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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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This note was uploaded on 11/15/2010 for the course ECON 306 taught by Professor Cramton during the Spring '06 term at Maryland.
- Spring '06