Private risk

Abstract

In the first essay of this thesis, we extend the traditional decision analysis theory of buying price and selling price of a lottery. We allow the decision maker to rebalance his financial portfolio in the course of determination of a lottery's buying (selling) price. We build on the classical portfolio allocation problem in complete markets, generalizing to include both traded and non-traded unique risks. Our principal focus is on private risks-risks that are not tradable in financial markets. The first essay: Generalizes the treatment of the buying price and the selling price of a private risk lottery by allowing portfolio rebalancing in the course of determining these prices and Outlines the implications of this generalization for distributive bargaining. The second essay is a study of methods for pricing unique risks in real options problems. This essay is a critical evaluation of how methods currently in vogue for pricing private risks affect real option value. We build a framework for valuing investments under uncertainty in the presence of private risks and demonstrate by example that different methods for pricing private risk can lead to decisively different real option values. To this end we use the classical oil and gas exploration and development example pioneered by Paddock, Siegel and Smith(1978). We show how, when private risks are present in this setting, alternative methods for valuation can lead to large differences in choice of a development policy and in associated valuations.