Lecture 07: Quantifying Uncertainty and Risk

Beginning with this lecture we introduce uncertainty in the world and attemp
to quantify uncertainty and risk in this new framework. But before we do so, we
will briey revisit some of the basics of mathematical statistics. We will have
to deal now with random variables which have uncertain outcomes, but with
well-dened probabilities.
The simplest case of a random variable x (i.e., r.v.) is one where there are
only two states of the world: 1 with probability 1/2, and -1 with probability
1/2. Thus:
E(x) = x =
V ar(x) =

1
1
1 + ( 1) = 0
2
2

(1)

1
(1
2

(2)

(3)

1
x)2 + ( 1 x)2 = 1
2
p
= V ar(x) = 1

Now suppose that y is 1/3 with probability 0.9 and -3 with probability 0.1.
Then:
E(y) = y = (0:9)(1=3) + (0:1)( 3) = 0
V ar(y) = 0:9(1=3

0)2 + 0:1( 3

(4)

0)2 = 0:1 + 0:9 = 1

(5)

So here we have two random variables which look quite dierent, yet the
mean and standard deviation are the same. Thus, standard deviation and expectation are insu cient to characterize two separate r.v.s. The joint distribution provides us with information regarding the likelihood of x and y being
jointly high or low together (x and y being on the main diagonal) or one being
high while the other is low (x and y being on the o-diagonal). However, remember that the joint distribution is not determined by the distribution of x
alone or y alone.
This leads us to the concept of the covariance of x and y. There are four
possible combinations: x could turn out to be 1 when y is 1/3, and x could turn
out to be 1 when y is -3. Further, x could be -1, and we could get 1/3 for y or
-3:
cov(x; y)

= P (1; 1=3)(1 x)(1=3 y) + P ( 1; 1=3)( 1

+P (1; 3)(1 x)( 3 y) + P ( 1; 3)( 1

x)(1=3
x)( 3

y) (6)
y) (7)

Covariance is giving you a sense of whether things are moving together or

moving the opposite way. The covariance is linear in x, because if you double x
you are going to double every term involving x in the expression for covariance.
Other useful formulas:

V ar(x) = Cov(x; x)

(8)

V ar(x + y; x + y) = Cov(x + y; x + y) = Cov(x; x) + Cov(y; y) + 2Cov(x; y) (9)

The formula above follows from the linearity of covariance. Assuming that
x and y are independent then P (x = X; y = Y ) = P (x = X)P (y = Y ) or
cox(x; y) = 0:
0.0.1

Key Observations about Uncertainty

0.0.2

Diversication

Most investors care about expected returns and dislike risk (i.e., standard
deviation). For instance, assume that E(x) = E(y) = 0 and x = y = 1:
Suppose I put half my money into x and half my money into y, x and y are
independent and I get half the payo of each. Thus, I make half a bet and get
half the outcome. What happens to my expectation? Well, the expectation will
equal:
1
1
E( x + y) = E
2
2

1
x +E
2

1
y
2

=0

(10)

But how about the variance of this portfolio?

V ar

1
1
x+ y
2
2

1 1
1 1
x; x + cov
y; y + 2cov
2 2
2 2
1
1
1
V ar(x) + V ar(y) + 0 =
4
4
2

= cov
=

1 1
x; y (11)
2 2
(12)

At rst, it seems like a total waste of time to put half my money in each.
After all, they give the same standard deviation, but in fact, they do not. If they
are independent you are drastically reducing your standard deviation. Because if
they are independent the covariance is 0 and the variance of the portfolio is half
the variance of each separate investment. Thus, by diversication you have
reduced your standard deviation without aecting your expectation. The key
insight is to look for independent risks. Thus, this is one lesson in mathematics
that has big applications in economics.
0.0.3

Adding N independent risks

If you had N independent risks with identical means and variances, (say, E(xi ) =
x; V ar(xi ) = 2x ) what would happen to the expectation and variance of the
portfolio, respectively?
E

1
xi
N

1
Nx = x
N

(13)

V ar

1
xi
N

1
N
N2

2
x

1
N

2
x

(14)

or that portf olio = p1N x : Therefore, with many independent portfolio allocations you get a lot of o diagonal outcomes, which are canceling each other:
if one investment is turning out badly the other one is turning out well. In this
way, you leave the expectation the same, but you reduce the variance.
0.0.4

Sum of N independent variables

Remember that by summing N independent random variables, you get a normally distributed random variable with a corresponding expectation and standard deviation. For instance, if you add one of our random variables from above
(say x) to itself a bunch of times that can only generate 1 and -1, it produces
totally dierent outcomes: say you can get 18 1s and 12 -1s, so that gives you 6.
But an outcome of 6 can also be generated by sampling and adding outcomes
from the distribution of y: Thus even though x and y yield dierent outcomes,
once you are adding them up you are starting to produce numbers dierent
from 1 and -1, or 1/3 and -3. So surprinsingly, if you add random variables
that are independent to each other you get something normally distributed that
has a bell shaped distribution. The normal distribution is characterized only by
the mean and standard deviation. The normal distribution is also thin tailed
meaning that the probabilities in the tails go to 0 very fast.

