Chapter 15 Coping with risk in economic life David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 15.2 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 15.3 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. 15.4 Moral hazard and adverse selection  Moral hazard – is the exploiting of inside information to take advantage of the other party to a contract  e.g. if you take less care of your property because you know it is insured  Adverse selection – occurs when individuals use their inside information to accept or reject a contract, so that those who accept are not an average sample of the population  e.g. smokers taking out life insurance 15.5 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 15.6 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. 15.7 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 on to somebody else.  A speculator – temporarily holds an asset in the hope of making a capital gain. . 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. Chapter 15 Coping with risk in economic life David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 15. 2 Individual. premiums. 15. 4 Moral hazard and adverse selection  Moral hazard – is the exploiting of inside information to take advantage of the other party to a contract  e.g. if you take less care of your property