CHAPTER 2:

CHOICES
UNDER RISKS
CHAPTER OUTLINE
I. DESCRIBING RISKS
II. PREFERENCES TOWARD RISKS
III. REDUCING RISKS
IV. THE DEMAND FOR RISKY ASSETS

2
DESCRIBING RISK
Certainty is the situation when the
decision maker is 100% sure about the
outcome.
Risk is a situation in which a decision
maker knows all of the possible outcomes
of a decision and also knows the
probability associated with each outcome.

3
DESCRIBING RISK
probability Likelihood that a given
outcome will occur.
Subjective probability is the
perception that an outcome will occur.

4
DESCRIBING RISK
expected value Probability-
weighted average of the payoffs
associated with all possible outcomes.

The expected value measures the

central tendency—the payoff or value
that we would expect on average.
5
DESCRIBING RISK
Table 2.1: Business Profits

Outcome 1 Outcome 2 Expected

Value
Profit Prob. Profit Prob.

Plan A 50 0.7 70 0.3 56

Plan B 40 0.8 80 0.2 48

6
DESCRIBING RISK
Roulette game
If you gamble $1 and the dice falls into
your chosen, you get $35. If it doesn’t,
you’ll lose that

TABLE 2.2: PLAYING ROULETTE

OUTCOME 1 OUTCOME 2
EXPECTED
PROB. PAYOFF PROB. PAYOFF VALUE

1/38 $35 37/38 -$1 -$2/38

7
DESCRIBING RISK
variability Extent to which possible
outcomes of an risk event differ.
deviation Difference between
expected payoff and actual payoff

8
DESCRIBING RISK
standard deviation Square root of
the weighted average of the squares
of the deviations of the payoffs
associated with each outcome from
their expected values.

9
DESCRIBING RISK
TABLE 2.3: CALCULATING STANDARD DEVIATION

Outcome 1 Outcome 2 Expected Standard

Value Deviation

Income Prob. Income Prob.

Job A 20 0.5 10 0.5

Job B 16 0.875 8 0.125

10
DESCRIBING RISK
TABLE 2.4

Outcome 1 Outcome 2
EV σ
Income Prob. Income Prob.

Job A 21 0.5 11 0.5 16 5

Job B 16 0.875 8 0.125 15 2.65

11
DESCRIBING RISK
Coefficient of Variation: also known as
relative standard deviation, is the ratio of
standard deviation to the expected value.

CV is a standardized measure of

dispersion of a probability distribution or
frequency distribution
CVA = 0.3125; CVB= 0.177.
12
PREFERENCES TOWARDS RISK
TABLE 2.5

Outcome 1
Job A Outcome 2
$25,000 EV σ
Income Prob. Income Prob.

Job A $10,000 0.5 $40,000 0.5 $25,000 15,000

Job B Income = $25,000; σ= 0

13
14
 PREFERENCES TOWARD RISK
Different Preferences Toward Risk
risk averse Condition of preferring a certain
income to a risky income with the same
expected value  Prefer B to A
risk neutral Condition of being indifferent
between a certain income and an uncertain
income with the same expected value
Indifferent btw A and B
risk loving Condition of preferring a risky
income to a certain income with the same
expected value Prefer A to B
15
PREFERENCES TOWARDS RISK
RISK AVERSE

EI= I1*P1 + I2*P2 = I3

EU= U 1 * P1 + U 2 * P2

16
 PREFERENCES TOWARDS RISK
RISK AVERSE
U
U= f(I)  Total
U2 utility curve is
D
U3 B concave to the
EU= U4
C F
horizontal axis
U1  U’’(I) < 0
A
 MU’(I) <0
 MU goes on
diminishing
0
I1 I4 EI = I3 I2 I

17
 PREFERENCES TOWARDS RISK
U RISK AVERSE
U= f(I)
B
U2  Risk premium:
C measures the amount
EU= U4 of income that an
F
U5 individual would give
U1 up to leave her
A
indifferent between a
risky choice and a
certain one.
 CF = I3 – I4

0
I 1 I5 I 4 I3 I2 I
18
 PREFERENCES TOWARDS
RISK
RISK AVERSE
Expected income Expected income

0 0
σ σ

Slightly Risk Strongly risk

Averse averse 19
PREFERENCES TOWARDS RISK
Risk Neutral
risk neutral Condition of being
indifferent between a certain income
and an uncertain income with the
same expected value.

