David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 12 Risk and information
• 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 by 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 of 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 efficient 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 efficiency, 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.
• Information is expensive to produce but very cheap to copy and distribute. From the users' viewpoint,
e-products have four key attributes: experience, overload, switching costs and network externalities.
Experience explains why sellers allow sampling and browsing. Sellers also invest in a good reputation
to reduce the need for buyers to sample. Potential information overload explains why specialist
agents develop to pre-screen material. Switching costs make future opportunities depend on current
choices. Network externalities arise when the value of a network depends on how densely it is
populated.
Review questions
connect
1 A fair coin is to be tossed. If it comes down heads, the player wins £1. If it comes down tails, the
player loses £1. Person A doesn't mind whether or not he takes the bet. Person B will pay £0.02 to
play the game. Person C demands £0.05 before being willing to play. Characterize the three people's
attitude to risk. Which is most likely to take out insurance against car theft?
2 You see an advert for life insurance for anyone over 45 years old. No medical examination is
required. Do you expect the premium rates to be high, low or average? Why?
3 In which of the following are the risks being pooled: (a) life insurance, (b) insurance against the
Thames flooding, (c) insurance for a pop star's voice?
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