Uncertainty

UNCERTAINTY
CHOICES IN AN UNCERTAIN ENVIRONMENT

RISK AND UNCERTAINTY
Ordinary meaning:
UNCERTAINTY unpredictable, immeasurable and
uncontrollable outcome
RISK is a consequence of action taken in spite of
uncertainty
Economic meaning:
Frank Knight (1921)
RISK is measurable uncertainty; UNCERTAINTY is
immeasurable outcome
RISK AND UNCERTAINTY
Business (D. Hubbard, 2007)
Uncertainty: existence of more than one possibility;
"true" outcome/state/result/value is not known. It is
measured by a set of probabilities assigned to a set
of possibilities.
Risk: A state of uncertainty where some of the
possibilities involve a loss or undesirable outcome. It
is measured by probabilities associated the
outcomes and value of loss
EXPECTED UTILITY
PROBABILITY refers to relative frequency with

which an event occurs.
EXPECTED VALUE refers to (weighted) average

outcome of an uncertain event.
Example: A gamble involving 60% chance of winning
P100 and 40% chance of losing P100
Expected value = 0.6 (100) + 0.4 (-100) = 20
EXPECTED CHOICE
Suppose there are possible outcomes (events):

Status quo, with income of P100
Win P50
Lose P50
Expected utility
EU = p1u(100)+ p 2u(150)+ p 3u(50)

INDEPENDENCE assumption: choices that an
individual plans in one event is independent
from the choices that he plans to make in other
events.
ATTITUDE TOWARDS RISK
A consumer has P100 now and is contemplating a gamble
that gives a 50% probability of winning P20 and 50%
probability of losing P20.
Expected value of income
EV = (0.5) (120) + (0.5) (80) = 100
Expected utility
EU = (0.5) u(120) + (0.5) u(80)
RISK AVERSE : u( EV) > EU

RISK LOVER : u (EV) < EU
RISK NEUTRAL : u(EV) = EU
RISK AVERSE
UTILITY
U3 = EXPECTED UTILITY
U1 U2 = UTILITY AT EV
U2
U3 U(EV) > EU
U4
80 100 120 INCOME

RISK AVERSE
UTILITY
GAMBLE 1: 50% WIN OF P20;
50% LOSS OF P20

U3 50% LOSS OF P50
U5
50 80 100 120 150 INCOME

RISK AVERSE
UTILITY
50% LOSS OF P20

U3 50% LOSS OF P50
U5
75 85
50 80 100 120 150 INCOME
RISK LOVER
UTILITY
U2 = UTILITY AT EV
U(EV) < EU
U1
U2
INCOME
80 100 120
RISK NEUTRAL
UTILITY
U2 = UTILITY AT EV
U(EV) = EU
U2 = U1
INCOME
80 100 120
REDUCING RISK AND UNCERTAINTY
Insurance
Diversification
Flexibility
Information
INSURANCE
UTILITY
Suppose Joey has P150.
He faces a 50-50 chance
of losing P100.
U2
FAIR INSURANCE
U1 Premium 50
Joey is willing to pay up
to P75 in premium.
75
50 100 150 INCOME
INSURANCE
UNINSURABLE RISK
Risk is unique and difficult to evaluate
Buyer and seller of insurance have different
assessments of risk
ADVERSE SELECTION : those who expect large losses
buy insurance, while those expecting small losses
MORAL HAZARD : insurance makes people more
likely to incur losses
DIVERSIFICATION
Suppose Joey has P35,000 now, of which P15,000
may be invested in stocks. Each stock costs P1.
Investors believe that the stock value can increase
to P2 if the company performs well next year, but it
can be worthless if the company performs poorly.
Each company has a 50-50 chance of doing well.
If all P15,000 are invested in one stock:

EV = .5 (50,000) + .5 (20,000) = 35,000
DIVERSIFICATION
If P7,500 is invested in company J and P7,500 in

company B:
Company B
Poor Good
Company J Poor 20,000 35,000
Good 35,000 50,000
EV = .25 (20000) + .5 (35,000) + .25 (50,000)

= 35,000
DIVERSIFICATION
UTILITY
U1 undiversified
U2 diversified
Y
U2 Z
U1
X W
20 35 50 INCOME
FLEXIBILITY
Joey is attending a party but is unsure whether the

proper attire is casual or formal.
Casual Formal
Long sleeves 150 0
Barong Tagalog 100 100
Coat & Tie 0 150
FLEXIBILITY
OPTION is a financial contract offering the right, but

not the obligation, to buy or sell an asset over a
specified period.
Attributes:
Underlying transaction
Period during which it may be exercised
Price
FLEXIBILITY
Suppose JRB stock sells for P25 now. There is a 50-50

chance that it could become either P30 or P20 next
month.
Option to buy JRB stock at P27 next month
How is the price of the option affected by the ff.?

An increase in the current price of JRB stock from P25 to
P27
There is now a 50-50 chance that JRB stock could sell for
either P32 or P18
An increase in the strike price of the option from P27 to
P28

Uncertainty

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UNCERTAINTY

CHOICES IN AN UNCERTAIN ENVIRONMENT

PROBABILITY refers to relative frequency with

EXPECTED VALUE refers to (weighted) average

Suppose there are possible outcomes (events):

EU = p1u(100)+ p 2u(150)+ p 3u(50)

RISK AVERSE : u( EV) > EU

80 100 120 INCOME

GAMBLE 2: 50% WIN OF P50;

50 80 100 120 150 INCOME

GAMBLE 2: 50% WIN OF P50;

If all P15,000 are invested in one stock:

If P7,500 is invested in company J and P7,500 in

EV = .25 (20000) + .5 (35,000) + .25 (50,000)

Joey is attending a party but is unsure whether the

OPTION is a financial contract offering the right, but

Suppose JRB stock sells for P25 now. There is a 50-50

How is the price of the option affected by the ff.?

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