Introduction, Uncertainty and

Risk Management
Gabriella Chiesa

Introduction
macroeconomic definitions
Saving
Consume less than your current resources
So as to have more resources in the future
Investment
Put current resources to a productive use (e.g.
build factories,..)
So as to produce more resources in the future

Financial Autarky
Autarky = self-sufficiency (no market access)
For an invidual (or an economy) in autarky:

Saving = Investment
Example a castaway on a tropical island

Roles of Financial Markets

Financial markets aloow for a separation of
Saving decisions
Investment decisions
*** distribute/channel resources from savers to
entrepreneurs/real investment
If you want to save: you dont need to create an enterprise
and invest on your own;
If you want to invest (for example, because you have a great
business idea): you dont need to come up with all the
money on your own .. and bear all risks

Roles of Financial Markets

Consumption timing intertemporal allocation
of resorces;
Risk Allocation ;
Information role of market prices: Aggregation
and trasmission of information

Real Assets and Financial Assets

Entrepreneurs: use current resources to create
productive capita, which will produces resources in
the future
Investe in real assets (e.g., factories..)
Savers: buy claims on these future resources
(securities) from entrepreneurs:
Invest in financial assets, e.g. stocks, bonds, =
central focus of finance
Financial markets create financial assets
=
claims on real assets

Classes of Financial Assets

a) Fixed income securities (or debt)
- money market : maturity up to 1 year (e.g.,
deposits, debt securities with maturity < 1 year)
- bond market: maturity >1 year
b) Stocks (or Equity)
c) Derivatives (Options, Credit Default Swaps)
b),c) management of the risk which nested in real
activity
a) liquidity

Financial Intermediaries
Difficult for small households to interact with
Corporations that need finance and/or with
Sovereign States that require fundings
Financial Intermediaries:
bring borrowers (businesses) and lenders
(households) together:
- pool savings from households (e.g. deposits)
- diversify risk by lending to many businesses
(companies, Sovereign States,..)
- have expertise in screening, monitoring of
borrowers...

The Investment Process

Portfolio: collection of all assets of an investor

Asset Allocation: decision/choice of what asset

classes to invest in (debt, equity,...)
Security selection: choice of what individual
securities to pick within these asset classes (e.g.
Google, Apple, CocaCola,ENI,)

Players in Financial Markets

Business firms require fundings
households save: provide fundings
Sovereign States (Governments) require
fundings, but few save (China, Oil exporters
Germany,....)
Financial Intermediaries:
- Banks
- Investment Companies
- Pension Funds
- Insurance Companies

Savers
depositors

BANKS

Debtors
and
Creditors

Borrowers
Firms
(real
investment)

Final investors :
Households
Foreign central Bks
Sovreign funds

Intermediaries:
Banks
Investment funds
Pension Funds
Venture Capitalists
Insurance companies
Hedge funds

Debtors
Creditors
and interconnected

firms
households
subprime..

Dealing with Risk

-Risk Management-

Decisions under uncertainty

Financial decisions/choices have intertemporal
nature. To day financial decisions produce
consequences in the future:
Financial choices/investments are decisions
taken under uncertainty.
The understanding of financial phenomena
requires understanding the basic principles
that underline the decision process under
uncertainty

Choosing an action = choosing a

probability distribution
How does an individual choose between
probability distributions (lotteries)?
Expected Utility Theory:
Given two lotteries:
P1 =(x1,x2, xn; p11, p21,..pn1)
P2 =(x1,x2, xn; p12, p22,..pn2)
P1 > P2 if
u(xi)pi1 > u(xi)pi2
u(xi)pij is the expected utilities of the lottery PJ

Expected Utility
u(xi)pij also expressed as:
E(u()|P
J)
Expected utility is the mathematical expectation
of the utilities assigned to the realizations of
random variable
Is the weighted average of the utilities that
an agent assigns to the realizations of random
payoffs, where the weights are the probabilities
that any particular outcome xi will occur.

Example 1
Individual with util. function u(x)= x , chooses at
t=0 between two actions whose payoffs will
realize at t=1:

actions

S1 pr. 1/2

S2 pr 1/2

a1
a2

300
100

0
100

Which action will he choose?

a1 if : (0,5)300 > 100
NOT verified: preferred actions: a2

With u(x)= x
a1 if: 0,5(300) > 100 : verified

Whats the difference between u(x)=x and

u(x)=x??
Both funcions are increasing in x the first
derivative is positive;
but x is concave the second derivative is
negative
Concavity matters (concavity risk aversion)

Example 2
Individual with u(x)=x and wealth 100. Can choose
between:
real investment project which requires 100 a t=0 and
generates an uncertain payoff at t = 1:
S2 (pr. )
s1 (pr )
300

riskless asset: each unit invested at t = 0, gives one unit

for sure at t = 1.
What will he choose?
(the matrix of the consequences is the same as that of the
example 1): he will choose the riskless asset he will not
take the real investment project

Example 3: fractioning the risk

u(x)=x ; W=100, choice between:
a) r.i.project that requires 100/n at t = 0, with
an uncertain payoff at t = 1:
S1 (pr. )
300/n

S2 (pr )
0

b) riskless asset: each unit invested at t = 0,

gives one unit for sure at t = 1

What will he choose?

