Risk and Decision Making Flashcards
Explain the concept of risk.
In order to accept a higher risk , a higher return is required.
Expected value (Using possibilities and probabilities)=
Sum of (each possibility x the associated probability)
What are the three limitations of the expected value model?
- 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.
What is “sensitivity analysis”?
The change required (%) in order for the NPV of a project to change to 0.
What is “predictive analytics”?
Using data to create predictions (linear regression/decision trees/simulation).
Explain “prescriptive analytics”.
It calculates the optimum outcome by using predictions and other tools such as Artificial Intelligence (Capital rationing/replacement analysis)
What does diversification do to risk?
Reduce it but never eliminates.
What is specific/unsystematic risk?
Caused by factors specific to particular projects/products/companies. Affects some companies positively and some negatively. Hence it is possible to diversify away.
What is systematic risk?
Caused by economy-wide factors. Not all companies have the same level of risk.
How many investments should an investor hold to diversify away specific risk?
15-20
What’s the formula for required return (CAPM)?
rj=rf+β(rm-rf)
What is β and how do you calculate it?
- Systematic risk.
- Obtained by looking at similar quoted companies.
What is rf and how do you calculate it?
- Risk free return.
- Gilt return.
What is rm and how do you calculate it?
- Return on market portfolio.
- By looking at historic risk.
Name an issue with Rf-
Gilt return is not risk free and varies with the term of the bond.
Name an issue with Rm-
Historic return is not necessarily a good guide to future returns.
Name an issue with β-
Only uses systematic risk. Simplistic.
What is the “Arbitrage pricing theory”?
Similar to CAPM but divides the risk premium into multiple elements.
What is the “Bond yield plus premium model”?
Uses the bond yield to account for risk, then adds a fixed premium to reflect the increased return needed for equity.
What is the “Dividend valuation model”?
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.)
What two data analytics techniques can a business use to improve forecasting for a new project?
Predictive and Prescriptive analytics.
When a company is looking to diversify into a completely different sector what is an important point to raise?
Are the management qualified/have the knowledge to run a business in that sector.
