The Wiley Finance Series
Contents

Acknowledgements ix
General Introduction 1
Financial assets 1
Risks 2
Uncertainty and precaution 4
Problems: new methods and new instruments 7
Presentation of the book 8
PART I INDIVIDUAL vs COLLECTIVE CHOICE 11
Introduction to Part I 13
1 Risks in a Public Project: The Millau Viaduct 15
2 Individual Valuations and Economic Rationality 23
2.1 Preferences on consequences and utilities of decisions 24
2.2 Decisions, acts and contingent assets 25
2.2.1 Time contingent consumption 26
2.2.2 Games of chance 26
2.3 Criterion and individual valuation: averaging 28
2.4 A simple decision theoretic model 31
2.5 A general criterion of individual valuation 33
2.6 The two main criteria for decision-making in front of a known probability
distribution: paradoxes and limitations 38
3 Aggregation of Individual Choices 43
3.1 Public choices 43
3.1.1 Comparability of individual utility functions 43
3.1.2 Arrow’s impossibility theorem 45
3.1.3 Cost–benefit analysis 47
3.2 Market aggregation of individual preferences 49
3.2.1 The general equilibrium model under uncertainty 50
3.2.2 Reference to market prices in public capital budgeting 56
vi Contents
4 Individual and Collective Risk Management Instruments 63
4.1 Decision trees 63
4.1.1 Decision tree structure 63
4.1.2 Quantification of the decision tree 67
4.1.3 Decision trees in practice 69
4.2 Optimisation under constraints: mathematical programming 70
4.3 Risk and cost–benefit analysis 72
4.3.1 Valuation of non-traded commodities 73
4.3.2 Risk weighting 74
Concluding comments on Part I 79
PART II RISK vs UNCERTAINTY 83
Introduction to Part II 85
5 Insurable and Uninsurable Risks 89
5.1 Insurance of risks with a known probability distribution 90
5.2 Insurance of risks with uncertainties 93
5.3 Non-insurable risks 96
6 Risk Economics 97
6.1 Laws of large numbers and the principles of insurance 98
6.2 Risk aversion and applications to the demand for insurance 101
6.3 Background risk 107
6.4 Risk measures: variance and Value at Risk 109
6.5 Stochastic dominance 110
6.6 Aversion to risk increases 112
6.7 Asymmetric information: moral hazard and adverse selection 114
7 Marketed Risks 117
7.1 A general theory of risk measurement 117
7.1.1 Risk valuation 118
7.1.2 Equilibrium models of risk trades 123
7.2 Applications to risk valuation 125
7.2.1 Financial assets 125
7.2.2 Insurance 127
8 Management Instruments for Risk and for Uncertainty 131
8.1 Choosing optimal insurance 131
8.2 Insurance claims securitisation 134
8.2.1 Hedging catastrophe risks 134
8.2.2 Social risks 137
8.3 Valuing controversial risks 141
8.3.1 Reference to CAPM 144
8.3.2 Tracking error minimisation 145
8.3.3 Looking for a functional relationship 145
8.3.4 Looking for a comonotonic relationship 145
Concluding comments on Part II 147
Contents vii
PART III STATIC vs DYNAMIC 149
Introduction to Part III 151
9 Risk Businesses 153
9.1 Lotteries and the gambling business 153
9.2 Risks and investments 156
9.2.1 Financial market risks 156
9.2.2 Interest rate risk 157
9.2.3 Venture capital 159
9.2.4 Country risk 160
9.3 Credit risk 162
10 Valuation without Flexibilities 165
10.1 The net present value 165
10.2 Discounting 167
10.3 Static models of financial market equilibrium pricing 170
10.4 The value at risk 173
11 Valuation with Options 175
11.1 General theory of a dynamic measure of risks 175
11.1.1 Discrete time valuation 176
11.1.2 Valuation in continuous time 180
11.2 Applications to risk valuation 183
11.2.1 Financial risks 184
11.2.2 Investment projects 190
12 Static and Dynamic Risk Instruments 195
12.1 Static risk management instruments 195
12.2 Managing flexibilities 198
12.2.1 Managing credit risk 199
12.2.2 Construction of a hedging portfolio 202
Concluding comments on Part III 207
General Conclusion 211
1 How to deal with controversies 211
2 Look for market valuation 212
3 Measuring time 212
Traps 212
Research Paths 214
References 217
Index 221