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Monday, March 12, 2007

Randomness and risk

This article in HET discusses the concepts of risk and uncertainty in economics.

Much has been made of Frank H. Knight's (1921: p.20, Ch.7) famous distinction between "risk" and "uncertainty". In Knight's interpretation, "risk" refers to situations where the decision-maker can assign mathematical probabilities to the randomness which he is faced with. In contrast, Knight's "uncertainty" refers to situations when this randomness "cannot" be expressed in terms of specific mathematical probabilities.

Apart from this distinction - which can be disputed - there is also a difference between objective and subjective probabilities. Only with the work of von Neumann and Morgenstern was uncertainty formalised in the utility framework. From here it's only a small step to modern risk management in which once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories: (Dorfman, 1997)
  • Tolerate (aka retention)
  • Treat (aka mitigation)
  • Terminate (aka elimination)
  • Transfer (aka buying insurance)

In financial risk management the measure of value-at-risk is often used. VaR is the maximum amount at risk to be lost from an investment (under 'normal' market conditions) over a given holding period, at a particular confidence level. This is shown in the graph below.

















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