Every action taken has a future outcome that is not certain and henceinvolves risk.Life is full of gambles• Skiing on holiday• Cycling to university• Investing in the stock marketStudying 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 spendbillions on gambling• Lotteries• Horse racing• Etc.
Gambling which is considered fun and exciting is risky, yet we pay to doit – 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 ofwinning 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 termsof 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 onaverage• A risk-averse person will refuse a fair gamblei.e. one which on average will make exactly zeromonetary profit• A risk-lover will bet even when a strict mathematical calculation revealsthat the odds are unfavourable
Risk and InsurancePooling of risks is the basis for insurance. Life insurance companiespool risk as death rates vary by age. Pooling of risk is difficult wheneveryone faces some risk, so many companies do not insure what arecalled „act of God‟, earthquakes, epidemics etc.• Risk-pooling works by aggregating independent risks to make the aggregate morecertain• Risk-sharing works by reducing the stake
• By pooling and sharing risks, insurance allows individualsto deal with many risks at affordable premiums Lloyd‟s in London, through hundreds of „syndicates‟ enableslarge risks to be covered such as US space shuttle.Two important factors can inhibit the effective operation of insurancemarkets, where insurance companies use statistical probabilities toestimate the chances of an outcome taking place. Moral hazard andadverse selection.
Moral hazard and adverse selection• Moral hazard is the exploiting of inside information to take advantage of theother party to a contract e.g. if you take less care of your property because you know it isinsured – remember during a meal that you might not havelocked your car door but not going back to check.• Adverse selection occurs when individuals use their inside information to accept orreject a contract, so that those who accept are not an averagesample of the population e.g. smokers taking out life insurance – this changes the odds.
Moral hazard increases the cost of insurance. To attempt to reducemoral hazard, insurance companies may only cover part of thereplacement costs or reduce premiums if you want only part coverage.• Excess on car insuranceInsurance companies give you an incentive to attempt to reduceprobability of unfortunate event.
Portfolio selectionThere are a number of ways in which individuals can carrywealth from the present to the future. Portfolio selection is a wayin which individuals can attempt to manage risk.• The risk-adverse consumer prefers a higher averagereturn on a portfolio of assets but dislikes risk• Diversification is a strategy of reducing risk by risk-pooling across several assetswhose individual returns behave differently from one another correlations in returns on assets influences how diversificationchanges 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 sharesreturn moves with the return on the whole stock market gold price may increase in time of uncertainty and recessionwhen other prices fall. Negative beta shares or commoditiesmove in the opposite direction to the market
Efficient asset marketsKeynes 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 ofinformation quickly responding to new information to adjust share pricescorrectly• An efficient asset market already incorporates existinginformation properly in asset prices
However, evidence that asset markets to exhibit temporary bubbles• housing markets• dot.com• 1929 Wall Street crash1720 South Sea Bubble arose as company set up to import exoticgoods, people bought shares in company but the company neverimported the goods.
According to the Efficient Market Hypothesis share priceschange as information changes and the stock market isinformationally efficient. Current prices reflect all information thatis currently available as a result it is predicted that the stockmarket should follow a random walk.Faith in the efficient market hypothesis was questioned followingthe 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 abetter understanding of how markets operate including• the extent to which humans act irrationally• are risk seeking or risk averseMalkiel (2003) noted as long as stock markets exist, thecollective judgements of investors will sometimes make mistakesOthers have noted supply shortages can lead to the creation ofbubbles. If housing prices are rising sharply, incentive forindividuals to enter the market. This can fuel a bubble andeventual 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 specifiedfuture date at a price agreed today do not exist in many markets as difficult to write legally bindingcontracts• 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 relativelyinsecure jobs large return to entrepreneurial success may be the carrot needed toencourage such activity