1. 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

2. 15.1 Individual attitudes towards risk n A risk neutral person – is only interested in whether the odds will yield a profit on average n A risk-averse person – will refuse a fair gamble n i.e. one which on average will make exactly zero monetary profit n A risk-lover – will bet even when a strict mathematical calculation reveals that the odds are unfavourable

3. 15.2 Risk and insurance n Risk-pooling – works by aggregating independent risks to make the aggregate more certain n Risk-sharing – works by reducing the stake n By pooling and sharing risks, insurance allows individuals to deal with many risks at affordable premiums.

4. 15.3 Moral hazard and adverse selection n Moral hazard – is the exploiting of inside information to take advantage of the other party to a contract á e.g. if you take less care of your property because you know it is insured n 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 á e.g. smokers taking out life insurance

5. 15.4 Portfolio selection n The risk-averse consumer prefers a higher average return on a portfolio of assets – but dislikes risk. n Diversification – is a strategy of reducing risk by risk-pooling across several assets whose individual returns behave differently from one another. n Beta – is a measurement of the extent to which a particular share's return moves with the return on the whole stock market

6. 15.5 Efficient asset markets n 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 n An efficient asset market already incorporates existing information properly in asset prices.

7. 15.6 More on risk n A spot market – deals in contracts for immediate delivery and payment n A forward market – deals in contracts made today for delivery of goods at a specified future date at a price agreed today n Hedging – the use of forward markets to shift risk on to somebody else. n A speculator – temporarily holds an asset in the hope of making a capital gain.