11. Uncertainty and Risk Flashcards
What is uncertainty?
Where there are a range of possible outcomes but there is no basis on which probabilities can be estimated
What is risk?
Where there are a number of possible outcomes resulting from a decision or event. Past experience allows the estimation of probabilities that can be assigned to the possible outcomes
What methods can be used to deal with uncertainty?
Simulation or maximax, maximin and minimax regret
What is stress testing?
Looking at how financial projections would be affected by major decisions
What is stress testing used for?
To look at the impact of a decision or event, the impact of consequences of that event, and the consequences of actions that could be taken to mitigate those effects.
What is maximax?
Maximising the maximum achievable profit - which choice has the highest possible return
Who chooses on the basis of maximax?
Risk seekers
What is maximin?
Maximising the minimum achievable profit - the choice where the worst case scenario is the best
Who chooses on the basis of maximin?
Risk averse people
What is minimax regret?
Minimising the maximum regret of making the wrong decision
What is the sensitivity percentage at breakeven point?
(Profit Level)/Variable x 100%
What are the 2 main issues with sensitivity analysis?
- Only one variable at a time can be measured
2. Difficult to base decisions on if you don’t know the probability of variables changing
What are the 3 limitations of using Expected Value?
- Not relevant in one off decisions as they represent long run averages
- Ignores the spread of possible returns
- Relies on the accuracy of probabilities
What will a risk neutral investor base their decision on?
Maximising expected value
What is the value of perfect information?
How much we would be willing to pay to somebody who was able to tell us what the economic state was going to be before we have to make purchase decisions
