Handbook of Critical Issues in Finance

Handbook of Critical Issues in Finance

Elgar original reference

Edited by Jan Toporowski and Jo Michell

This vital new Handbook is an authoritative volume presenting key issues in finance that have been widely discussed in the financial markets but have been neglected in textbooks and the usual compilations of conventional academic wisdom.

Chapter 39: Risk

Tracy Mott

Subjects: economics and finance, financial economics and regulation, post-keynesian economics

Extract

Risk, in economics, has traditionally been taken to be a matter of the variability of a magnitude of wealth or income or of the utility of such a magnitude. To differentiate risk from uncertainty, which also signifies variability, economists have generally followed Frank Knight ([1921] 1985), who defined risk as a situation where the outcomes can be given specific probabilities and uncertainty where specific probabilities cannot be assigned. Knight thus held that risk can be insured against, while uncertainty cannot. A situation where either risk or uncertainty, as so defined, exists, however, cannot be one of certainty, so one might ask whether Knight’s distinction is one of degree or difference. Taking risk to be variability has quite naturally led economists to measure risk by the standard deviation or by the variance of the distribution of the relevant variable. This has been criticized on the grounds that these measures require a utility maximizer to have a quadratic utility function, which imposes some implausible conditions on an individual, such as greater aversion to constant additive risk at high levels of wealth than at low levels of wealth, which contradicts observed behavior, and Karl Borch’s (1969) demonstration of an inconsistency in the rank-orderings generated by the mean-standard deviation approach.

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