0.1

Iterated Expectations

One more thing that is used in economics all the time, and that we need to
know before we talk about the economics of uncertainty is called the iterated
expectations. For instance, if I told you that x and y were positively correlated
and that if x turned out to be 1, that would tell you a lot about what y was
going to be. Therefore, knowing x is going to completely change your mind
about the expectation of y.
So conditional expectation simply means re-computing expectation using
updated probabilities from your information. For instance, if you knew the
joint distribution of x and y and you were furher told that the good outcome of
y occured (i.e., y = 1=3), then you can compute the probability that x = 1 based
on this information. For example, suppose that we knew that y = 1=3 always
when x = 1 (i.e., x and y are perfectly dependent). Then, P (x = 1; y = 1=3) =
0:5 and P (x = 1; y = 3) = 0: Further, we have that P (x = 1; y = 3) = 0:1
and P (x = 1; y = 1=3) = 0:4: The marginal probabilities have to add up to 1.
Therefore,
P (x = 1jy = 1=3) =

0:5
5
P (x = 1; y = 1=3)
=
=
P (y = 1=3)
0:9
9

(15)

However, if x and y were independent, then P (x = 1; y = 1=3) = 0:45 and

P (x = 1jy = 1=3) = 0:5:
3

0.1.1

The Odds of Advancing the Europa League group stages

Suppose that someone might try to assess Athletic Bilbaos chances of advancing
to the Europa League playos. If I ask you your opinion after the rst game,
well, obviously if Athletic Bilbao wins the rst game your opinion is going to
go up, so you are going to have a dierent opinion. If Athletic Bilbao loses the
rst game your opinion is going to go down, so youll have a dierent one. But
you can ask now another question, what is your expected opinion going to be?
So the law of iterated expectations is, the expectation of x has to equal the
expected expectation of x given some information.
Suppose Athletic Bilbao is 70 percent likely to win. If Athletic Bilbao wins
their rst game, one may think it is 80 percent, and after the rst game if
Athletic Bilbao loses, one may think it has gone down to 60 percent (it had
better be that the average of ones opinion after the information is the same as
the number one started with).
Thus, it is not only the expectation of x, but as you learn stu you can
anticipate ones opinion is going to change, but the average opinion has to
always stay the same as x was.
And now lets do a simple application of this. So in fact, to that very
question, suppose that a betor bets on Atheltic Bilabaos chances of advancing
the group stage. Atletic Bilbao is playing three other teams and lets suppose
that Atletic Bilbao has a 60 percent chance of winning any game. What is the
chance that Athletic wins a 3 game round-robin tournament (I am making a
simplifying assumption that Athetic plays the three other teams on neutral sites
with no home and away games)? How do you gure that out?

Exponential Recombining Tree

One can use a recombining tree to show the probabilities of going up (winning) and going down (losing). Thus, probability of going up is .6 and probability of going down is .4. You could imagine 8 possible paths each of length 3
where you give the whole sequence of wins and losses. So you could compute
the probability of every path (there are 8 of them), and then multiply that
probability by the outcome and youll get the chance that Athletic will advance
the group stages. For instance, the probability of Athletico of advancing is
0:6^3 1 + 3 0:6^2 0:4 1 + 3 0:4^2 0:6 0 + 0:4^3 0 = 0:648.
But there is a much faster way of doing the exercise above by using the law
of the iterated expectation. Notice that above the number of branches on the
tree grows exponentially. However, even if the branches grow exponentially, we
can simplify things if the trees are recombining. For instance, in the second
instance where we get a 1 there are three dierent possible ways of getting to
that state (i.e., win-win-lose, win-lose-win, lose-win-win). However, it doesnt
really matter how you precisely get there. What matters is the nal outcome.
Thus, we can re-design the tree to take into account this aspect above and come
up with a tree that grows linearly and not exponentially.

