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Managing Risk - MANAGING RISK Risk Aversion o Lets say you...

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MANAGING RISK Risk Aversion o Let’s say, you are offered the following gamble: Toss a fair coin. If heads, you win $1000. If tails, you lose $1000. Should you take this gamble? o If you are risk averse, the pain of losing $1000 would exceed the pleasure of winning $1000, and since both outcomes are equally likely, you should not take this gamble. The Utility Function o Utility is a subjective measure of well-being that depends on wealth. o As wealth rises, the curve becomes flatter due to diminishing marginal utility : the more wealth a person has, the less extra utility he would get from an extra dollar.
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The Utility Function & Risk Aversion o Because of diminishing marginal utility, a $1000 loss reduces utility more than a $1000 gain increases it. The Role of Insurance o A person facing a risk pays a fee to the insurance company, which in return accepts part or all of the risk. o Insurance allows risks to be pooled, and can make risk averse people better off: E.g. , it is easier for 10,000 people to each bear 1/10,000 of the risk of a house burning down than for one person to bear the entire
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