Risk and uncertainty

Question 1

What is the difference between risk and uncertainty?

Answer 1

Risk is quantifiable as outcomes have associated probabilities

Uncertainty is unquantifiable as outcomes cannot be mathematically modelled

Question 2

What are the three attitudes to risk?

Answer 2

Risk adverse
Higher risk will only be accepted if a significantly higher reward results

Risk neutral
Ignore the range of outcomes and aim for the highest average reward

Risk seeker
Aim for the best possible outcome in the best case scenario

Question 3

What is the three attitudes to uncertainty?

Answer 3

Optimist
Aims to maximise the potential upside

Pessimist
Aims to limit the potential downside

Sore loser
Aim to minimise the regret of making a bad decision

Question 4

What is expected values?

Answer 4

Unexpected value summarises all the different possible outcomes by calculating a single weighted average.

It is the long run average (mean).

EV= sum of probability X Value of future outcome

Question 5

What are the advantages and disadvantages of using expected values?

Answer 5

Advantages
- Takes risk into account
- Easier decisions
- simple

Disadvantages
- Probabilities are subjective
- Little meaning for a one off project
- Ignore attitude to risk
- The answer may not exist as it is a theoretical average

Question 6

Measuring risk - what is a spread?

Answer 6

This is a simplest measure of risk and it is to compare the highest and lowest possible outcomes

Question 7

Measuring risk - what is standard deviation?

Answer 7

This compares how the actual outcomes deviate from the mean

This is a measure of volatility. The larger the deviations the more risk involved in the investment or decision.

Question 8

Measuring risk - what is the coefficient of variation?

Answer 8

This is Used when we have two projects with very different expected values meaning it would not be easy to compare their standard deviations to see what would be the riskiest.

We would calculate the coefficient of variation, which is the standard deviation divided by the mean .

This would measure the relative size of the risk for the projects that have very different standard deviations . The smaller the coefficient the less risky the project.

Question 9

What is a decision tree?

Answer 9

There is a complex problem broken down into smaller, easier to handle sections.

It forces the decision-maker to consider the logical sequence of events .

The financial outcomes and probabilities are shown separately and the decision is rolled back by calculating expected values and making decisions .

Question 10

What do squares and circles mean on a decision tree?

Answer 10

Squares
These are used to represent a decision point . The value at this point will be the highest possible expected value from the options being considered.

Circles
This is used to represent a chance point . The value at this point will be the expected value based on the probability of the outcomes possible from this point forward

Question 11

What are the three types of payoff tables?

Answer 11

Maximax
- Best in the best probability .
- It maximises the Max payoff achievable
- This approach would be suitable for an optimist

Maximin
- If goes badly, what one is the least bad?
- Maximises the minimum payoff achievable
- This approach would be appropriate for a pessimist

Minimax
- Aim to minimise the maximum regret
- Regret being the opportunity loss through having made the wrong decision
- This technique suits a sore loser