D. Risk and uncertainty in the short term Flashcards
What is the difference between risk and uncertainty?
risk
- quantifiable
- outcomes have probabilities so can apply maths
uncertainty
- unquantifiable
- outcomes cant be mathematically modelled as probabilities are unknown
What is the expected value (EV)?
average result of all possible outcomes
-e.g if outcome is performed 1000 times
How is the expected value calculated?
sum of (p multiplied by x)
X=future outcomes
p=probability of the outcome occurring
weighted average of all possible outcomes
What is on the axis of a histogram?
outcomes vs probability
-each bar represents an outcome
What are the advantages of EV?
- takes account of risk
- easy decision rule: single number
- simple to calculate
What are the disadvantages of EV?
- subjective
- not useful for one-offs
- ignores attitude to risk (assumed risk neutral)
- answer may not be possible
- ignores the spread of outcomes
What does the EV NOT represent?
- most likely outcome (one with highest probability)
- may not even represent a possible outcome
What are the 3 types of decision makers?
risk seeker
risk neutral
risk averse
What is a risk neutral decision maker?
- consider all possible outcomes
- select strategy that maximises the EV
- focus on the EV
What is a risk seeking decision maker?
- select strategy with best possible outcome
- regardless of likelihood
- ignore EV
What is a risk averse decision maker?
- avoid risk
- select lower, but more certain outcome than higher payoff
What is the basis of utility theory?
individual’s attitude to certain risk profiles will depend on the amount of money involved
-shows that basing options solely on EV ignores range of possibilities
What is a pay-off table?
illustrates all possible profits/losses
What is the maximax rule?
select option that maximises the maximum pay-off
-for optimists/risk lovers
What is the maximin rule?
option that maximises the minimum possible pay-off
-for pessimist/risk averse
What is the minimax regret rule?
minimises maximum regret
- i.e opportunity loss/ shortfall from maximum contribution
- regret table:max demand at each choice then pick minimum
What is perfect information?
forecast is correct
- 100% accurate prediction
- choose most beneficial action
What is imperfect information?
not 100% correct
How can value of information be caluclated?
expected profit (outcome) WITH the info less expected profit (outcome) WITHOUT the info
What is a decision tree?
diagrammatic representation of a decision problem, where all possible courses of action are represented and every possible outcome of each course of action is known
What is a joint probability?
where outcome of one event depends on the outcome of a preceding event
What do squares and circles represent in a decision tree?
square: represent a decision point i.e can choose a course of action
circle: change outcome point i.e subject to probabilities
How are decision trees used in decision making?
- calculate EV at each outcome point from right to left
- choose best option at each decision point
- recommend course of action to management
What are the benefits of using a decision tree?
- maps out clearly decisions in uncertainty
- shows how interrelated events are
- clearly annotates tree with probabilities, cash floes and EVs
What other factors should be taken into account when considering decision tree-type problems?
- assumes risk neutrality
- sensitivity analysis:values are subjective
- oversimplification:to make trees manageable, has to be simplified
- suffers limitations of EV
What is standard deviation?
compares actual outcomes to expected value
-measure of volatility:how far they deviate
How does the standard deviation aid decision making?
higher SD means more risk and volatility
What is the coefficient of variation?
measures the relative size of risk for projects that have varying SDs
-smaller coefficient=less dispersed and less risky
How is the coefficient of variation calculated?
- find SD:square of the deviations from the mean
- divide by mean or EV
What is the peak of a normal distribution curve?
the mean
How is data split in the bell shaped curve?
50% to the right, 50% to the left
What are the characteristics of a normal distribution curve?
- continuous probability distribution
- probabilities are represented by areas under the curve
- total area under curve=1
- curve is symmetrical and bell shaped
- width of the curve is measured in terms of SD
- mean, median and mode are at the centre of the curve
What is the z score?
allows us to calculate the proportion of the distribution meeting certain criteria for any normal distribution
-i.e we can determine probabilities
How is z score calculated?
difference/SD
-deduct z score from 0.5
What is sensitivity analysis in decision making?
- takes each uncertain factor in turn
- calculates the change that would be necessary in that factor before the original decision is reversed
- established which estimates are more critical
What is the sensitivity analysis process?
- best ESTIMATES made and a decision arrived
- each variable analysed in turn to see EFFECTS of change on estimate
- estimates for each variable can then be reconsidered to assess the LIKELIHOOD of the decision being wrong
What are the strengths of sensitivity analysis?
- info presented to mgmt in a form which facilitates subjective judgement to decide the likelihood of the various possible outcomes considered
- identifies area which are crucial to the success of the project so they can be monitored
What are the weaknesses of sensitivity anlaysis?
- assumed that changes to variables can be made independently. Can simulate to make more than one change
- only identifies how far a variable needs to change; does not look at the probability of such a change
- provides information on the basis of which decisions can be made but it does not point to the correct decision directly
