Dutch Book Theorem

AAA

DEFINITION of 'Dutch Book Theorem'

A type of probability theory that postulates that profit opportunities will arise when inconsistent probabilities are assumed in a given context and are in violation of the Bayesian approximation. The assumed probabilities can be rooted in behavioral finance, and will be a direct result of human error in calculating the probability that an event will occur.

INVESTOPEDIA EXPLAINS 'Dutch Book Theorem'

In other words, the theory states that when an inaccurate assumption is made about the likelihood that an event will occur, a profit opportunity will arise for an intermediary.

For example, assume there is one insurance company and 100 people in a given house insurance market. If the insurance company predicts that the probability that a homeowner will need insurance is 5%, but all homeowners predict that the probability of needing insurance is 10%, then the insurance company can charge more for home insurance. This is because the insurance company knows people will pay more for insurance than what will be needed. The profit comes from the difference between premiums charged for insurance and the costs the insurance company incurs through settling insurance claims.

RELATED TERMS
  1. Probability Distribution

    A statistical function that describes all the possible values ...
  2. Gambler's Fallacy

    When an individual erroneously believes that the onset of a certain ...
  3. Behavioral Finance

    A field of finance that proposes psychology-based theories to ...
  4. Behavioral Economics

    The study of psychology as it relates to the economic decision ...
  5. Insurance

    A contract (policy) in which an individual or entity receives ...
  6. Precedent Transaction Analysis

    A valuation method in which the prices paid for similar companies ...
RELATED FAQS
  1. How do I use the rule of 72 to estimate compounding periods?

    The rule of 72 is best used to estimate compounding periods that are factors of two (2, 4, 12, 200 and so on). This is because ... Read Full Answer >>
  2. How can I use Bollinger Bands® to spot options trading opportunities?

    Traders can use Bollinger Bands in a couple of different types of trading strategies. The most common strategy is using Bollinger ... Read Full Answer >>
  3. How can I run linear and multiple regressions in Excel?

    The first step in running regression analysis in Excel is verifying that your software has the capabilities to perform the ... Read Full Answer >>
  4. How do I calculate a modified duration using Matlab?

    The modified duration gauges the sensitivity of the fixed income securities to changes in interest rates. To calculate the ... Read Full Answer >>
  5. How do I calculate the rule of 72 using Matlab?

    In finance, the rule of 72 is a useful shortcut to assess how long it takes an investment to double given its annual growth ... Read Full Answer >>
  6. How do I calculate the standard error using Matlab?

    In statistics, the standard error is the standard deviation of the sampling statistical measure, usually the sample mean. ... Read Full Answer >>
Related Articles
  1. Insurance

    Understanding Your Insurance Contract

    Learn how to read one of the most important documents you own.
  2. Active Trading Fundamentals

    Using Logic To Examine Risk

    Know your odds before you put your money on the table.
  3. Active Trading Fundamentals

    Behavioral Finance

    Learn the science behind irrational decision making and how you can avoid it.
  4. Fundamental Analysis

    Understanding the Profitability Index

    The profitability index (PI) is a modification of the net present value method of assessing an investment’s attractiveness.
  5. Economics

    What is Neoliberalism?

    Neoliberalism is a little-used term to describe an economy where the government has few, if any, controls on economic factors.
  6. Fundamental Analysis

    Explaining the Monte Carlo Simulation

    Monte Carlo simulation is an analysis done by running a number of different variables through a model in order to determine the different outcomes.
  7. Economics

    Understanding Limited Liability

    Limited liability is a legal concept that protects equity owners from personal losses due to their ownership interest in the company.
  8. Fundamental Analysis

    Explaining the Empirical Rule

    The empirical rule provides a quick estimate of the spread of data in a normal statistical distribution.
  9. Economics

    Explaining Demographics

    Demographics is the study and categorization of people based on factors such as income level, education, gender, race, age, and employment.
  10. Fundamental Analysis

    Calculating Degree of Financial Leverage

    Degree of financial leverage (DFL) is a metric that measures the sensitivity of a company’s operating income due to changes in its capital structure.

You May Also Like

Hot Definitions
  1. Multicurrency Note Facility

    A credit facility that finances short- to medium-term Euro notes. Multicurrency note facilities are denominated in many currencies. ...
  2. National Currency

    The currency or legal tender issued by a nation's central bank or monetary authority. The national currency of a nation is ...
  3. Treasury Yield

    The return on investment, expressed as a percentage, on the debt obligations of the U.S. government. Treasuries are considered ...
  4. Bund

    A bond issued by Germany's federal government, or the German word for "bond." Bunds are the German equivalent of U.S. Treasury ...
  5. European Central Bank - ECB

    The central bank responsible for the monetary system of the European Union (EU) and the euro currency. The bank was formed ...
  6. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!