Bus. Fin. 640_Class 1

Bus. Fin. 640_Class 1 - Class 1: Introduction Insurance and...

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Class 1: Introduction Insurance and Risk Management George D. Krempley Bus. Fin. 640 Autumn 2007

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Expected value rule Holds that: In an uncertain situation, human beings will select the alternative with the highest expected value. Does it work? Does it account for human behavior? Can we use it to predict our decisions under conditions of uncertainty?
Expected Value EV = P X Where: EV = the expected value of the outcome P = the probability of outcome, X X = the outcome in money value = “the sum of”

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Expected Value Rule: Prediction Everyone will always and everywhere invest in the stock market. Why? “In an uncertain situation, human beings will select the alternative with the highest expected value.” Does this hold?
Petersburg Paradox 18th century Swiss mathematician and physicist, Daniel Bernoulli Showed how the expected value rule regularly breaks down.

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Consider the following One player flips a fair coin If coin lands heads, the player will pay the other player \$2.00. If the coin lands tails, it is tossed again. If the second toss heads, the first player plays the second player (\$2.00) and the game is over. 2
Consider…(cont.) The game is continued until the first head appears. The first player pays the second player: (\$2.00) i Where i equals the number of tosses required to get the first head. How much will the second player being willing to pay to enter the game?

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Consider… Seldom is anyone willing to pay more than \$10.00. But, the game has an infinite value 2200∑ P i i X i i = (2)(½) + (2)²(½)² + (2)³(½)³… = 1 + 1+ 1+… = Infinity
The Question Why will people only pay a few dollars to enter a game that has an infinite value? Risk matters!

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Implication Risk is present: Whenever circumstances give rise to an outcome that cannot be predicted with certainty “Not knowing” the future creates risk.
Definition of Risk Risk is defined as uncertainty concerning the occurrence of a loss

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Items To Be Discussed Meaning of Risk Chance of Loss Peril and Hazard Basic Categories of Risk Types of Pure Risk Burden of Risk on Society Methods of Handling Risk Standard Deviation Pooling
Meaning of Risk Risk : Uncertainty concerning the occurrence of a loss Objective Risk vs. Subjective Risk Objective risk is defined as the relative variation of actual loss from expected loss It can be statistically calculated using a measure of dispersion, such as the standard deviation Subjective risk is defined as uncertainty based on a person’s mental condition or state of mind Two persons in the same situation may have different perceptions of risk High subjective risk often results in conservative behavior

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Chance of Loss Chance of loss : The probability that an event will occur Objective Probability vs. Subjective Probability Objective probability refers to the long-run relative frequency of an
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This note was uploaded on 11/20/2011 for the course FINANCE 640,722 taught by Professor Chabiyo,reeves during the Fall '11 term at Ohio State.

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Bus. Fin. 640_Class 1 - Class 1: Introduction Insurance and...

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