EC-103Information and Risk

Lecture 8

Every action taken has a future outcome that is not certain and hence involves risk.

Life is full of gambles• Skiing on holiday• Cycling to university• Investing in the stock market

Studying any academic subject for the first time involves a risk:• Will you enjoy it?• How will you use the skills?

A number of economic institutions have been created to deal with risk.

A vast quantity of money is spent on insurance, but we also spend billions on gambling

• Lotteries• Horse racing• Etc.

Gambling which is considered fun and exciting is risky, yet we pay to do it – Grand National. Yet we spend billions on insurance, car insurance, house insurance and holiday insurance to reduce risk.

The National Lottery was introduced in 1997 and the chances of winning is estimated at 1 in 14 million.

Adam Smith referred to lotteries as a tax on fools.

The UK National Lottery does involve giving to good causes.

However, it has been estimated that those in the bottom 20% in terms of income account for 30% of the ticket sales.

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

Risk and Insurance

Pooling of risks is the basis for insurance. Life insurance companies pool risk as death rates vary by age. Pooling of risk is difficult when everyone faces some risk, so many companies do not insure what are called ‘act of God’, earthquakes, epidemics etc.

• 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 Lloyd’s in London, through hundreds of ‘syndicates’ enables

large risks to be covered such as US space shuttle.

Two important factors can inhibit the effective operation of insurance markets, where insurance companies use statistical probabilities to estimate the chances of an outcome taking place. Moral hazard and adverse selection.

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 – remember during a meal that you might not have locked your car door but not going back to check.

• 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 – this changes the odds.

Moral hazard increases the cost of insurance. To attempt to reduce moral hazard, insurance companies may only cover part of the replacement costs or reduce premiums if you want only part coverage.

• Excess on car insurance

Insurance companies give you an incentive to attempt to reduce probability of unfortunate event.

Portfolio selection

There are a number of ways in which individuals can carry wealth from the present to the future. Portfolio selection is a way in which individuals can attempt to manage risk.

• The risk-adverse 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 correlations in returns on assets influences how diversification

changes risk if returns perfectly correlated, just as in the case of insurance and

‘acts of God’ diversification will not work

• Beta

is a measurement of the extent to which a particular share's return moves with the return on the whole stock market

gold price may increase in time of uncertainty and recession when other prices fall. Negative beta shares or commodities move in the opposite direction to the market

Source: BBC website 7 March 2012

Efficient asset markets

Keynes stated the stock market operated like a casino, dominated by short term speculators

• 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

However, evidence that asset markets to exhibit temporary bubbles

• housing markets• dot.com• 1929 Wall Street crash

1720 South Sea Bubble arose as company set up to import exotic goods, people bought shares in company but the company never imported the goods.

According to the Efficient Market Hypothesis share prices change as information changes and the stock market is informationally efficient. Current prices reflect all information that is currently available as a result it is predicted that the stock market should follow a random walk.

Faith in the efficient market hypothesis was questioned following the 2007-2009 financial crisis and Mankiw and Taylor (2011) note “there have been many who have consigned EMH to the ‘dustbin of history’”.

However they argue what may come of the financial crisis is a better understanding of how markets operate including

• the extent to which humans act irrationally• are risk seeking or risk averse

Malkiel (2003) noted as long as stock markets exist, the collective judgements of investors will sometimes make mistakes

Others have noted supply shortages can lead to the creation of bubbles. If housing prices are rising sharply, incentive for individuals to enter the market. This can fuel a bubble and eventual crisis.

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 do not exist in many markets as difficult to write legally binding

contracts

• Hedging the use of forward markets to shift risk on to somebody else.

Company mining commodities may use this to reduce risk.

• A speculator temporarily holds an asset in the hope of making a capital gain.

• Compensating differentials in the return to labour individuals in risky jobs likely to earn more than those in safe jobs individuals in secure jobs likely to earn more than those in relatively

insecure jobs large return to entrepreneurial success may be the carrot needed to

encourage such activity