Lecture 25

# Lecture 25 - Brian Rodriguez James Le Mon 1:00-1:50 Mon...

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1 Fri 1:00-1:50 Wed 12:00- 12:50 Tues 8:00-8:50 Mon 4:00-4:50 Mon 3:00-3:50 Mon 1:00-1:50 016 038 034 024 138 137 Gina Russell Cynthia Wu Sam Dastrup Iveel Lonjid James Le Brian Rodriguez Enter the 3-digit TA code in the “Exam Number” boxes Chapter 19: Uncertainty and information A. Risk and expected value B. Risk neutrality and risk aversion C. Private information D. Insurance markets E. Market for loans F. Managing risk in financial markets Suppose you can invest \$100,000 in one of two projects. –Each project promises you an equal chance of \$50,000 profit or a \$25,000 loss. –The expected return on each project is (\$50,000 × 0.5) + (–\$25,000 × 0.5), which is \$12,500. Diversified •Invest 50 percent of your money in Project 1 and 50 percent in Project 2.

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2 The four possibilities are – 1. Lose \$12,500 on each project and your return is a loss of \$25,000. – 2. Earn \$25,000 on Project 1 and lose \$12,500 on Project 2 and your return is \$12,500. – 3. Lose \$12,500 on Project 1 and earn \$25,000 on Project 2, and your return is \$12,500. – 4. Earn \$25,000 on each project, and your return is \$50,000. –Your expected return is now (-\$25,000 × 0.25) + (\$12,500 × 0.25) + (\$12,500 × 0.25) + (\$50,000 × 0.25) = –\$6,250 + \$3,125 + \$3,125 + \$12,500 = \$12,500. By diversifying your portfolio of assets, you have maintained an expected return of \$12,500. But you have lowered the chance that you will earn \$50,000 from 0.5 to 0.25. –You have also lowered the chance that you will lose \$25,000 from 0.5 to 0.25. –And you have increased the chance that you will earn your expected return of \$12,500 from 0 to 0.5. That diversification reduces risk is an implication of the law of large numbers 10 1 10 2 10 3 10 4 10 5 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Number of observations Fraction of successes
3 How to play the stock market and walk away with a small fortune Start with a big fortune Suppose instead I’d claimed to have found the following pattern Average stock price 85 90 95 100 105 110 Monday Tuesday Wednesday Thursday Friday Then you should sell on Tuesdays at 105 Buy on Wednesdays at 95 Sell on Thursdays at 105 Average stock price 85 90 95 100 105 110 Monday Tuesday Wednesday Thursday Friday But if people follow this advice, it would make the price on Tuesday lower than 105 And it would make the price on Wednesday higher than 95 And reduce the price on Thursday Average stock price 85 90 95 100 105 110 Monday Tuesday Wednesday Thursday Friday

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4 • Efficient markets theory: there should be no predictable movements in stock prices • The change on Tuesday should be driven by Tuesday news that was impossible to predict on Monday Managing Risk in Financial Markets –So an efficient market has two features: –1. Its price equals the expected future price and embodies all the available information. –2. No
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## This note was uploaded on 03/21/2009 for the course ECON 2 taught by Professor Kim during the Spring '08 term at UCSD.

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Lecture 25 - Brian Rodriguez James Le Mon 1:00-1:50 Mon...

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