One can show that if n > 9/8 , the r.i. Project is
undertaken
Hint:
actions

S1 (pr. )

S2 (pr. )

a1:Project and the

remaining
resources in the
riskless asset

(300/n)+
(100- 100/n)

100 100/n

a2: everyting in the 100

riskless asset

100

Undertakes the project if:

0,5 (300/n + 100 100/n)1/2+0,5 (100 -100/n)1/2
>1001/2
Which holds for n > 9/8 (two shareholders are
enogh for real investm to take place)

Conclusion
This means that if the project is fractioned
between investors in number n > 1, then the
optimal (utility maximizer) choice by the
individual is to undertake the risky project,
that is: invest 100/n in the project (the risky
activity) , and the remaining in the riskless
asset. If the project is not fractioned, that is if
n = 1, then the optimal choice is not to take
the project and invest exclusively n the riskless
asset.

Fractioning the risk

It modifies the variance of the payoff that
accrues to the investor :
Var(|a
1) = Var(/n)
= Var ()/n
2

For n, the var of the payoff 0

Risk Aversion
And
Certain Equivalent

Risk Aversion
Concavity of the utility function
u''(x)
RA ( x) =u'(x)
u(x)
u'(x) =
x
u'(x)
u'' ( x) =
x

RA(x)
Is a measure of the degree of concavity of u(x);
RA(x) is also named absolute risk aversion.
If the u(x) is strictly concave; that is, the
marginal utility is decreasing (as, for example
u(x) = x), then RA(x) > 0
there is a relation between the concavity of
the utility function of an individual and his risk
attitude.

Certain Equivalent
The certain equivalent of a probability distribution (or,
lottery) P is the value CEP that satisfies:
u(CEP) = E(u()|P)

(1)
The certain equivalent of a lottery P is the payoff value
CEP that given to the individual with certainty provides
the individual with a utility level, u (CEP ), identical to
the utility assigned to the lottery P , that is E (u()|P

):
individual is indifferent between having the sum CEP
with certainty and the probability distribution P (that
is, the uncertain payoffs provided by the lottery P).

Certain Equivalent
CEP is the reserve price of the lottery P
the maximum price the individual is willing to
pay for the lottery P
Note that: The Certain Equivalent of the same
lottery P can differ between individuals. It
differs whenever different individuals have
different utility functions.

Concavity of the utility function and risk attitude

One can prove that the Certain Equivalent of a
lottery P (that is, the solution to eq (1)) can be
proxied with a function of the expected value of
the lottery,
E(x|P), the variance of the lottery, Var(x|P), and
the absolute risk aversion:

()

1
CEP E(x | P) - RA x Var(x | P)
2
xE(x | P)

()

u''(x)
RA x u' x

()

()

1
CEP E ( x | P) - RA x Var ( x | P)
2

i) If the utility function is strictly concave, u(x) < 0, then

the Certain Equivalent (reserve price) of the lottery is
smaller than the expected value of the lottery E(x|P).
The more so, the higher the variance, Var(x|P), and the
greater the individuals risk aversion RA(..);
ii) If the utility function is linear, that is if u(x) = 0, then
the Certain Equivalent (the reserve price) of the lottery
equals the expected value of the lottery E(x|P);
iii) If the utility function is convex, that is if u(x) > 0, than
the certain equivalent (reserve price) of the lottery
exceeds the expected value of the lottery E(x|P).
Occjio! CE=E(X)-1/2 R...
ma anche u(CE)=u(E(x)! sono due concetti diversi! quindi
giustamente il valore per cui ti sta bene fare la lotteria che ti sta
bene quanto a utilit minore del valore expected della lotteria,
proprio perch ha peso la risk adversion!

negative exponential utility function

u( x) = -e-bx ,b > 0
We have that:

RA ( x) -

u''(x)
= b,"x
u'(x)

That is, risk aversion is constant . The certain equivalent

is :

1
CEP E(x | P)- bVar(x)(2)
2

negative exponential utility function

and

Normal Distribution
If the utility function is a negative exponential,
and the distribution of the random variable x
is a Normal distribution, then the solution of
equation (1) is given exactly by the right hand
side of (2), that is (2) is not an approximation
but the exact definition of the Certain
Equivalent.

Indifference Curves

Stochastic Dominance
Two risky activities: A, B. When can we say that
any rational individual (prefers more to less)
who is risk averse prefers A to B?
The key to answer this question is the concept
of stochastic dominance

Stochastic Dominance
Lottery A dominates lottery B if
E(rA ) > E(rB ) and 2 < 2
2 = Var(rA) , 2 = Var (rB)
With at least one inequality holding strictly

Any individual that chooses between lotteries on the basis

of the expected utility, prefers A to B no matter his risk
attitude.
For any individual, the CE of lottery A is greater than that of
lottery B:
A will bring the individual on a higher indifference curve --