Topic14_Uncertainty

# F f f if a manager is worried about being fired if

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f f f If a manager is worried about being fired if the firm makes losses, she may avoid risk (even if doing so lowers firm’s expected profits doing so lowers firm s expected profits. That means the manager is willing for the firm to pay risk premium to avoid extreme risk to pay risk premium to avoid extreme risk. 26

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Ri k Attit d f M Risk Attitude of Managers If managers compensation is based on short If managers compensation is based on short term profits and if they can walk away in the event of bad outcomes, they may prefer risk. event of bad outcomes, they may prefer risk. Shareholders might want managers not to take risk of suffering loss take risk of suffering loss. This is specially true if bankruptcy imposes a large costs on the share holders large costs on the share holders. 27
Q i 1 Quiz 1 Natasha has utility function U = 5(I) 1/2 where where I is weekly income. a) Natasha is risk ne tral Natasha is risk neutral. b) Natasha is risk lover. c) Natasha is risk averse. d) She could be risk lover of risk averse depending on the situation. e) None of the above. 28

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Q i 2 Quiz 2 Vivian is offered a prospect that gives her 1600 with Vivian is offered a prospect that gives her 1600 with p=0.1, 2500 with p = 0.4 and 3600 with p=0.5. Her U = Y and so EU = 0.1 1600 + 0.4 2500 + 0 5 3600 54 Whi h f th f ll i i t ? 0.5 3600 = 54. Which of the following is true? a) The certain income that would give the same utility as this prospect is 54 2 = 2916 = 2916. b) The risk premium is 2960 - 2916 = \$44. c) Both a and b Both a and b. d) None of the above. 29
A idi Ri k Avoiding Risk Consumers are generally risk averse and Consumers are generally risk averse and therefore want to reduce risk (whether the bet is fair or biased against them). Risk neutral people avoid unfair bets that is against them. For example: if you receive \$2 if heads but lose \$4 if tails, then E(X) = - 1. A risk neutral person avoids this bet. Even risk preferring people avoid very unfair bets. 30

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A idi Ri k Avoiding Risk You can avoid risk by just by saying “NO” You can avoid risk by just by saying NO to risky activities (such as buying a lottery, investing in a start up firm). Even when you cannot avoid risks altogether, you can take precautions: maintain your car as recommended by manufacturer, lock your door, install fire alarm, and buy a product with warranty, etc. 31
A idi Ri k Avoiding Risk Some ways to reduce risks: 1. Diversification or risk pooling 2. Buy Insurance 3. Obtain more information: before buying a refrigerator, you can read a consumer report to determine how often a ti l b d i lik l t b k d particular brand is likely to break down. 32

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Di ifi ti Diversification Diversification: “don’t put all your eggs in one basket.” Reducing risk by allocating resources to a variety of activities whose outcomes are not closel related not closely related. Diversification can eliminate risk if two t f tl ti l l t d events are perfectly negatively correlated.
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