individual prefers the

certain outcome over the gamble
U(E {W }) > E {U(W )}

An individual is considered risk-seeking or risk-loving if the

individual prefers the gamble over the certain outcome.
U(E {W }) < E {U(W )}

Who chooses the least risky and who chooses the most risky gamble?
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Risk Preferences Diversification

Question

Look at the following two lotteries:

What will a risk-averse agent choose?

What will a risk-neutral agent choose?

Most of the theories are built on the assumption of risk-averse

individuals

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Risk Preferences Diversification

The Shapes of Utility Function

The shape of the utility function, U(W ), is

concave for risk-averse agents
linear for risk neutral agents
convex for risk-seeking agents

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Risk Preferences Diversification

Certainty Equivalent and Risk Premium

The sure payment that makes a risk-averse individual indifferent

between that sure payment and a corresponding gamble is called
certainty equivalent of the gamble
With risk-averse individuals, certainty equivalent of a gamble is less
than the expected value. This difference is called the risk premium
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Risk Preferences Diversification

Fair Premium and Risk Premium: Example

Let us assume your monthly income is MXN

p 40,000 and your utility is
a function of money given as: U(M) = (M)
With probability 0.1, the car you drive might break down and you have
to pay MXN 7,600 for repairs
What is the fair premium?
Given the probabilities and the cost of repair are the same across all
customers of the insurance company, how much will the company will
have to pay per person on an average?
Fair premium: 0.1 × 7, 600= MXN 760
How much are you willing to pay for insurance?
√ √
Expected utility wit no insurance: 0.1 · 32, 400 + 0.9 · 40, 000 = 198
Rather than the fluctuation in money,
√ you would be willing to accept a
minimum of certainty equivalent: CE = 198 =⇒ CE = 39, 204
Thus, you would rather pay upto a maximum of 40, 000 − 39, 204 =
MXN 796 than sometimes incurring the cost of repairs

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Risk Preferences Diversification

Fair Premium and Risk Premium: Example

What is the risk premium?
The maximum amount you are willing to pay over and above the fair
premium to get rid of the risk involved in a fluctuating income stream
MXN 796 − 760 = MXN 36
What is the actual insurance premium you will pay?
If the insurance company know that you are willing to pay a maximum
of MXN 796, there is no point charging anything less

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Risk Preferences Diversification

Risk Diversification

Diversification is a way to reduce risk (good for risk-averse agents!)

How does it work?

Hold numerous risky assets with returns that are not be perfectly and
positively correlated
The return of the portfolio will be more predictable, but not
necessarily greater

Risk types and if they can be diversified:

Idiosyncratic Risk stems from forces specific to the asset in
question—Diversifiable
Systematic Risk arises from an economy-wide phenomenon such as a
recession and causes a correlation in the asset’s payoff—Not
Diversifiable

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Risk Preferences Diversification

Risk Diversification: 2 Asset Example

Consider:
Two assets, A & B, whose returns are random variables
Variance of these returns1 : σA2 and σB2
Correlation coefficient between returns of A and B: ρAB
Proportions of the portfolio’s value invested in A and B: yA and yB

If rA and rB are rate of return for assets A & B, the rate of return on
the portfolio is given as:
rP = yA rA + yB rB
Variance of the portfolio return:
σP2 = yA2 σA2 + 2yA yB Cov (A, B) + yB2 σB2
=⇒ σP2 = yA2 σA2 + 2yA yB ρAB σA σB + yB2 σB2

1
High variance in return =⇒ Higher severity of both good and bad events =⇒ high risk (imagine what will risk-averse
agent prefer: Lottery 1—$120 with probability 0.5, and $0 with probability 0.5; or Lottery 2—$80 with probability 0.5, and $40
with probability 0.5)
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Risk Preferences Diversification

Risk Diversification: 2 Asset Example (Contd.)

Risk vs Return

How do we end up in the overhedged region?

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Risk Preferences Diversification

Risk Diversification: 2 Asset Example (Contd.)

Holding fixed yA , yB , σA , and σB , we see that δσP2 /δρAB > 0 =⇒

portfolio risk increases with the correlation between the returns
With perfect and positive correlation in returns, ρAB = 1
σP = yA σA + yB σB
Diversification does not reduce portfolio risk in this case (Imagine
σA = σB = σ, yA = yB = 0.5 for simplicity)

With uncorrelated
p
returns, ρAB = 0
σP = yA2 σA2 + yB2 σB2 < yA σA + yB σB
Diversification reduces portfolio risk in this case

With perfect and negative correlation in returns, ρAB = −1

σP = |yA σA − yB σB |
Portfolio risk can be reduced to 0! (Imagine σA = σB = σ,
yA = yB = 0.5 for simplicity or yA = yB ∗ {σB /σA })

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Risk Preferences Diversification

Risk Diversification: 2 Asset Example (Contd.)

Risk vs Return

How do we replicate this graph?

How does the lines corresponding to ρ = 1, ρ = 0 and ρ = −1
correspond to results from the previous page?
Let us draw this in an excel sheet
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Risk Preferences Diversification

Risk Diversification: ‘N’ Asset Example

Consider assets with returns pairwise uncorrelated with the returns of
every other asset

Variance of the portfolio return:

N
X
σP2 = yi2 σi2
i=1

Assuming the same investment in all assets i.e. yi = 1/N,

N
X σi2 2
N · σmax 2
σmax
σP2 = ≤ =
N2 N2 N
i=1

Therefore:
with sufficiently many assets with (pairwise) uncorrelated returns,
portfolio risk decreases and returns can be made highly predictable
in the limit, as N goes to infinity, σP →− 0
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Risk Preferences Diversification

Risk Diversification: ‘N’ Asset Example (Contd.)

Can investors drive their risks to zero? No! Why Not?

Systemic Shocks: Some economy wide shocks like the recession or
wars, natural calamities such as floods and earthquakes, create a
positive correlation among the returns of various assets
Costs: Cost of administration and the cost of acquiring new
information about assets increases with the assets in the portfolio

A large fraction of the potential benefits of diversification is

obtained by holding a relatively small number of securities

Marginal benefits of diversification decline rapidly as the

number of securities increases

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