204_summer_2009_lecture_23

204_summer_2009_lecture_23 - University of Toronto...

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University of Toronto Department of Economics ECO 204 Summer 2009 Sayed Ajaz Hussain Lecture 23 1 S. Ajaz Hussain. [email protected]
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Last Time Probability: 3 interpretations and rules Criteria for decision making under uncertainty Expected Value Is crime “rational”? Expected Utility Attitudes towards Risk Certainty Equivalence Deriving utility function S. Ajaz Hussain. [email protected] 2
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Today Risk Premium Avoiding Risk Insurance Actuarially fair insurance Credit default swaps Interest rate swaps Decision making under uncertainty Perfect tests Imperfect tests Value of information S. Ajaz Hussain. [email protected] 3
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S. Ajaz Hussain. [email protected] 4 Risk Premium (RP) Utility $X X 1 X 2 U(X 2 ) U(X 1 ) EV U(EV) CE RP EU Risk premium maximum amount you’ll pay to avoid risk minimum amount you’ll want to face risk
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S. Ajaz Hussain. [email protected] 5 Example 1: Risk Premium (RP) Utility $X 10 30 U(X 2 ) U(X 1 ) 20 U(EV) 16 4 EU You face income gamble (30,10; ½ , ½). How much money would you forego to avoid uncertainty? Risk premium maximum amount you’ll pay to avoid risk
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S. Ajaz Hussain. [email protected] 6 Example 2: Risk Premium (RP) Utility $X 10 30 U(X 2 ) U(X 1 ) 20 U(EV) 16 4 EU You have 16 for certain.
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