Chapter 5 Choice Under Uncertainty
Chapter 5 Choice Under Uncertainty
Topics to be Discussed ■ Describing risk Preferences Toward risk ■ Reducing risk a The Demand for Risky Assets Chapter 5 Slide 2
Chapter 5 Slide 2 Topics to be Discussed ◼ Describing Risk ◼ Preferences Toward Risk ◼ Reducing Risk ◼ The Demand for Risky Assets
Introduction a Choice with certainty is reasonably straightforward a How do we choose when certain variables such as income and prices are uncertain (i.e. making choices with risk)? Chapter 5 Slide 3
Chapter 5 Slide 3 Introduction ◼ Choice with certainty is reasonably straightforward. ◼ How do we choose when certain variables such as income and prices are uncertain (i.e. making choices with risk)?
Describing Risk a To measure risk we must know 1)All of the possible outcomes 2) The likelihood that each outcome will occur(its probability) Chapter 5 Slide 4
Chapter 5 Slide 4 Describing Risk ◼ To measure risk we must know: 1) All of the possible outcomes. 2) The likelihood that each outcome will occur (its probability)
Describing Risk a Interpreting Probability The likelihood that a given outcome will occur Chapter 5 Slide 5
Chapter 5 Slide 5 Describing Risk ◼ Interpreting Probability ⚫ The likelihood that a given outcome will occur
Describing Risk a Interpreting Probability Objective Interpretation o Based on the observed frequency of past events hapter 5 Slide 6
Chapter 5 Slide 6 Describing Risk ◼ Interpreting Probability ⚫ Objective Interpretation ◆Based on the observed frequency of past events
Describing Risk a Interpreting Probability Subiective Based on perception or experience with or without an observed frequency Different information or different abilities to process the same information can influence the subjective probability Chapter 5 Slide 7
Chapter 5 Slide 7 Describing Risk ◼ Interpreting Probability ⚫ Subjective ◆Based on perception or experience with or without an observed frequency ⚫ Different information or different abilities to process the same information can influence the subjective probability
Describing Risk ■ Expected Value The weighted average of the payoffs or values resulting from all possible outcomes The probabilities of each outcome are used as weights .Expected value measures the central tendency the payoff or value expected on average Chapter 5 Slide 8
Chapter 5 Slide 8 Describing Risk ◼ Expected Value ⚫ The weighted average of the payoffs or values resulting from all possible outcomes. ◆The probabilities of each outcome are used as weights ◆Expected value measures the central tendency; the payoff or value expected on average
Describing Risk ■ An Example Investment in offshore drilling exploration o Two outcomes are possible Success-the stock price increase from $30 to $40/share .Failure --the stock price falls from $30 to $20/share Chapter 5 Slide 9
Chapter 5 Slide 9 Describing Risk ◼ An Example ⚫ Investment in offshore drilling exploration: ⚫ Two outcomes are possible ◆Success -- the stock price increase from $30 to $40/share ◆Failure -- the stock price falls from $30 to $20/share
Describing Risk ■ An Example Objective Probability +100 explorations, 25 successes and 75 failures Probability(Pr) of success 1/4 and the probability of failure 3/4 Chapter 5 Slide 10
Chapter 5 Slide 10 Describing Risk ◼ An Example ⚫ Objective Probability ◆100 explorations, 25 successes and 75 failures ◆Probability (Pr) of success = 1/4 and the probability of failure = 3/4
