The Universal Principle of Risk Management: Pooling and the Hedging of Risks – Yale, ECON 252, 2.1
Posted on | January 28, 2009 | 1 Comment
This is synopsis one of two from lecture two of Dr. Shiller’s Yale ECON 252 course: Financial Markets. Go to the ECON 252 link to access all synopses to this point.
Probability theory is extremely important with regards to insurance. The likelihood of an event happening is considered probability theory. The idea originated in the 1600′s when individuals started using life tables to analyze the probability of dying based on age and sex. The word probable was actually used by Shakespeare in describing a young man as trustworthy. In essence, we should trust probability theory.
The concept of insurance was developed in ancient Rome in the form of burial insurance. To have an improper burial was looked down upon by the Romans, so it was important to have some type of insurance on a burial procedure. In 1666, fire insurance was thought to be developed due to the Fire of London. This does not exactly make sense because insurance is the pooling of indepedent probabilities. If the entire city of London caught on fire, all the insurance companies would go bankrupt because they did not pool and hedge their risks indepedently.
It is interesting that some people feel they can influence probability with luck or fortune. Individuals are more willing to bet on a coin flip when they can flip the coin themselves. In all reality, it does not matter who flipped the coin or how many times it was flipped. There is still a .5 probability that it will land on heads. Probabilty is a number between 0 and 1. Zero is defined as something that will never happen while 1 is something that is absolutely going to happen.
The multiplication rule states that if the variables are independent, the probability will be the product of the events. In other words, if event A is .25 and event B is .25, the likelihood of A and B is .25 times .25. This is the basis for insurance companies. It is highly unlikely that every single car they insure will have an accident, therefore they are hedging their risks by multiplying the likelihood of a single accident.
The expected value of an event is actually the mean as shown in the equation below:
The most important thing to know about expected values is that one must know the true probabilities to get the correct expected value. Another important average is the geometric average. Jeremy Seigel actually believes that the geometric average should be used to analyze the performance of stock returns. The geometric average is less optimistic as it does not divide by the number of occurances, but the nth root of the resulting product. In laymen’s terms, it is less optimistic as it is not simply an average.
To explain this consider your mortgage broker. He claims to have an average of gaining 12% on the stock market over the last 10 years. Well, that can be a swayed statistic. What if he did great for nine years and lost it all last year? You would have NOTHING to show for the previous returns, but the average is still 12%. Wall Street does not use geometric averages because it is much less optimistic and it is their job to sell financial plans.
Variance is the average of the squared distance of the expected value. The higher the variance, the less predictable an event will be. Investors want to have high returns with low variance because ultimately variance is risk. If an investor has returns of 8%, 27% and -6%, then they would have very high variance or risk. Many cannot stomach the roller coaster ride of their investments; they would rather see 9%, 10% and 10%. Both would return around 10%, but most would rather put their money in the second set of investments.
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January 29th, 2009 @ 10:22 am
Greetings,
I was wondering if you have heard anything about the Nasdaq’s “PORTAL Alliance”? This consortium of Rothschild-influenced banks was created in November of last year, but there has been a complete media blackout regarding any of its activities since it was created.
When you look at the list of financial institutions and banks that are “members”, everything that has happened in the financial markets since last November (a fascist coup) starts to make one uneasy…
From Forbes.com:
(1744-1812) Meyer Amschel Rothschild:
Meyer Amschel Rothschild helped invent modern banking by introducing concepts such as diversification, rapid communication, confidentiality and high volume. The superlatively discreet foreign-exchange banker diversified from the very beginning, selling antiques and procuring loans. Remarkably, Rothschild was willing to cut into his own profits in order to secure future business.
And, earlier than most, he understood that time and information meant money, and he pulled out all the stops to remain in constant contact with associates across Europe. That network came in handy when he helped finance England\’s war effort during the Napoleonic Wars. Rothschild institutionalized his bank with a far-sighted will that ensured the continuation of his business. Considered a founding father of international finance, his banking empire–thanks to his five sons–had expanded to London, Paris, Vienna and Naples at the time of his death.
Corporate Heirs:
Merrill Lynch (nyse: MER ), Lehman Bros. (nyse: LEH ), Bear Stearns (nyse: BSC ), Goldman Sachs (nyse: GS )…
http://www.forbes.com/business/2005/07/21/rothschild-banking-international-cx_0721bizmanrothschild.html
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PORTAL Alliance:
The founding members of The PORTAL Alliance are: Bank of America, Bear Stearns, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, NASDAQ, UBS and Wachovia Securities.
(see: “PORTAL Alliance” – 144a)
http://biz.yahoo.com/pz/071112/131151.html
http://ir.nasdaq.com/releasedetail.cfm?ReleaseID=275224
http://www.reuters.com/article/companyNewsAndPR/idUSN1245320920071112?sp=true
http://www.portalalliancemarket.com/
Thanks for your time and please continue your work!
JL Wallace