Risk Aversion, Foreign Exchange Speculation and Gambler's Ruin

The apparent persistence of unexploited opportunities for expected profits in foreign exchange markets suggests highly risk-averse market participants. Financial institutions put tight limits on the foreign-exchange positions they may have at risk at any time, despite beliefs that the odds are favorable that the positions will be profitable. This 'safety-first' practice is consistent with keeping the probability of ruin low enough to be of no practical concern. The setting of a very low probability of ruin for prudential reasons provides a rationale for traders behaving as if they have a degree of risk aversion that might otherwise seem implausibly high. Copyright 1998 by The London School of Economics and Political Science

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