4.5.1 Risk and uncertainty

Question 1

difference between risk and uncertainty

Answer 1

• Risk can be quantified but uncertainty cannot be predicted
• External shocks or unprecedented events can occur → eg a new source of oil is found increasing supply and decreasing prices significantly
• Firms profit levels can be hard to predict → changes in external factors like gov policies
• Uncertainty makes it difficult for businesses and governments to plan for the future

Question 2

external shocks

Answer 2

• Unprecedented events that gave a significant impact on one or more economeis
• Eg fall of commodity prices
• Shock for commodity exporters like Nigeria, Russia etc
• Financial crisis
• Shocks make businesses less likely to invest so FDI slows
• Effect of shock can be felt for variable amount of times

Question 3

insurance and banks

Answer 3

• Risks shared between all those who wish to protect themselves from unseen circumstances
• Insurance companies → have to have large reserves to cover possibility of many consumers needing compensation all at once
• Buy shares, government bonds, loans and other financial products → important sources of investment finance → playing a part in public and private sector finance
• Businesses can function as they can insure against serious misfortunes that might threaten their survival → insurance is a cost of production and should be reflected in prices charged

Question 4

forward markets

Answer 4

• Financial markets provide forward markets in currencies and commodities
• allow agents to insure against price volatility
• includes futures and options
• Can buy a certain quantity of goods or foreign currency at a price agreed today, for delivery as a specific future date

Question 5

futures

Answer 5

• Contract that requires the holder to buy or sell an underlying asset at a specific price on a specific date in the future
• Allow firms that use volatile commodities to buy commodities at fixed prices
• Have an increased certainty for buyers → businesses can plan ahead without fears of major changes in prices and exchange rates
• fixed term contracts: energy/gas bills can be fixed for the future if large firms buy energy/gas at a fixed price
• chocolate like Cadbury’s can be at a fixed price while their competitors prices increase as cocoa supply decreases
• Only gain if prices of commodity do not instead decrease, therefore firm is no Longer competitive —> bought inputs at a higher fixed price

Question 6

options

Answer 6

• Gives holder the right, but not obligation, to buy or sell an underlying asset at a specific price on a specific date
• can buy certainty but also opt out if commodity price decreases
• Therefore there is a fee a buyer must pay to gain certainty
• seller of option therefore gains profit from guaranteed fee

Question 7

extent to which a firm can eradicate risk and uncertainty

Answer 7

• Insurance
  short term high cost but long term less cost than incidents that could happen without insurance

forward markets and commodities
diversification to spread risk
unexpected finance problems like an overdraft

cash flow forecasting: planning and risk decrease

break even analysis
allows you to reduce shocks through planning
research

total quality management, increased quality of suppliers to be more efficient
cannot eliminate risk entirely, but can mitigate and minimise