Risk And Uncertainty Flashcards
What is risk?
“Risk is applied to a situation where there are several possible outcomes and there is relevant past experience to enable statistical evidence to be produced for predicting the possible outcomes”
What is uncertainty?
“Uncertainty exists where there are several possible outcomes, but there is little previous statistical evidence to enable the possible outcomes to be predicted”
What are the risk attitudes?
Risk neutral
Considers all possible outcomes and selects the strategy that maximises the expected value of benefit
Risk seeker
Selects strategy with the best possible outcome, regardless of the likelihood that it will occur
Risk averse
Considers the worst outcome each time
What are expected values?
The financial forecast of the outcome of a course of action multiplied by the probability of achieving that outcome
If a decision maker is faced with a number of alternative decisions, each with a range of possible outcomes, the optimum decision will be the one which gives the highest expected value
How do you calculate expected values?
EV = ∑px
p=probability of the outcome occurring
x=future outcome
What are the advantages of EV’s?
Takes risk into account by considering probabilities of each outcome
The information is reduced to a single number resulting in easier decisions
Calculations are relatively simple
What are the disadvantages of EV’s?
Probabilities are subjective
EV is a weighted average
EV does not correspond to any of the actual possible outcomes
EV does not give any indication of the dispersion of possible outcomes i.e. risk
What are pay off tables?
Used to record all the possible outcomes(or pay offs) in problems where the action taken affects outcomes
What are the three approaches to pay off tables?
Maximin – action taken that maximises the smallest pay-off for each action
Maximax – action taken that has the highest maximum possible pay off
Minimax – action taken that minimises the maximum possible regret
What is the decision making criteria and his attitudes to maximax?
Best possible outcome
Choose the best of the best
risk seeker
What is the decision making criteria and his attitudes to maximin?
Worst possible outcome
Choose the best of the worst
Risk averse
What is the decision making criteria and his attitudes to Expected value?
Weighted average profit
Choose the highest expected value
Risk neutral
What is perfect an imperfect information?
Perfect information is guaranteed to predict the future with 100% accuracy
Imperfect information is better than no information at all, but could be wrong in its prediction of the future
Value of perfect information is the difference between EV of profit with perfect information and the EV of profit without perfect information
