Chapter 21 Flashcards
(25 cards)
random variable
A variable with an uncertain future value
expected value
The weighted average of all possible values, where the weights on each possible value correspond to the probbility of that value occurring
State of the world
A possible future event
Risk
Uncertainty about future outcomes
When the uncertainity is about monetary outcomes, it becomes financial risk
financial risk
When uncertainty about monetary outcomes exists
expected utility
The expected value of an individual’s total utility given uncertainty about future outcomes
premium
A payment to an insurance company in return for the insurance company’s promise to pay a claim in certain states of the world
Fair insurance policy
An insurance policy for which the premium is equal to the expected value of the claim
Risk-averse
Individuals will choose to reduce the risk they face when that reduction leaves the expected value of their income or wealth unchanged
Risk-neutral
A person who is completely insensitive to risk
capital at risk
The funds that n insurer places at risk when providing insurance is called the insurer’s capital at risk
efficient allocation of risk
An allocation of risk inwhich those who are most willing to bear risk are those who end up bearing it
independent events
Two possibl events are independent if each of them is neither more nor less likely to happen if the other one happens
diversification
Investing in several different things, so that the possible losses are independent events
Share
A company is a partial ownership of that company
Pooling
A strong form of diversification in which an investor takes a small share of the risk in many independent events. This produces a payoff with very little total overall risk
positively correlated
When each event is more likely to occur if the other event also occurs
private information (asymmetric information)
Information that some people have that others do not
adverse selection
When an individual knows more about the way things are than other people do.
Private information leads buyers to expect hidden problems in items offered for sale, leading to low prices and the best items kept off the market
Screening
Using observable information about people to make inferences about their private information
reduces adverse selection
signaling
Revealing private information through actions that credibly reveal what they know
reduces adverse selection
ex. used car companies offering large waranties
Reputaiton
Allows an individual to reassure others that he or she isn’t concealing adverse private information
Moral hazard
Occurs when an individual knows more about his or her own actions than other people do.
Leads to a distortion of incentives to take care or to exert effort when someone else bears the costs of the lack of care or effort
Deductible
An insurance policy is a sum that the insured individual must pay before being compensated for a claim
