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Unformatted text preview: Econ 306 Exam 2 Review Chapter 5 Probability is the likelihood that given outcomes will occur- probability for all events must add up to 1. One objective interpretation relies on frequency with which certain events tend to occur. Subjective probability is the perception that an outcome will occur. The expected value associated with an uncertain situation is a weighted average of the payoff-values associated with all possible outcomes Expected value measures the central tendency-the payoff or value that we would expect on average Expected value=Pr1X1+Pr2X2 Variability is the extent to which the possible outcomes of an uncertain situation differ Deviation is the difference between expected payoff and actual payoff Standard deviation is the square root of the weighted average of the squares of the deviations of the payoffs associated with each outcome from their expected values Standard deviation=Pr1[(X1-E(X))2]+Pr2[(X2-E(X))2] Expected utility is the sum of the utilities associated with all possible outcomes, weighted by the probability that each outcome will occur Risk averse is a condition of preferring a certain income to a risky income with the same expected value-most common attitude toward risk For a risk averse person, losses are more important (in terms of the change in utility) than gains. Risk neutral is a condition of being indifferent between a certain income and an uncertain income with the same expected value The marginal utility of income is constant for a risk neutral person Risk loving is a condition of preferring a risky income to a certain income with the same expected value The risk premium is the maximum amount of money that a risk averse person will pay to avoid taking a risk Risk averse people prefer a smaller variability of outcomes The greater the variability of income, the more the person would be willing to pay to avoid the risky situation All the indifference curves are upward sloping because risk is undesirable, the greater the amount of risk, the greater the expected income needed to make the individual equally well off Diversification is the practice of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related Negatively correlated variables are variables having a tendency to move in opposite directions; whenever sales of one are strong, sales of the other are weak. As long as you can allocate your resources toward a variety of activities whose outcomes are not closely related, you can eliminate some risk-diversification Mutual funds are organizations that pools funds of individual investors to buy a large number of different stocks or other financial assets Positively correlated variables are those having a tendency to move in the same direction (ie. The onset of a severe recession, which is likely to reduce the profits of many companies, may be accompanied by a decline in the overall market). of many companies, may be accompanied by a decline in the overall market)....
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- Spring '06