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Friday 27 April 2012

Financial markets aren't like casinos – but they aspire to their condition

In this week's City AM column, Prof. Anthony J. Evans explains how hard it is to convert uncertainty into risk, using his own recent experience in Las Vegas to illustrate his point.

"Casinos are a triumph of human achievement – a beacon of what financial markets hope to accomplish. No, I'm not being facetious. Consider the distinction the economist Frank Knight made between risk and uncertainty. Risk is calculable because the range of possible outcomes is known. In roulette, for example, a ball is released into a spinning wheel that contains 38 slots. The probability of correctly guessing is 1/38, and casinos will pay out odds of 35 to 1 (the difference constitutes the house advantage). Uncertainty is everything else. It is the range of possible outcomes that cannot be reduced to calculable risk. For roulette, if an Elvis impersonator jumped onto the table and stole the ball this might constitute an uncertain event. By definition it cannot be included in the payoffs, because there is no known distribution.

"Both Austrian and Keynesian economists share this risk/uncertainty distinction, and while some cynical commentators like to suggest similarities between casinos and financial markets, this provides a neat way to understand the real difference between the two – casinos are temples to precisely-calculated and managed risk; financial markets exist to convert uncertainty into risk.

"Casinos can also provide insight into just how hard that is..."

You can read the rest of this article by visiting City AM online. All of Anthony's columns are archived here.


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