2. Risk and decision making

Question 1

What is a Monte Carlo Simulation?

Answer 1

Simulation technique based on the use of random numbers and probability statistics to investigate problems

Question 2

Advantages of simulation

Answer 2

1. It gives more information about the possible outcomes and their relative probabilities
2. It is useful for the problems which cannot be solved analytically.

Question 3

Disadvantages of simulation

Answer 3

1. It is not a technique for making decisions (just gathering info)
2. It can be very time consuming
3. It can be expensive for complex projects
4. Monte Carlo techniques require assumptions to be made about probability distributions (unreliable)

Question 4

Advantages of of Expected values

Answer 4

1. The information is reduced to a single number for each decision option
2. The idea of an average is readily understood

Question 5

Disadvantages of expected values

Answer 5

1. The probabilities of the different possible out may be difficult to estimate.
   - Object probabilities based on past experience of similar projects
   - Subjective probabilities eg, from the results of market research, where there is no past experience as a guide to the future
2. The expected value may not correspond to any of the possible expected outcomes
3. Unless the same decision has to be made many times, the expected value will not be achieved; it is therefore not a valid way of making a decision in ‘one-off’ situations unless the firm has a number of independent projects and there is a portfolio effect.
4. The average gives no indication of the spread of possible results i.e. ignores risk.

Question 6

Define Risk averse investor

Answer 6

One who requires a higher average return in order to take on a higher level of risk.

Question 7

What is prescriptive analytics

Answer 7

Combining predictive analytics with AI

Question 8

What is the risk that can be eliminated by diversification?

Answer 8

Unsystematic risk, or Specific risk

Question 9

What risk CANNOT be eliminated by diversification?

Answer 9

Systematic, or MARKET risk

Question 10

What is a risk-free security

Answer 10

Treasury Bills, Government backed and short term

Question 11

What is CAPM

Answer 11

Capital Asset Pricing Model, it’s used to measure the systematic risk of investments and their required returns

Question 12

What are the alternatives to CAPM?

Answer 12

Alpha Value
Arbitrage Pricing Model
Fama-French Three Factor Model
Bond Yield plus premium approach
Fundamental Beta

Question 13

What is the Alpha Value

Answer 13

An amount added on during the CAPM calculcation,

This can be seen as a measure of how wrong CAPM is

Question 14

What is the Fama-French Three Factor Model

Answer 14

An alternative to CAPM, Like the APM model but specifies that the three factors are:

• The Size Factor
• The Return on Market Portfolio less risk free rate of interest
• The Value Factor

Question 15

What is the Arbitrage Pricing Model?

Answer 15

An alternative to CAPM, this model assumes that the return on each security is based on a number of independent factors.

Question 16

What is the Bond Yield Plus Premium approach?

Answer 16

An alternative to CAPM, since equities are riskier than bonds this model Looks at bond yields and adds a fixed premium

Question 17

What is the Fundamental Beta?

Answer 17

An alternative to CAPM, a subjective adjustment up or down based on expected future cash flows