# Open Yale Courses Financial Markets: Lecture 2 The Universal Principle of Risk Management: Pooling and the Hedging of Risks

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Professor Robert Shiller: Today I want to spend — The title of today's lecture is: The Universal Principle of Risk Management, Pooling and the Hedging of Risk. What I'm really referring to is what I think is the very original, the deep concept that underlies theoretical finance — I wanted to get that first. It really is probability theory and the idea of spreading risk through risk pooling. So, this idea is an intellectual construct that appeared at a certain point in history and it has had an amazing number of applications and finance is one of these. Some of you — This incidentally will be a more technical of my lectures and it's a little bit unfortunate that it comes early in the semester. For those of you who have had a course in probability and statistics, there will be nothing new here. Well, nothing in terms of the math. The probability theory is new. Others though, I want to tell you that it doesn't — if you're shopping — I had a student come by yesterday and ask — he's a little rusty in his math skills — if he should take this course. I said, "Well if you can understand tomorrow's lecture — that's today's lecture — then you should have no problem."

I want to start with the concept of probability. Do you know what a probability is? We attach a probability to an event. What is the probability that the stock market will go up this year? I would say — my personal probability is .45. That's because I'm a bear but — Do you know what that means? That 45 times out of 100 the stock market will go up and the other 55 times out of 100 it will stay the same or go down. That's a probability. Now, you're familiar with that concept, right? If someone says the probability is .55 or .45, well you know what that means. I want to emphasize that it hasn't always been that way and that probability is really a concept that arose in the 1600s. Before that, nobody ever said that.

Ian Hacking, who wrote a history of probability theory, searched through world literature for any reference to a probability and could find none anywhere before 1600. There was an intellectual leap that occurred in the seventeenth century and it became very fashionable to talk in terms of probabilities. It spread throughout the world — the idea of quoting probabilities. But it was — It's funny that such a simple idea hadn't been used before. Hacking points out that the word probability — or probable — was already in the English language. In fact, Shakespeare used it, but what do you think it meant? He gives an example of a young woman, who was describing a man that she liked, and she said, I like him very much, I find him very probable. What do you think she means? Can someone answer that? Does anyone know Elizabethan English well enough to tell me? What is a probable young man? I'm asking for an answer. It sounds like people have no idea. Can anyone venture a guess? No one wants to venture a guess?

Student: fertile?

Professor Robert Shiller: That he can father children? I don't think that's what she meant but maybe. No, what apparently she meant is trustworthy. That's a very important quality in a person I suppose.

So, if something is probable you mean that you can trust it and so probability means trustworthiness. You can see how they moved from that definition of probability to the current definition.

I want to start with the concept of probability. Do you know what a probability is? We attach a probability to an event. What is the probability that the stock market will go up this year? I would say — my personal probability is .45. That's because I'm a bear but — Do you know what that means? That 45 times out of 100 the stock market will go up and the other 55 times out of 100 it will stay the same or go down. That's a probability. Now, you're familiar with that concept, right? If someone says the probability is .55 or .45, well you know what that means. I want to emphasize that it hasn't always been that way and that probability is really a concept that arose in the 1600s. Before that, nobody ever said that.

Ian Hacking, who wrote a history of probability theory, searched through world literature for any reference to a probability and could find none anywhere before 1600. There was an intellectual leap that occurred in the seventeenth century and it became very fashionable to talk in terms of probabilities. It spread throughout the world — the idea of quoting probabilities. But it was — It's funny that such a simple idea hadn't been used before. Hacking points out that the word probability — or probable — was already in the English language. In fact, Shakespeare used it, but what do you think it meant? He gives an example of a young woman, who was describing a man that she liked, and she said, I like him very much, I find him very probable. What do you think she means? Can someone answer that? Does anyone know Elizabethan English well enough to tell me? What is a probable young man? I'm asking for an answer. It sounds like people have no idea. Can anyone venture a guess? No one wants to venture a guess?

Student: fertile?

Professor Robert Shiller: That he can father children? I don't think that's what she meant but maybe. No, what apparently she meant is trustworthy. That's a very important quality in a person I suppose.

So, if something is probable you mean that you can trust it and so probability means trustworthiness. You can see how they moved from that definition of probability to the current definition.

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