An understanding of risk and how to deal with it is an essential part of modern economics. Whether liability litigation for pharmaceutical firms or an individual's having insufficient wealth to retire, risk is something that can be recognized, quantified, analyzed, treated--and incorporated into our decision-making processes. This book represents a concise summary of basic multiperiod decision-making under risk. Its detailed coverage of a broad range of topics is ideally suited for use in advanced undergraduate and introductory graduate courses either as a self-contained text, or the introductory chapters combined with a selection of later chapters can represent core reading in courses on macroeconomics, insurance, portfolio choice, or asset pricing. The authors start with the fundamentals of risk measurement and risk aversion. They then apply these concepts to insurance decisions and portfolio choice in a one-period model. After examining these decisions in their one-period setting, they devote most of the book to a multiperiod context, which adds the long-term perspective most risk management analyses require. Each chapter concludes with a discussion of the relevant literature and a set of problems. The book presents a thoroughly accessible introduction to risk, bridging the gap between the traditionally separate economics and finance literatures. The book presents a thoroughly accessible introduction to risk, bridging the gap between the traditionally separate economics and finance literatures. Preface ix I Decision Theory 1(42) Risk Aversion 3(24) An Historical Perspective on Risk Aversion 3(4) Definition and Characterization of Risk Aversion 7(2) Risk Premium and Certainty Equivalent 9(4) Degree of Risk Aversion 13(3) Decreasing Absolute Risk Aversion and Prudence 16(1) Relative Risk Aversion 17(2) Some Classical Utility Functions 19(3) Bibliographical References, Extensions and Exercises 22(5) The Measures of Risk 27(16) Increases in Risk 28(8) Aversion to Downside Risk 36(1) First-Degree Stochastic Dominance 37(2) Bibliographical References, Extensions and Exercises 39(4) II Risk Management 43(108) Insurance Decisions 45(20) Optimal Insurance: an Illustration 47(2) Optimal Coinsurance 49(4) Comparative Statics in the Coinsurance Problem 53(3) The Optimality of Deductible Insurance 56(3) Bibliographical References, Extensions and Exercises 59(6) Static Portfolio Choices 65(12) The One-Risky--One-Riskfree-Asset Model 65(3) The Effect of Background Risk 68(2) Portfolios of Risky Assets 70(4) Bibliographical References, Extensions and Exercises 74(3) Static Portfolio Choices in an Arrow--Debreu Economy 77(12) Arrow-Debreu Securities and Arbitrage Pricing 78(2) Optimal Portfolios of Arrow-Debreu Securities 80(3) A Simple Graphical Illustration 83(2) Bibliographical References, Extensions and Exercises 85(4) Consumption and Saving 89(18) Consumption and Saving under Certainty 89(6) Uncertainty and Precautionary Savings 95(3) Risky Savings and Precautionary Demand 98(1) Time Consistency 99(2) Bibliographical References, Extensions and Exercises 101(6) Dynamic Portfolio Management 107(16) Backward Induction 108(1) The Dynamic Investment Problem 109(4) Time Diversification 113(1) Portfolio Management with Predictable Returns 114(3) Learning about the Distribution of Excess Returns 117(2) Bibliographical References, Extensions and Exercises 119(4) Risk and Information 123(18) The Value of Information 123(7) Comparative Statics Analysis 130(4) The Hirshleifer Effect 134(2) Bibliographical References, Extensions and Exercises 136(5) Optimal Prevention 141(10) Prevention under Risk Neutrality 142(1) Risk Aversion and Optimal Prevention 142(2) Prudence and Optimal Prevention 144(1) Bibliographical References, Extensions and Exercises 145(6) III RISK SHARING 151(38) Efficient Allocations of Risks 153(16) Risk Sharing: an Illustration 153(2) Description of the Economy and Definition 155(2) Characterization of Efficient Allocations of Risk 157(6) Aggregation of Preferences 163(2) Bibliographical References, Extensions and Exercises 165(4) Asset Pricing 169(20) Competitive Markets for Arrow-Debreu Securities 169(1) The First Theorem of Welfare Economics 170(2) The Equity Premium 172(3) The Capital Asset-Pricing Model 175(2) Two-Fund Separation Theorem 177(2) Bond Pricing 179(5) Bibliographical References, Extensions and Exercises 184(5) IV Extensions 189(42) Asymmetric Information 191(22) Adverse Selection 192(7) Moral Hazard 199(4) The Principal--Agent Problem 203(6) Bibliographical References, Extensions and Exercises 209(4) Alternative Decision Criteria 213(18) The Independence Axiom and the Allais Paradox 215(2) Rank-Dependent EU 217(4) Ambiguity Aversion 221(3) Prospect Theory and Loss Aversion 224(2) Some Concluding Thoughts 226(1) Bibliographical References, Extensions and Exercises 227(4) Index 231