20
 PREFERENCES TOWARDS RISK
Risk Neutral
U
Total utility curve
U2 is linear.
B
EU= U3
Marginal utility is
F
constant.
U1
A

0 I1 EI = I3 I2 I

21
PREFERENCES TOWARDS RISK
Risk Loving

risk loving Condition of preferring a

risky income to a certain income with
the same expected value.

22
PREFERENCES TOWARDS RISK
Risk Loving
U
•Total Utility
U2
B
curve is convex to
the horizontal
axis.
EU F • Marginal Utility

U3 is increasing.
U1 A D

0 I1 EV = I3 I2 I

23
REDUCING RISKS
3.1. DIVERSIFICATION

Hot Cold

TR Prob. TR Prob.

Cool air 300 0.5 100 0.5

conditioner

100 0.5 300 0.5

Heater

24
 REDUCING RISKS
Insurance

Table 2. 7

Insurance Lose Safe Expected Standard

(P=0 .1) (P =0.9) Value Deviation

No 40,000 50,000 49,000 3000

Yes 49,000 49,000 49,000 0

25
REDUCING RISKS
Insurance

Bad: P1, I1
Good:P2, I2
Expected return: EV = I3
Expected loss = I2 – I3

26
 REDUCING RISKS
Insurance
U
 Insurance Premium U= f(I)
B
cannot be smaller U2
than the expected loss C
(I2 – I3) EU= U4
F
 If the insurance
premium is greater than U1
A
(I2 – I4)
 The income < I4
 U if buy insurance < EU

 Insurance Premium 0
I1 I4 I3 I2 I
cannot exceed (I2 – I4) 27
Risks faced by insurance company
 Buyers of insurance will always know more than insurance companies about
the likelihood of the event being insured against happening.
 For example, people with bad health habits and histories of health problems
will have a better idea of the probability that they will suffer a heart attack or
other health problem than will insurance companies.
 Insurance companies cover their costs only if they set the prices (premiums)
of their policies at levels that represent how many payment claims the people
they have insured are likely to submit.
 The adverse selection problem can be reduced if people are automatically
covered by insurance. For example, state governments require drivers to
have automobile insurance.
 Adverse selection problems can also be reduced by offering group coverage
to large companies and other organizations.

28
 100 people: 90 are healthy and 10 are sick
 With a healthy person over the next year, there's a
10% chance that they will incur a $10,000 charge, and
a 90% chance that they'll have zero costs.
 For the sickly guy, there's a 50% chance that they'll
cost $10 K, and a 50% chance that they'll cost zero.
Expected cost?

29
 With large enough samples, it can be predicted that with
certainty-- that if everyone buys insurance, the company
will spend $1,400 a year per person.
 If the company sets a premium of $1,500, the company
will make $100 per person. If 100 buy, that's $10,000
profit.
 While at such premium, 100% of sick people will
definitely buy insurance, the decision of healthy people is
unclear depending on their risk aversion and risk premium.

30
 Supposed that 50 healthy guys are willing to pay $1,500
for full coverage of $1,000 expect loss.
 Total revenue = $1,500 * 60= $90,000
 Total cost = $1,000 * 50 + $5,000 *10 = $100,000
 Loss = $10,000

31
Risks faced by insurance company
Moral hazards: Individuals may engage in
more risky behavior because they are not
concerned with the costs associated with
damages that may arise from that risky
behavior as the costs are covered by the
insurance company.
 Examples:
‒ Parking on the street instead of a garage
‒ Parking in relatively unsafe areas

32
 Risks faced by insurance company
MC: marginal cost of careful action
MB: Marginal benefit of careful action
MBPI: Marginal benefit of careful action when buying partial insurance
MBFI: Marginal benefit of careful action when buying full insurance (=0)

