Saturday, September 19, 2009

Risks and Moral Hazards

I was searching for some simple problems in finance to demonstrate the use of scipy for such cases. I realised that I needed to understand a lot more and decided to explore the Financial Markets Open Yale course.

The perspective of risk management was quite enlightening, e.g. a few sentences from the 3rd lecture of Prof. Shiller :

  • The problem with long-term risks, also, is that anything that we do to mitigate these risks creates moral hazard.
  • When you manage risks, you create moral hazard. That's why we need invention and theory in finance to minimize that.
  • Everything is evolving, so I'm actually presenting here our modern finance as the outgrowth of socialism, but that's not the usual way to present it.
He quotes the classic example of fire insurance - I get fire insurance on my house and so I behave badly: I deliberately burn the house down to collect on my insurance.

I have, possibly unhappily, known and accepted that people who handle money will earn a lot. Not explicitly mentioned, but I suppose it is implicit in the lecture that if a person is handling a lot of public money, better pay him well or there is the moral hazard of him cheating.

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