1. EC-103
Information and Risk
Lecture 8

2. 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.

3. 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.

4. 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

5. 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

6. • 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.

7. 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.

8. 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.

9. 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

10. • 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

11. Source:
BBC website
7 March 2012

12. 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

13. 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.

14. 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‟”.

15. 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.

16. 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.

17. • 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