Adverse Selection

Essay Assignment 2

Chapter 5

2. Why is it important to be able to quantify risk?

It is important to be able to quantify risk, because we want to know which investment is riskier. The riskier investment will be less desirable than others and to determine the price we are willing to price.

8. Banks pay substantial amount to monitor the risks that they take. One of the primary concerns of a banks “risk managers” is to compare the value at risk. Why is value at risk so important for the bank ( or any financial institution)?

Value at risk is the worst possible loss over a specific time horizon, at a given probability. Since the banks has a restriction of sorts the can hold, bank managers and financial regulators try to limit the chances of a financial collapse. They don’t want to take on a lot of risk and lose a lot of money. The purpose of a bank is to help people save money, so they can loan it out to other people of companies, but if they take on to many risk and lose money they will have to close.

11. Which of the investments in the following table would be most attractive to a risk-averse investor? How would you answer differ if the investor was described as risk-neutral?

A risk-averse would always prefer an investment with a certain return to an investment with the same expected return but any amount of uncertainty. So Investment C would be most attractive to a risk-averse because it has the same expected return as Investment B but is has more uncertainty with a standard deviation of 20. A risk-averse investor trades off between risk and expected return, the higher the risk, the higher the expected return risk-averse investor will require for holding an investment. My answer would change if the investor was a risk-neutral. An risk-neutral investor is totally opposite from a risk-averse investor.

Chapter 6

1. Consider a U.S. Treasury bill with 270 days to maturity. If the annual yield is 3.8 percent, what is the price?

100/ (1+0.038)^9/12= 97.24...