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
15.2
Individual attitudes towards risk
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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
15.3
Risk and insurance
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Risk-pooling
–
works by aggregating independent risks to


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
15.6
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