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Risk and Uncertainty for Fun and for Profit

Risk and Uncertainty for Fun and for Profit. Risk = “Objective Uncertainty” You know the probabilities of all the outcomes Uncertainty = “Subjective Uncertainty” You don’t know the probabilities of the outcomes Ambiguity You don’t know all the outcomes. Our Objective.

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Risk and Uncertainty for Fun and for Profit

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  1. Risk and Uncertainty for Fun and for Profit • Risk = “Objective Uncertainty” • You know the probabilities of all the outcomes • Uncertainty = “Subjective Uncertainty” • You don’t know the probabilities of the outcomes • Ambiguity • You don’t know all the outcomes

  2. Our Objective • Understand securitization • Selling shares in risky ventures • Understand insurance • Placing losing bets • Understand futures markets • Lock in current prices • Offset potential losses

  3. How to Decide Maximize Expected Monetary Value (EMV) • The house does • You’ll win on average • You’ll win in the long – run • … but you may not survive the long – run EMV = p1 X1 + p2 X2 + … + pn Xn

  4. How to Decide Maximize Expected Utility (EU) same as EMV when risk – neutral • But most folks are risk – averse • Some folks are risk – seeking EU = p1U(X1)+ p2U(X2)+ … + pnU(Xn) Must elicit decision – maker’s utility function

  5. Reasons it won’t work …well • Framing effects • Zero illusion • Subjective uncertainty • Ambiguity • Certainty effect • Mean/variance tradeoff • Overweight small probabilities: go for broke! • Portfolio effects • Utility of gamble depends on what else you own • Temporal resolution of uncertainty • When you learn outcome matters • Uncertainty hurts • Decision – maker doesn’t bear all risks Ignore these and proceed!

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