E-Book, Englisch, 182 Seiten
ISBN: 978-1-09-833387-4
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“Fear is a reaction, courage is a decision” Winston Churchill INTRODUCTION: FUTURE UNCERTAINTY AND HUMAN BEHAVIOR In this chapter we discuss the response of human beings to uncertainty. We analyse the risk-aversion of humans with respect to uncertainty, whether risk-aversion is rational, and whether it can be exploited. Forecasting gone wrong Let’s start this chapter with some forecasting quotes: “God himself could not sink this ship” Captain Edward Smith of the Titanic “Stock markets have reached what looks like a permanently high plateau.” Irving Fisher, New York Times in 1929, just before the stock market crash of 90% “I just have a hunch that Stalin is not that kind of [evil] man” FDR on Stalin “Bear Stearns is fine. Do not take your money out!” Jim Kramer from CNBC in 2008, just before Bear Stearns crashed from $62 to $2. “Hillary Clinton has an 85% chance to win” New York Times on November 8, 2016, the day of the election. What is the take-away from these forecasts or unforeseen events such as the 1906 San Francisco earthquake, the Japanese attack on Pearl Harbour 1941, the 9/11 Terrorist attack in 2001, or the Coivd-19 shock in 2020? It is that extreme events have a non-zero probability. So we should always be aware of extreme tail events1 and try to forecast them to avoid their detrimental impacts. We will quantify these extreme tail events in chapter 9, Extreme Value Theory. “Nothing is certain but death and taxes” Benjamin Franklin Is all Future Uncertain? Well, almost. Exceptions are the movement of the stars and planets in the short term. The death of stars, such as our sun is also certain. Our sun will run out of hydrogen and turn into a red giant, burning the planets in our solar system. Don’t worry though, this will happen in about 5 billion years, so we have some time to tackle the problem. The universe’s expansion, which is accelerating, will also continue for the foreseeable future. However, most economic variables such as GDP growth rate, unemployment, inflation, interest rates or trade balance are uncertain. The same logic applies to financial variables such as stocks, bonds, exchange rates, commodities, or option and future prices. In this book we will suggest 10 methods to forecast, i.e. find probabilities for the future state of economic and financial variables. How do Human Beings react to Future Uncertainty? Humans beings buy insurance to reduce unforeseeable future harm. This is why most people have health insurance for their family and themselves. The principle of insurance is that an individual is protected by the community of insurance buyers. For example, if a person gets very sick, the health insurance will cover the cost from the premiums of the other insurance buyers. There is a big discussion in the US on whether health insurance is a privilege or a human right. In Europe this discussion does not exist, since most Europeans believe health insurance should be available to everyone. Should insurance be mandatory? If a person can harm another person with his or her action, then yes. A good example is car insurance. If an individual hurts a person or their property with his/her car, the individual may not be able to cover the cost, but the insurance is typically able to. Therefore, car insurance is mandatory. Should homeowner’s insurance be mandatory? If a person lives in a high-rise, then yes. He or she can possibly burn down the whole building and harm others. Which brings us back to the question of health insurance. Should it be mandatory? Insurance only works if there are many insurance buyers who do not actually use the insurance. So young people who often do not get very sick, should also buy health insurance. That is why Obamacare has a penalty for not buying health insurance.2 Another interesting question is whether buying insurance is a zero-sum game. In a zero-sum game, what person A gains, person B loses, as in a stock trade. If A sells the Apple stock to B at $300, and the Apple stock goes to $290, A gains $10 and B loses the same amount of $10 (assuming no commissions and transaction cost). So is buying insurance a zero-sum game? The answer is, typically no: If a person has health insurance and never uses it, it does give peace of mind. So the person does benefit, just as the insurance seller does monetarily from selling the insurance. The same non-zero game property applies to other insurances, such as life insurance or homeowners insurance. How do Human Beings deal with Risk? Although in finance every risk is an opportunity, most human beings don’t like risk. We can define human risk-aversion as A risk-averse person prefers an outcome with certainty over the same outcome with uncertainty An example would be: Option 1: A person is offered $50,000 with certainty. Option 2: The person can gamble with a coin: He gets $100,000 for Heads and $0 for Tails. Most humans would take the $50,000 with certainty since they are risk-averse. A risk-neutral person would be indifferent between option 1 and 2. A risk-loving person would prefer option 2. The degree of risk-aversion can be seen in Table 1. The answers are from students. I prefer $10,000 with certainty and not gamble for $50,000 0% I prefer $20,000 with certainty and not gamble for $50,000 5% I prefer $30,000 with certainty and not gamble for $50,000 20% I prefer $40,000 with certainty and not gamble for $50,000 30% I prefer $50,000 with certainty and not gamble for $50,000 90% Table 1: Different Degrees of Risk-Aversion In Table 1, 90% of students were risk-averse. 5% of students were highly risk-averse, preferring $20,000 with certainty over gambling with an expected outcome of $50,000. 10% of students reported being indifferent to taking the $50,000 with certainty and gambling for it (not displayed in Table 1). They are considered risk-neutral. A risk-loving person would gamble for the $50,000 even if he or she is offered an amount higher than $50,000 with certainty. In my many years of playing this game, about 1% of students were risk-loving. Graphically, risk-aversion is displayed in Figure 1: Figure 1: Risk-Aversion: The utility of $50,000 with certainty is higher than the utility of $50,000 with uncertainty i.e. U (Gamble) What factors determine the degree of a person’s risk-aversion? One factor is genetical. Some humans are just more risk-averse than others. Another factor is wealth. As the saying goes: Money matters when you don’t have it. So if a person is in financial need such as a mortgagor having to make mortgage payments or a student who has student debt, risk-aversion is typically higher. Another factor can be age. Risk-aversion with respect to age may be a u-shaped function: A student in her early 20s with little or no income may be quite financially risk-averse. A person in her 30s, 40s, and 50s may have a higher financial risk-tolerance, i.e. have a lower risk-aversion. With older age, typically risk-aversion increases again. Risk-Aversion is everywhere in Finance In Table 1 and Figure 1 we displayed risk-aversion. Risk-aversion can also be found in many areas in financial reality. One of the first to point out risk-aversion in financial markets was Edward Altman in 1989: A bond-yield spread is the difference between a risky bond yield and a risk-free Treasury bond yield. This bond yield spread is a measure of the default probability of a bond in reality3. Comparing the bond yield spread to historical default probabilities of bonds, we find that the bond yield spread is significantly higher than historical default probabilities as seen in Table 2: Rating Historical Default Probability Bond Yield Spread Aaa 0.04% 0.67% Aa 0.06% 0.78% A 0.13% 1.28% Baa 0.47% 2.38% Ba 2.47% 5.07% B 7.69% 9.02% CCC 16.9% 21.3% Table 2: Low historical bond default probabilities compared to bond yield spreads (which are bond price implied default probabilities). The take-away from Table 2 is that bond prices in the...
