Basic discussion of risk for my Money & Banking students.

1. Risk
juliohuato@gmail.com

2. 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

3. 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).

4. 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

5. 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)

6. Possibilities, Probabilities, and
Expected Value
 We can construct a table of all outcomes
and probabilities for an event, like tossing
a fair coin.

7. Lottery A


8. Lottery B


9. Lottery C


10. The 3 lotteries
Lotto x bar Range:
max(x)-
min(x)
A $1 $0
B $1 $2
C $1 $4
With which lottery do the effects of your
uncertainty feel more painful?

11. Risk aversion
People prefer a certain payoff to an uncertain one
In a market system, people trade off risk for reward

12. Statistics


13. Exercise
 Calculate the variance, standard deviation, and
coefficient of variation of the lotteries above.

14. Exercise


15. Exercise


16. Exercise


17. 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

18. Sources of Risk
All risks can be classified into two groups:
1. Those affecting a small number of
people but no one else:
idiosyncratic or unique risks
2. Those affecting everyone:
systemic, systematic, economy-wide, or
macro risks

19. Sources of Risk
Idiosyncratic risks can be classified into two
extreme 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.

20. 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

21. 5-21
Hedging 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.

22. 5-22
Spreading 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.

23. 5-23
Spreading 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.

24. 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 risk
In our next session, we will study how the risk premium
on bonds can be estimated (under certain
assumptions)