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CHAPTER 12
Risk and information
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Individual attitudes towards risk
• A risk neutral person
– is only interested in whether the odds will yield a
profit on average.
• A risk-averse person
– will refuse a fair gamble
– i.e. one which on average will make exactly
zero monetary profit.
• A risk-lover
– will bet even when a strict mathematical
calculation reveals that the odds are
unfavourable.
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Risk and insurance
• Risk-pooling works by aggregating
independent risks to make the
aggregate more certain.
• Risk-sharing works by reducing the
stake.
• By pooling and sharing risks, insurance
allows individuals to deal with many
risks at affordable premiums.
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Moral hazard
Moral hazard (or hidden action): in this case the
uninformed agent cannot observe a particular
action of the informed individual.
• For example, a worker may put little effort in
performing his job if it is difficult for the employer
to monitor her.
• The problem of moral hazard is also known as
the principal-agent problem, where the
principal is the name we give to the uninformed
individual while the agent is the informed one.
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Moral hazard and adverse selection
• Adverse selection (or hidden information) is the
case where the uninformed individual does not
know about an unobservable characteristic of the
informed individual.
• Example of adverse selection: A person with a fatal
disease signs up for life insurance.
• Example of moral hazard: Reassured by the fact
that he took out life assurance to protect his
dependants, a person who has unexpectedly
become depressed decides to commit suicide.
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Education and signalling (1)
• The theory assumes that people are born with
different innate ability.
• The problem for firms is to tell which applicants are
the ones with high productivity. There is a problem
of asymmetric information.
• Signalling theory says that, in going on in
education, people who know that they are clever
send a signal to firms that they are the highproductivity workers of the future.
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Education and signalling (2)
• To be effective, the screening process
must separate the high-ability workers from
the others.
• Lower-ability workers do not go to
university because they could not be
confident of passing.
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Decreasing returns to scale
Utility
c
a
Total utility
of income
The utility of having £5 with
certainty (point a) is higher
than the expected utility
from buying the asset
(point d).
The consumer is risk averse.
Point d lies on the chord
connecting points b and c.
d
b
This is because expected
utility is given by:
£2,50
£5.00
£7.50
Income
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E(U)=0.5U(£2.5)+0.5U(7.5)
Point b is associated with
U(£2.50) while point c is
associated with U(£7.50).
Portfolio selection
• The risk-averse consumer prefers a higher
average return on a portfolio of assets
– but dislikes risk.
• Diversification
– is a strategy of reducing risk by risk-pooling
across several assets whose individual returns
behave differently from one another.
• Beta
– is a measurement of the extent to which a
particular share's return moves with the return
on the whole stock market.
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Beta
• A share with beta = 1 moves the same way
as the whole market.
• A high beta share does even better when
the market is up, even worse when the
market is down.
• A low beta share moves in the same
general direction as the market but more
sluggishly than the market.
• Negative beta shares move against the
market.
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Beta for selected sectors in 2013
A share with a low (or even negative) beta will be in high
demand. Risk-averse purchasers are anxious to buy these as they
reduce the total portfolio risk.
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More on risk
• A spot market
– deals in contracts for immediate delivery and
payment.
• A forward market
– deals in contracts made today for delivery of
goods at a specified future date at a price
agreed today.
• Hedging
– the use of forward markets to shift risk onto
somebody else.
• A speculator
– temporarily holds an asset in the hope of
making a capital gain.
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Hedging
• Suppose today you can sell 1 tonne of
copper for delivery in 12 months’ time at a
price of £860 agreed today. You have
hedged against the risky future spot price.
• You have sold your copper for only £860,
even though you expect copper then to sell
for £880 on the spot market.
• You regard this as an insurance premium to
get out of the risk associated with the future
spot price.
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Hedging: The speculator
• You sell the copper to a trader whom we can call a
speculator.
• The speculator has no interest in the copper per se.
Having promised you £860 for copper to be
delivered in one year’s time, she currently expects
to resell that copper immediately it is delivered.
• She expects to get £880 for that copper in the spot
market next year, thus making £20 as compensation
for bearing your risk.
• The speculator pays no money now. But If spot
copper prices turn out to be less than £860 next
year the speculator will lose money.
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Efficient asset markets
• The theory of efficient markets
– says that the stock market is a sensitive
processor of information,
– quickly responding to new information to
adjust share prices correctly.
• An efficient asset market already
incorporates existing information properly in
asset prices.
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Behavioural finance
• Empirical evidence in support of efficient
markets is mixed.
• Behavioural finance links finance,
economics and psychology.
• Bounded rationality leads people to make
decisions using heuristics.
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Concluding comments (1)
• Most people are risk-averse.
• Risk-aversion reflects the diminishing marginal
utility of wealth.
• Insurance pools risks that are substantially
independent to reduce the aggregate risk, and
spreads any residual risk across many people so
that each has a small stake in the risk that cannot
be pooled away.
• Insurance markets are inhibited by adverse
selection and moral hazard.
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Concluding comments (2)
• When risks on different asset returns are
independent, the risk of the whole portfolio can be
reduced by diversification across assets.
• In equilibrium risky assets earn higher rates of return
on average to compensate portfolio holders for
bearing this extra risk.
• In an efficient market assets are priced to reflect
the latest available information about their risk and
return.
©McGraw-Hill Education, 2014