Linear Recombining Tree

In other words, all you care about is whos won how many games. So how
am I going to solve this now? Well, for the top branch I know Athletico ended
up winning all 3 games. For the second branch they won 2, for the third they
won 1, and for the last they won none. So those are the four possible outcomes.
So instead of trying to gure out path by path, through the exponential number
of paths in Figure 1 I am now going to do something simple. I am going to say,
what would I think if Athletico had already won 2 games? Well, I know that

they would win. That would be a 1. They would advance for sure (i.e., outcome
is 0.6*1 +0.4*1=1).
What would I think if they lost the rst two games? I would know it was
over: 0.6*0 + 0.4*0=0. What would my opinion be if they split? Well, if they
split, my opinion of them winning would be 0.6*1+0.4*0=0.6. So the odds
Athletico would qualify with 1 game left knowing that they win 60 percent of
the time its .6. But now what do I think if Athletico wins the rst game?
What is my opinion? The odds would be 0.6*1+0.4*0.6=0.84. What would I
think after Athletico lost the rst game? I would think it was only a 36% (i.e.,
0.6*0.6+0.4*0) chance of the Athletico winning. So at the very beginning, the
chance of Athletico qualifying is 0.6*0.84+0.4*36 which is 0.684 just like above.
The Excel spreadsheet Trees.xls documents even more complex scenarios.
0.1.2

Impatience and Uncertainty

Lets suppose our uncertainty is of a dierent kind meaning we do not know how
impatient we are. Remember that the most important idea that we have seen
so far is impatience. This is the reason why you get an interest rate and the
interest rate is the key to nding out the value of all assets. Irving Fisher put
tremendous weight on impatience. When talking about uncertainty the natural
thing to make uncertain is how impatient you are going to be. Impatience from
Irving Fishers point of view is the discount rate. Do we really believe that
people just discount the future, 1 year they discount by delta, 2 years discount
by delta squared, 3 years by delta cubed, 4 years by delta to the fourth. Is it
really true that every year people think of as delta less important as the year
before? The argument for this is you might not live beyond a certain point in
time.
But let me tell a story that seems to contradict that. Suppose someone asks
you to clean your room and they give you a choice of doing it. If somebody says
do it today or do it tomorrow that may makes a huge dierence. You may think
doing it today is just impossible, doing it tomorrow one can be almost force into
agreeing. So clearly there is a big discount between today and tomorrow, but
what about between a year from now and a year and a day from now? Do you
think there is any dierence in that? The answer is no. This is called hyperbolic
discounting. Hyperbolic discounting is discounting much less than exponential
discounting. This has a tremendous importance for the environment.
If you thought that people exponentially discounted like they thought each
year was only 95 percentif the interest rate is 5 percent it sounds like the
discounting is .95, so if next years only 95 percent as important as this year,
and the year after that is only 95 percent as important as the rst year, and the
third year is only 95 percent as important as the second year, .95 in 100 years
to the hundredth is an incredibly small number.
So there is no point in doing something today and investing a lot resources in
order to clean up the environment and help people 100 years from now, because
by discounting it this much nobody could because the future is so unimportant.
You shouldnt be investing resources now to do something that is going to have
6

such a small eect later. So in all the reports on the environment a crucial half
of the report is devoted to what the discount rate should be.
However, some have never thought of doing the most obvious thing which
is to ask what would happen if the discounting was uncertain. All of these are
certain discount rates. So if you made the discounting uncertain what would
you imagine doing? So suppose you discount today at 100 percent, and maybe
next period youre going to discount at 200 percent, this is the interest rate, and
then it might go down to 50 percent. It could go up to 400 percent or it could
go down to 100 percent again, or it could go down to 25 percent. The discount
rate is thus:
=

1
1+r

(16)

Ho-Lee Interest Rate Model

The higher the r, the less you care about the future. So the question is if
you ask for a dollar sometime in the future, what will people be willing to pay
for it? So you know today that you think the future is only half as important
as the present. And tomorrow it might be that you think the next year is only
2/3 as important as that current year, or you might think the futures only 1/3
as important as this year.
Further, two years from now you might think the future is only 1/5 as
important as the following year. So you dont know what it is going to be, and
if anything this process seems to give you a bias towards getting really high
numbers, high discounts, meaning the future doesnt matter. This is the most
famous interest rate process in nance. This is called the Ho-Lee interest rate

model where you think todays interest rate might be 4 percent. Maybe itll
be 10 percent higher next year or 10 percent lower and itll keep going up and
down like that, and thats the uncertainty about the interest rate. So if we think
interest rates are so important, and patience is so important, and we want to
add uncertainty, the rst place to do it is to the interest rate, and the Ho-Lee
model in nance does that.
Nobody bothered to compute this interest rate tree more than 30 years.
Suppose you get 1 dollar for sure in year 1. How much would you pay for 1
dollar in year 1? Well, if your discount is 100 percent, you would pay half a
dollar. How much would you pay for 1 dollar in year 2?
Well, you know how much more a dollar now is worth than 1 year from
now, but you dont know 2 years from now so you have to work by backward
induction. So for any time I could gure out d(t) = amount I would pay today
for 1 dollar for sure at time t. And d(t) is going to go down as t goes up, and we
know how to compute it by backward induction (i.e., in the Excel spreadsheet
you just put the 1s further and further out and then you go backwards by
backward induction).