Thursday’s Finance 4335 class meeting will be devoted to a math tutorial, and next week we will devote our attention to various topics in probability and statistics that are important for Finance 4335. The week following, we will begin to delve into a wide array of risk management topics.
The first risk management topic in Finance 4335 is decision theory, which addresses decision making under risk and uncertainty. Risk management lies at the very heart of decision theory. However, in order to manage risk, we need to measure risk, which is why next week’s tutorial on probability and statistics is quite important.
Initially, we’ll focus our attention upon variance as our risk measure. Most basic finance and economics models implicitly or explicitly assume that risk = variance. We’ll learn that while this is a reasonable assumption to make under some circumstances, other circumstances exist where it is not appropriate. Furthermore, since individuals and firms are typically exposed to multiple sources of risk, we need to take into consideration the portfolio effects of risk. To the extent to which risks are not perfectly positively correlated, this implies that risks often “manage” themselves by canceling each other out. Thus the risk of a portfolio is typically less than the sum of the individual risks which comprise the portfolio.
The decision theory provides us with a very useful framework for thinking about concepts such as risk aversion and risk tolerance. The calculus comes in handy by providing an analytic framework for determining “optimal” exposure to risk. More specifically, the calculus helps us determine how much risk we hold onto and how much risk we transfer to others. Such decisions occur regularly in our daily lives, encompassing all sorts of practical problems such as deciding 1) how to allocate assets in a 401-K or IRA, 2) whether to insure our health, life, and property, 3) whether to work for a startup or an established business, and so forth. There’s also quite a bit of ambiguity when we make decisions without complete information, but this course will at least help you think critically about costs, benefits, and trade-offs related to decision-making whenever you encounter risk and uncertainty.
After decision theory, the next risk management topic is the demand for insurance, which will be covered just prior to the first midterm exam in Finance 4335. This topic showcases the application of decision theory to a very practical problem that we all face in our lives; specifically, under what circumstances does it make sense to insure risk, and how do real-world contract features (such as coinsurance, deductibles, upper limits, etc.) affect our welfare.
After the first midterm, we’ll move on to other topics including asymmetric information, portfolio theory, capital market theory, option pricing theory, and corporate risk management.