9. Risk and Uncertainty in decision making Flashcards
Define Risk
Involves situations that may or may mot occur but whose probability of occurance can be calculated statistically using past records
Define Uncertainty
Events whose outcome cannot be predicted with statistical confidence
What are the different attitudes to risk
- Risk seeker: interested in best outcome no matter how small the chance
- Risk neutral: concerned with all possible outcomes and select strategy with highest expected value
- Risk averse: acts on the assumption that the worst outcome will occur
What is meant by expected value
- Financial forecast of the outcome of a course of action multiplied by the probability of achieving that outcome
- Value from 0 to 1
What is the formula for Expected value
EV = ∑px
p = probability of outcome occuring
x= value of outcome
What are the limitations of EV
- Ignores the range of possible outcome
- Depends on probability estimates
- Long run average and therefore inappropriate for one off decisions
- EV may not correspond to any of actual possible outcomes- eg part units
How does standard deviation help look at risk
As a variability of return on range of possible outcome
What is the formula for SD
sigma = sqr root ( ∑ (x - X)^2/n)
X = mean
x = each possible outcome
What does the coefficient of variation show
Measures the standard deviation as a percentage of the mean
- To compare teh dispersion of two dispersions
What is the formula for coefficient of variation
Coefficient of variation = SD/ Mean
When probabilities are not available what is organisation facing
Uncertainty rather than risk
What are techniques to incorporate uncertainty into decision making
MaxiMin
Maximax
Minimax regret
What is maximin decisions
Taken by risk averse decision makers = pessimists
To maximise the minimum return that the decision maker could get
‘best decisions of worst outcome’
What is meant by Maximax decision
Decisions taken by risk seeking decision makers = optimists
To maximise the maximum return
’ best decision of best outcome’
What is meant by minimax regret
Regret calculated from opportunity cost = defensive position
Decisions taken to minimise the maximum opportunity cost from making wrong decision
What is meant by perfect information
- Information may be available about uncertain variables - if this information is guaranteed to predict future with certainty then information is perfect
- Removes risk
What is the formula for Value of perfect information
VOP = EV (with perfect information) - EV (without perfect information) = VOP
What are features of decision tree
- Draw from left to right
- Evaluate calculations from right to left
Expected values at outcome = circles
Highest benefit at decision pooint = square
What is sensitivity analysis
- When uncdrtainty exists for future and the decision maker has no past experience to base it on
What are the benefits and drawbacks of using diagram tree
Benefits:
- Gives easier to understand view and present
Problems:
- Based on EV so relies heavily on probabilities
-Oversimplification
What are the two approaches to sensitivity analysis
- Calculate the maximum percentage change in a variable before decision would change
- Assessing if the decision would change is a variable changed by x% of estimate
What are strengths of sensitivy analysis
- Easy to understand
- Highlights key variables which are crucial to success of project to monitor
What are limitations of sensitivity analysis
- Only for one uncertain variable
- Assumes all changes are independent when in reality they interact
- Only identifies the amount of change required in one variable
- Does not offer a clear decision rule
What is what if analysis
Results of varying models’ key variables, parameters or estimates
- To provide better understanding of future cash flow
