CHAPTER 12 Risk and information ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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 high- productivity workers of the future. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

d Decreasing returns to scale Total utility of income Utility Income £2,50£5.00£7.50 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. This is because expected utility is given by: 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). a b c ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

Beta for selected sectors in 2013 ©McGraw-Hill Education, 2014 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.

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. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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. ©McGraw-Hill Education, 2014

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