Decreasing Risk by Adding Inside Noise: A Theory of Transfers of Risk

I present a theory of financial contracts that transfer risk from one party to another. Risk reduction is equivalent to adding inside noise to payoffs; this addition shifts probability weight away from the tails of a payoff's distribution. Adding outside noise is the inverse operation and it increases risk, while noise in the sense of a mean-preserving spread is a special case of outside noise. These concepts provide intuitive and graphic descriptions of the use of financial hedges and insurance contracts, describe the sharing of risk in equilibrium models of financial markets, and characterize stochastic dominance.