Risk and Decision Making

Question 1

Explain the concept of risk.

Answer 1

In order to accept a higher risk , a higher return is required.

Question 2

Expected value (Using possibilities and probabilities)=

Answer 2

Sum of (each possibility x the associated probability)

Question 3

What are the three limitations of the expected value model?

Answer 3

• The expected value may not be a possible outcome.
• Is an average value useful for a one off project?
• The spread of the possible outcomes is lost.

Question 4

What is “sensitivity analysis”?

Answer 4

The change required (%) in order for the NPV of a project to change to 0.

Question 5

What is “predictive analytics”?

Answer 5

Using data to create predictions (linear regression/decision trees/simulation).

Question 6

Explain “prescriptive analytics”.

Answer 6

It calculates the optimum outcome by using predictions and other tools such as Artificial Intelligence (Capital rationing/replacement analysis)

Question 7

What does diversification do to risk?

Answer 7

Reduce it but never eliminates.

Question 8

What is specific/unsystematic risk?

Answer 8

Caused by factors specific to particular projects/products/companies. Affects some companies positively and some negatively. Hence it is possible to diversify away.

Question 9

What is systematic risk?

Answer 9

Caused by economy-wide factors. Not all companies have the same level of risk.

Question 10

How many investments should an investor hold to diversify away specific risk?

Answer 10

15-20

Question 11

What’s the formula for required return (CAPM)?

Answer 11

rj=rf+β(rm-rf)

Question 12

What is β and how do you calculate it?

Answer 12

• Systematic risk.

- Obtained by looking at similar quoted companies.

Question 13

What is rf and how do you calculate it?

Answer 13

• Risk free return.

- Gilt return.

Question 14

What is rm and how do you calculate it?

Answer 14

• Return on market portfolio.

- By looking at historic risk.

Question 15

Name an issue with Rf-

Answer 15

Gilt return is not risk free and varies with the term of the bond.

Question 16

Name an issue with Rm-

Answer 16

Historic return is not necessarily a good guide to future returns.

Question 17

Name an issue with β-

Answer 17

Only uses systematic risk. Simplistic.

Question 18

What is the “Arbitrage pricing theory”?

Answer 18

Similar to CAPM but divides the risk premium into multiple elements.

Question 19

What is the “Bond yield plus premium model”?

Answer 19

Uses the bond yield to account for risk, then adds a fixed premium to reflect the increased return needed for equity.

Question 20

What is the “Dividend valuation model”?

Answer 20

Calculates the return actually being achieved using the companies own dividends and price. (On the grounds that in a perfect market, the return achieved is also the return required.)

Question 21

What two data analytics techniques can a business use to improve forecasting for a new project?

Answer 21

Predictive and Prescriptive analytics.

Question 22

When a company is looking to diversify into a completely different sector what is an important point to raise?

Answer 22

Are the management qualified/have the knowledge to run a business in that sector.