13.1 Risk and uncertainty in the short term

Question 1

Risk and uncertainty both refer to the likelihood

Answer 1

• That the outcome from decisions may differ from those which are expected when a decision is taken
• Decision makers will aim to account for both in decision making

Question 2

We tend to differentiate between risk and uncertainty in terms of availability of probabilities attached to each outcome

Answer 2

• Risk is quantifiable - Potential outcomes of decision are predictable and the probabilities for each possible outcome can be estimated
• Uncertainty is unquantifiable - Decision maker may not be able to estimate the likely outcomes and/or cannot estimate the probability that outcome will occur

Question 3

Dealing with ……. is more challenging / Potential approaches

Answer 3

• Uncertainty is more challenging than dealing with risk
• Potential approaches are to reduce time horizon for decisions (tends to be more uncertainty over longer time frames) or attempting to convert uncertainty into risk (eg market research)
• There are mathematical models available for dealing with risk

Question 4

Expected value

Answer 4

• Is one way to account for risk by determining an expected value based on the range of possible outcomes
• An expected value condenses all the different possible outcomes into one overall average result by calculating a single weighted average
• It is the most likely result, even if not a possible result (finds average if same event took place a 1000 times)

Question 5

Expected value formula

Answer 5

EV = Sum of (px)

x = Future outcome
p = Probability of outcome occurring

Question 6

Limitation of expected value technique

Answer 6

• It assumes that the decision maker is risk neutral
• A risk neutral investor neither seeks risk or avoids it, they are happy to accept an average outcome
• But decision makers will not normally be neutral and therefore pay no attention to the expected value

Question 7

Three main types of decision makers

Answer 7

• Risk neutral - Consider all possible outcomes and will select strategy that maximizes the expected value or benefit, therefore focus attention on expected value
• Risk seekers - Likely to select strategy with best possible outcome regardless of likelihood they will occur, therefore ignore the expected value
• Risk averse - Try to avoid risk. They would rather select a lower but certain outcome than risk going for a higher payoff which is less likely to occur. Therefore also ignore expected value

Question 8

Advantages of expected values:

Answer 8

• Takes account of risk
• Easy decision rule
• Simple

Question 9

Disadvantages of expected values:

Answer 9

• Subjective
• Not useful for one offs
• Ignores attitudes to risk
• Answer may not be possible
• Ignores the spread of outcomes

Question 10

Pay off tables

Answer 10

• A table that illustrates all possible profits / losses
• To consider the risk borne by each alternative it is necessary to consider all these different profit / loss possibilities
• Managements decision will often depend upon their attitude to risk

Question 11

The standard deviation compares

Answer 11

• All the actual outcomes with the expected value (or mean outcome) and then calculates how far on average the outcome deviates from the mean using a formula
• Helpful to show how wide ranging the possible outcomes are
• It is a measure of volatility and the more variation the more volatile the returns and therefore the more risk involved with decision

Question 12

Standard deviation formula:

Answer 12

SD = Square root of [Sum of (X - Xmean)sq] / n

X = Each value in data set
n = Number of values in data set

Question 13

Coefficient of variation measures

Answer 13

• The relative size of the risk for projects that have very different std deviations
• The smaller the coefficient of variation the less dispersed the variable is and therefore the less risky

CoV = SD / mean

Question 14

Using normal distributions in decision making

Answer 14

• If we know the mean and the std deviation for a distribution we can work out the probability (% chance) of a certain value occurring
• We first convert normal distribution to a std normal distribution
• Which as a mean of 0 and a SD of 1

Question 15

Std normal distribution formula

Answer 15

z = x - u / SD

x = variable
u = mean
SD = Std deviation

The z score allows us to calculate the proportion of distribution meeting certain criteria for any normal distribution (ie determine possibilities)