Risk and Uncertainty in Decision Making

Question 1

RISK

Answer 1

Has to do with a situation in which there are several possible outcomes and there is relevant past experience to enable statistical evidence to be produced for predicting the possible outcomes.

Question 2

UNCERTAINTY

Answer 2

Has to do with a situation in which there are possible outcomes, but there is little previous statistical evidence to enable the possible outcomes to be predicted.

Question 3

STATE OF NATURE

Answer 3

In the context of risk and uncertainty, factors that are outside the decision-maker’s control, also known as events.

Question 4

PROBABILITY

Answer 4

In the context of risk and uncertainty, the likelihood that an event (or state of nature) will occur, normally express decimal form with a value between 0 and 1.

Question 5

OBJECTIVE PROBABILITIES

Answer 5

Probabilities that can be established mathematically or complied from historical data.

Question 6

SUBJECTIVE PROBABILITIES

Answer 6

Probabilities based on an individual’s expertise, past experience, and observations of current variables which are likely to affect future events.

Question 7

PROBABILITY DISTRIBUTION

Answer 7

A list of all possible outcomes for an event and the probability that each will occur.

Question 8

EXPECTED VALUE (PAYOFF)

Answer 8

The weighted average of the possible outcomes.
Calculation: multiply each of the possible outcomes by the probability associated to it, then sum up everything.

It represents the long-run average outcome expected if a particular course of action is undertaken many times.

Question 9

How is risk measured?

Answer 9

Measured in terms of spread of possible outcomes.
Decision makers are probably more interested in a downside measure of risk that measures the possibility of risk being less than expected value.

Two measures: Standard deviation (ABSOLUTE MEASURE)
Coefficient of variation (RELATIVE MEASURE)

Question 10

STANDARD DEVIATION

Answer 10

The square root of the mean of the squared deviations from the expected value multiplied by probability of each outcome.

Question 11

COEFFICIENT OF VARIATION

Answer 11

If we are comparing the SD of two probability distributions with different EV, we cannot make a direct comparison.
In this case we can use the coefficient of variation which is SD/EV.

Question 12

What are the three different attitudes to risk?

Answer 12

Risk averse
Risk neutral
Risk seeking

Question 13

DECISION TREE

Answer 13

A diagram showing several possible course of action and possible events and the possible outcomes for each course of action.
Each alternative course of action or event is represented by a branch, which leads to subsidiary branches for further course of action or possible events.
A decision tree illustrates the interaction of different variables and choices leading to a range of possible outcomes.

Question 14

Stages of making a decision tree.

Answer 14

1. Draw out the decision tree.
2. Assign probabilities to events.
3. Determine outcomes.
4. Determine expected values.
5. Roll back to decision point(s).
6. Rank/compare/decide.

Question 15

PERFECT INFORMATION

Answer 15

-Possibility of obtaining additional information to mitigate the uncertainty associated to a decision.
What is the maximum amount it would be worth paying for acquiring some additional information?
We should compared the expected value of a project if the information is acquired against the expected value with the absence of the information.

Question 16

What are the three criteria for decision making?

Answer 16

Maximin
Maximax
Regret

Question 17

MAXIMIN CRITERIA

Answer 17

• Assumes that the worst possible state of nature will occur.
• The decision maker should maximise his/her payoff given this assumption.
• Assuming low growth, product A will be chosen.

Question 18

MAXIMAX CRITERIA

Answer 18

• Assumes that the best possible state of nature will occur.
• The decision maker should maximise his/her payoff given this assumption.

Question 19

REGRET CRITERION

Answer 19

• Assumes that, having selected an alternative that did not result to be the best, the decision maker will regret not having chosen another course of action when s/he had the opportunity to do so.
• It aims to minimise the maximum possible regret (opportunity cost).

Question 20

DIVERSIFICATION STRATEGY

Answer 20

A strategy of investing in a range of different projects in order to minimise risk.
The aim should be to measure incremental, rather than the total, risk of the project.