9. Risk and Uncertainty in decision making

Question 1

Define Risk

Answer 1

Involves situations that may or may mot occur but whose probability of occurance can be calculated statistically using past records

Question 2

Define Uncertainty

Answer 2

Events whose outcome cannot be predicted with statistical confidence

Question 3

What are the different attitudes to risk

Answer 3

• 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

Question 4

What is meant by expected value

Answer 4

• Financial forecast of the outcome of a course of action multiplied by the probability of achieving that outcome
• Value from 0 to 1

Question 5

What is the formula for Expected value

Answer 5

EV = ∑px

p = probability of outcome occuring
x= value of outcome

Question 6

What are the limitations of EV

Answer 6

• 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

Question 7

How does standard deviation help look at risk

Answer 7

As a variability of return on range of possible outcome

Question 8

What is the formula for SD

Answer 8

sigma = sqr root ( ∑ (x - X)^2/n)

X = mean
x = each possible outcome

Question 9

What does the coefficient of variation show

Answer 9

Measures the standard deviation as a percentage of the mean
- To compare teh dispersion of two dispersions

Question 10

What is the formula for coefficient of variation

Answer 10

Coefficient of variation = SD/ Mean

Question 11

When probabilities are not available what is organisation facing

Answer 11

Uncertainty rather than risk

Question 12

What are techniques to incorporate uncertainty into decision making

Answer 12

MaxiMin

Maximax

Minimax regret

Question 13

What is maximin decisions

Answer 13

Taken by risk averse decision makers = pessimists

To maximise the minimum return that the decision maker could get

‘best decisions of worst outcome’

Question 14

What is meant by Maximax decision

Answer 14

Decisions taken by risk seeking decision makers = optimists

To maximise the maximum return

’ best decision of best outcome’

Question 15

What is meant by minimax regret

Answer 15

Regret calculated from opportunity cost = defensive position

Decisions taken to minimise the maximum opportunity cost from making wrong decision

Question 16

What is meant by perfect information

Answer 16

• Information may be available about uncertain variables - if this information is guaranteed to predict future with certainty then information is perfect
• Removes risk

Question 17

What is the formula for Value of perfect information

Answer 17

VOP = EV (with perfect information) - EV (without perfect information) = VOP

Question 18

What are features of decision tree

Answer 18

• Draw from left to right
• Evaluate calculations from right to left

Expected values at outcome = circles
Highest benefit at decision pooint = square

Question 19

What is sensitivity analysis

Answer 19

• When uncdrtainty exists for future and the decision maker has no past experience to base it on

Question 20

What are the benefits and drawbacks of using diagram tree

Answer 20

Benefits:
- Gives easier to understand view and present

Problems:
- Based on EV so relies heavily on probabilities
-Oversimplification

Question 21

What are the two approaches to sensitivity analysis

Answer 21

• 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

Question 22

What are strengths of sensitivy analysis

Answer 22

• Easy to understand
• Highlights key variables which are crucial to success of project to monitor

Question 23

What are limitations of sensitivity analysis

Answer 23

• 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

Question 24

What is what if analysis

Answer 24

Results of varying models’ key variables, parameters or estimates
- To provide better understanding of future cash flow