Dutch Book Theorem

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.

BREAKING DOWN '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. Behavioral Finance

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

    The study of psychology as it relates to the economic decision ...
  3. Gambler's Fallacy

    When an individual erroneously believes that the onset of a certain ...
  4. Probability Distribution

    A statistical function that describes all the possible values ...
  5. Insurance

    A contract (policy) in which an individual or entity receives ...
  6. Tight Monetary Policy

    A course of action undertaken by the Federal Reserve to constrict ...
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

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  5. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  6. Economics

    The Basics Of Business Forecasting

    Whether business forecasts pertain to finances, growth, or raw materials, it’s important to remember that a forecast is little more than an informed guess.
  7. Economics

    Forces Behind Interest Rates

    Interest is a cost for one party, and income for another. Regardless of the perspective, interest rates are always changing.
  8. Term

    Three Ways to Profit Using Call Options

    A call option gives an investor the right, but not the obligation, to buy a stock at a specific price, known as the strike price.
  9. Markets

    The (Expected) Market Impact of the 2016 Election

    With primary season upon us, investor attention is beginning to turn to the upcoming U.S. presidential election.
  10. Investing

    New Year, New Investing Strategy: Exploring ETFs

    Whether you’re a seasoned investor or new to the markets, you need to learn as much as you can about the present environment and how to navigate it.
RELATED FAQS
  1. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  2. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  3. Do plane tickets get cheaper closer to the date of departure?

    The price of flights usually increases one month prior to the date of departure. Flights are usually cheapest between three ... Read Full Answer >>
  4. How do mutual funds split?

    Mutual funds split in the same way that individual stocks split, but less often. Like a stock split, mutual fund splits do ... Read Full Answer >>
  5. Is Colombia an emerging market economy?

    Colombia meets the criteria of an emerging market economy. The South American country has a much lower gross domestic product, ... Read Full Answer >>
  6. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center