MB,
MC • In a market without insurance, an agent
will act to improve the potential for a good
MC
outcome up until A*, where the marginal
benefit of further action, MB, equals the
marginal cost , MC.
MB • If the policy offers partial insurance, the
agent will have the incentive to take action
MBPI
—but not to the same degree as in the
MBFI absence of insurance (A*PI)
Quantity
API A • If instead the agent obtains full insurance,
of actions there is no marginal benefit to acting to
* *
improve the potential for a good outcome,
because he will be fully compensated for
any bad outcome.
 Risks faced by insurance company
 Seat belts tend to reduce the number of driver deaths by making it easier to survive
an accident. At the same time, seat belts tend to increase the number of driver deaths
by encouraging reckless behavior.
 Which effect is the greater? Is the net effect to decrease or to increase the number of
driver deaths?
 The first person to do that was Sam Peltzman of the University of Chicago. He
found that the two effects are of approximately equal size and therefore cancel each
other out.
 When seat belts were first introduced (along with padded dashboards and collapsible
steering columns) there were more accidents and fewer driver deaths per accident,
but the total number of driver deaths remained essentially unchanged.
 Pedestrian deaths, however, appear to have increased—pedestrians, after all, are not
equipped with padded dashboards.
 Subsequent studies have found comparable results for air bags and antilock brakes.

34
 Solutions to Insurance Company
 Improve the accuracy of identification and quantification
of risk factors, such as lifestyle choices that increase or
lessen an applicant's risk level.
 Establish a well-functioning system in place to verify
information provided by insurance applicants.
 Institute a co-pay and deductibles, which requires
individuals to pay for at least part of the services they
receive.
 Mandate actions to be taken by the insured
 Structure policies to encourage good behavior:
- Some auto insurance deductibles fall after each accident-free year.
- Life insurance premiums usually fall when efforts are made to improve health

35
THE DEMAND FOR RISK ASSETS

asset Something that provides a

flow of money or services to its owner.
risky asset Asset that provides an
uncertain flow of money or services to
its owner.

37
THE DEMAND FOR RISK ASSETS

return Total monetary flow of an asset

as a fraction of its price.
real return Simple (or nominal) return
on an asset, less the rate of inflation.
expected return Return that an asset
should earn on average.
actual return Return that an asset
earns.

38
THE DEMAND FOR RISK ASSETS
Investor’s choice
Return of risk-free assets: Rf
Return of risk assets : Rm
Investment portfolio:
Rp = bRm + (1-b) Rf (*)
Standard deviation:
p = b m (**)

39
THE DEMAND FOR RISK ASSETS
Investor’s choice
From (*) and (**) we could infer:
Rp = Rf + b(Rm – Rf)

Price of risk : To receive a higher

expected return, the investor must
incur some risk.
40
 THE DEMAND FOR RISK ASSETS
Investor’s choice
 The budget line Expected Return
describes the trade-off
between the expected
return and its
riskiness, as
measured by the Rm
BL
standard deviation of
the return. Rf
 The slope of the
budget line is (Rm−
Rf )/σm, which is the
price of risk. 0 σm Standard Deviat
41
 THE DEMAND FOR RISK ASSETS
Investor’s choice
The utility- Expected Return

maximizing BL

investment portfolio
is at the point where
indifference curve R*
U2 is
tangent to the
budget line.

0 σ* SD
42
 THE DEMAND FOR RISK ASSETS
Investor’s choice
 Investor A is highly risk
R UB
averse. Because his
portfolio will consist
mostly of the risk-free UA
asset, his expected return
RA will be only slightly
R*B
greater than the risk-free
return.
 Investor B is less risk R*
A
averse. She will invest a
large fraction of her funds
in stocks.

σ*A σ*B 43 σ
 THE DEMAND FOR RISK ASSETS
Investor’s choice
 Investor B, however, has a
very low degree of risk UB
aversion.
 Her indifference curve, UB,
is tangent to the budget UA
line at a point where the RB
expected return and Rm
standard deviation for her
portfolio exceed those for
the stock market overall RA
(Rm, σm) .
 This implies that she would
like to invest more than 100
percent of her wealth in the
stock market. σA σm σB 44