Risk, Return and Credit

Abstract

This dissertation investigates the role of credit in the evaluation of risk and return. The research comprises three essays, which analyze the use of credit from different perspectives. Chapter 1: The first essay proposes a comprehensive theory for the assessment and implementation of "acceptable" underwriting and rating variables. While the use of personal credit was the driving force behind the essay, we extend our theory and models to include all controversial rating classifications. It is shown that a rating classification would be appropriate when the cost to society is relatively small. The use of personal credit in the automobile insurance industry is provided as an application of the proposed models, and other considerations are explored. Chapter 2: For many years, gamblers have developed strategies to reach specific monetary and survival goals. In the second essay, a strategy is introduced in which a speculator engages in bet doubling to increase his chances of walking home a winner. It is shown that with enough credit it is quite possible to become a winner with a high degree of certainty--99.9%, even while facing a losing proposition. However, huge returns require huge risks, and so adopting such a strategy would eventually lead to large losses and negative expected profits. It is also shown that limited liability and a cost of obtaining credit are important factors to consider when analyzing expected gains. Chapter 3: "Hazardously immoral" contracts force external parties to bear significant losses without their consent. Abuses are particularly likely to occur when the threat of system-wide disruption is sufficient to make governments and international agencies bail out the offending organizations in order to limit total damages. The models provided in chapter 2 are presented in the third essay as strategies for externalizing extreme risks, and several results are derived.