Risk and Uncertainty in decision making

Question 1

What is a Risk Seeker attitude towards Risk?

Answer 1

Decision-maker who is interested in best outcomes no matter how small the chance that they may occur. (optimist)

Question 2

What is a Risk Neutral attitude towards Risk?

Answer 2

Is concerned with all possible outcomes and will select the strategy with the highest Expected Value (EV).

Question 3

What is a Risk Averse attitude towards Risk?

Answer 3

Acts on assumption that the worst outcome will occur (Pessimists)

Question 4

What is the definition of Expected Value?

Answer 4

Financial forecast of outcome of a course of action multiplied by the probability of achieving the outcome. Ranges from 0 to 1.

Question 5

What are the 4 limitations of EV?

Answer 5

1. Ignores range of possible outcomes
2. Heavily dependant on probability estimates
3. Long-run average and therefore inappropriate for one-off decisions
4. EV may not correspond with any actual possible outcomes.

Question 6

What are the 3 techniques used to deal with uncertainty?

Answer 6

1. Maximin (Pessimists).
2. Maximax (Optimists)
3. Minimax regret (Regret is calculated as opportunity cost lost)

Question 7

What is Perfect Information?

Answer 7

1. Information that may be available about uncertain variables.
2. if info is guaranteed to predict future with certainty, it is defined as perfect info.
3. Perfect info removes risk, therefore it is valuable.

Question 8

What is the definition of Risk?

Answer 8

Involves situations or events that may or may not occur but whose probability of occurrence can be calculated statistically and the frequency of their occurrence predicted from past records.

Question 9

What is the definition of Uncertain Events?

Answer 9

Uncertain events are those whose outcome cannot be predicted with statistical confidence.

Question 10

What is Standard Deviation?

Answer 10

Risk can be defined as variability of return or range of possible outcomes. The standard deviation compares each of the actual outcomes with the mean outcome. It then calculates how far on average the actual outcomes deviate from the mean.

Question 11

What is Coefficient of variation?

Answer 11

Measures the standard deviation as a % of the mean. Useful for comparing the dispersion of 2 distributions. The higher the percentage, the higher the dispersion.

Question 12

What is a joint probability table?

Answer 12

If two variables are uncertain or risky it may be helpful to record the range of possible outcomes in a joint probability table. Allows the risks to be assessed.

Question 13

What is a Decision Tree?

Answer 13

A pictorial method of showing a sequence of interrelated decisions and their expected outcomes. Decision trees can incorporate both the probabilities and value of expected outcomes and are used in decision making.
Most useful when there are several decisions and ranges of outcome.

Question 14

How do we EVALUATE a Decision Tree?

Answer 14

Use rollback analysis. Evaluate from right to left.
1. Calculate expected values at outcome points (denoted by a circle on the tree)
2. Take highest benefit at decision points (Denoted by a square on the tree).

Question 15

What is the benefit of using a Decision Tree?

Answer 15

Clearly shows all decisions and uncertain events and how they are interrelated

Question 16

What are the 3 problems of using a Decision Tree?

Answer 16

1. Based on EV, so suffers from same disadvantages as all EV techniques.
2. Heavily dependant on probabilities used
3. Oversimplification of reality

Question 17

What is a “What-if” Analysis?

Answer 17

This looks at results of varying a model’s key variables, parameters or estimates.