Chapter 15 - Risk and information. This chapter presents the following content: Introduction (), describing risky outcome – basic tools, evaluating risky outcomes, avoiding and bearing risk. | 1 Risk and Information Chapter 15 Copyright (c)2014 John Wiley & Sons, Inc. 1 2 Chapter Fifteen Overview Introduction: Describing Risky Outcome – Basic Tools Lotteries and Probabilities Expected Values Variance Evaluating Risky Outcomes Risk Preferences and the Utility Function Avoiding and Bearing Risk The Demand for Insurance and the Risk Premium Asymmetric Information and Insurance The Value of Information and Decision Trees Chapter Fifteen Copyright (c)2014 John Wiley & Sons, Inc. 3 Chapter Fifteen Tools for Describing Risky Outcomes Definition: A lottery is any event with an uncertain outcome. Examples: Investment, Roulette, Football Game. Definition: A probability of an outcome (of a lottery) is the likelihood that this outcome occurs. Example: The probability often is estimated by the historical frequency of the outcome. Copyright (c)2014 John Wiley & Sons, Inc. 4 Chapter Fifteen Definition: The probability distribution of the lottery depicts all possible payoffs in | 1 Risk and Information Chapter 15 Copyright (c)2014 John Wiley & Sons, Inc. 1 2 Chapter Fifteen Overview Introduction: Describing Risky Outcome – Basic Tools Lotteries and Probabilities Expected Values Variance Evaluating Risky Outcomes Risk Preferences and the Utility Function Avoiding and Bearing Risk The Demand for Insurance and the Risk Premium Asymmetric Information and Insurance The Value of Information and Decision Trees Chapter Fifteen Copyright (c)2014 John Wiley & Sons, Inc. 3 Chapter Fifteen Tools for Describing Risky Outcomes Definition: A lottery is any event with an uncertain outcome. Examples: Investment, Roulette, Football Game. Definition: A probability of an outcome (of a lottery) is the likelihood that this outcome occurs. Example: The probability often is estimated by the historical frequency of the outcome. Copyright (c)2014 John Wiley & Sons, Inc. 4 Chapter Fifteen Definition: The probability distribution of the lottery depicts all possible payoffs in the lottery and their associated probabilities. Property: The probability of any particular outcome is between 0 and 1 The sum of the probabilities of all possible outcomes equals 1. Definition: Probabilities that reflect subjective beliefs about risky events are called subjective probabilities. Probability Distribution Copyright (c)2014 John Wiley & Sons, Inc. 5 Probability Payoff .80 .70 .60 .50 .40 .30 .20 .10 0 .90 1 $25 67% chance of losing Chapter Fifteen Probability Distribution Copyright (c)2014 John Wiley & Sons, Inc. 6 33% chance of winning Chapter Fifteen Probability Distribution Probability Payoff .80 .70 .60 .50 .40 .30 .20 .10 0 .90 1 $25 $100 67% chance of losing Copyright (c)2014 John Wiley & Sons, Inc. 7 Chapter Fifteen Expected Value Definition: The expected value of a lottery is a measure of the average payoff that the lottery will generate. EV = Pr(A)xA + Pr(B)xB + Pr(C)xC Where: Pr(.) is the probability of (.) A,B, and C are the payoffs if outcome A, B or C occurs.
