Goals: To learn about… The effect of uncertainty in our economic life Ways in which risk can be estimated Our attitudes towards risk The different sources of risk The ways in which manage our economic risk
Uncertainty Kenneth J Arrow: “Uncertainty is our relative ignorance about the future effects of our current choices -- the more so, the further removed the effects are from these choices.” We are ignorant about how the world and our society functions (economics barely makes a dent), ultimately because our productive powers are finite On top of our regular ignorance vis-à-vis the rest of nature, uncertainty about our own social life is self- referential – it depends on how we deal with our own uncertainty (chicken-and-egg).
Risk In economics and finance, we usually think of risk as: The economic effect (benefits/costs) of our uncertainty One usual way in which risk is quantified in economics and finance is as the variability in payoffs
Probability & Statistics Probability is a mathematical theory about our cognitive behavior in the face of uncertainty Statistics is a set of techniques that use probability theory (and other assumptions) to extract knowledge from data (observations)
Possibilities, Probabilities, andExpected Value We can construct a table of all outcomes and probabilities for an event, like tossing a fair coin.
Risk in economics & finance Usually, we think of risk as a measure of uncertainty about the future payoff to a bond over a time period and compared to a benchmark The benchmark is usually a hypothetical risk-free bond Again, in a market system with prevailing risk aversion, there is a tradeoff between risk and reward The use of probability theory requires that we envision all possible scenarios (“states of the world”) and their likelihood
Sources of RiskAll risks can be classified into two groups:1. Those affecting a small number of people but no one else: idiosyncratic or unique risks2. Those affecting everyone: systemic, systematic, economy-wide, or macro risks
Sources of RiskIdiosyncratic risks can be classified into twoextreme types: 1. A risk is bad for one sector of the economy but good for another. 2. Unique risks specific to one person or company and unrelated to others.
Dealing with risk Risk can be reduced through: Hedging: building a portfolio with assets that have offsetting payoffs Diversification: randomly adding more assets to one’s portfolio, since the additional assets are unlikely to have payoffs that move exactly like those already in the portfolio
5-21Hedging Risk• Hedging is the strategy of reducing idiosyncratic risk by making two investments with opposing risks. • If one industry is volatile, the payoffs are stable.• Let’s compare three strategies for investing $100: • Invest $100 in GE. • Invest $100 in Texaco. • Invest half in each company.
5-22Spreading Risk You can’t always hedge as investments don’t always move in a predictable fashion. The alternative is to spread risk around. Find investments whose payoffs are unrelated. Weneed to look at the possibilities, probabilities and associated payoffs of different investments.
5-23Spreading Risk The more independent sources of risk you hold in your portfolio, the lower your overall risk. As we add more and more independent sources of risk, the standard deviation becomes negligible. Diversification through the spreading of risk is the basis for the insurance business.
We learned about… Uncertainty and its economic effect: risk Estimating risk by measuring the variation of payoffs to our assets Risk aversion and the tradeoff between risk and reward in a market system Idiosyncratic (unique) risk and systemic (macro) risk How hedging (if there are assets with contrarian payoffs) and diversification (spreading risk around) lowered idiosyncratic riskIn our next session, we will study how the risk premiumon bonds can be estimated (under certainassumptions)