BU353 Lecture Notes - Lecture 1: Risk Premium, Risk Aversion, Cash Flow
Document Summary
Someone who is risk neutral cares only about expected wealth and would not require a risk premium to accept risk. The increase in wealth if a loss occurs can be viewed as the benefit of insurance, and the reduction in wealth if a loss does not occur can be viewed as the cost of insurance. Although risk-averse people generally desire insurance, the extent to which they will purchase insurance depends on the policy"s premium loading. The premium on an insurance policy = expected claim costs plus what is referred to as a loading for administrative and capital costs. If the loading = 0, then purchasing insurance does not change a person"s expected wealth. Unfortunately, the premium loading is rarely zero since insurers must be compensated for their costs. A business"s value is defined as the pv of its expected net cash flows: Expected cash flow = 0. 9(100) + 0. 1(70) = . Value = 97 / (1 + 0. 135) = . 46/share.
