Risk pervades economic life. Some people gamble for fun,
some addicts gamble in spite of themselves. Most people are risk-averse.
They volunteer to take risks only if offered favourable odds that on average
yield a profit. Conversely, most people insure, despite less
than fair odds, to reduce the risks they otherwise face.
Risk-aversion reflects the diminishing marginal
utility of wealth. A fair gamble in monetary terms yields less extra
utility when it succeeds than it sacrifi ces when it fails. Hence people refuse
fair gambles, except for very small stakes. The prevalence of risk aversion
means that people look for ways to reduce risk, and must pay others to take
over their risk-bearing.
Insurance pools risks that are substantially independent
to reduce the aggregate risk, and spreads any residual risk across many people
so that each has a small stake in the risk that cannot be pooled away.
Insurance markets are inhibited by adverse selection and
moral hazard. The former means that high-risk clients are
more likely to take out insurance; the latter means that the act of insuring
increases the likelihood that the undesired outcome will occur.
Company shares have a higher average return but a much more variable return
than that on Treasury bills or bank deposits.
Portfolio choices depend on the investor’s tastes – the trade-offs
between risk and average return that yield equal utility – and on the
opportunities that the market provides – the risk and return combinations
on existing assets.
When risks on different asset returns are independent, the risk of the whole
portfolio can be reduced by diversification across assets.The risk that an
asset contributes to a portfolio is not measured by the variability of that
asset’s own return but on the correlation of its return with the return
on other assets.
An asset that is negatively correlated with other assets will actually
reduce the risk on the whole portfolio even though its own return is risky.
Conversely, assets with a strong positive correlation with the rest of the
portfolio increase the overall risk. The value of beta for
an asset measures its correlation with other assets.
In equilibrium risky assets earn higher rates of return on average to compensate
portfolio holders for bearing this extra risk. High beta assets have high
returns. If an asset is offering too high an expected return for its risk
class, people will buy the asset, bidding up its price until the expected
return is forced back to its equilibrium level.
In an effcient market assets are priced to reflect the
latest available information about their risk and return. There are no easy
systematic investment opportunities to beat the market unless you systematically
get or use new information faster than other people. Evidence from share prices
is compatible with stock market effi ciency, but speculative bubbles sometimes
occur.
Forward markets set a price today for future delivery
of and payment for goods. They allow people to hedge against
risky spot prices in the future by making a contract today. Speculators
take over this risk and require a premium unless they can match buyers and
sellers.
