Risk & Uncertainty

Question 1

Explain the difference between Risk and Uncertainty.

Answer 1

Risk is when there is more than one possible future outcome and the probability of each outcome CAN estimated.

Uncertainty is when there is more than one possible future outcome and the probability of each outcome CANNOT be estimated.

Question 2

What is sensitivity analysis used for?

Answer 2

Sensitivity Analysis is used to measure the margin of safety of any variables subject to uncertainty.

Question 3

What are the 4 Attitudes to risk?

Answer 3

1. Risk Seeker
2. Risk Averse
3. Regret Averse
4. Risk Neutral

Question 4

What characterises someone with a “Risk Seeker” attitude to risk?

Answer 4

Someone who will seek high returns and is prepared to accept high risk.

Question 5

What characterises someone with a “Risk Averse” attitude to risk?

Answer 5

They will look to limit risk and make low risk choices.

These low risk choices usually mean low returns.

Question 6

What characterises someone with a “Regret Averse” attitude to risk?

Answer 6

They will seek to minimise the adverse impact of “getting things wrong”.

Question 7

What characterises someone with a “Risk Neutral” attitude to risk?

Answer 7

Will ignore risk and focus on a statistical value.

This is called Expected Monetary Value

Question 8

What risk model would someone who is “Risk Seeking” look to implement?

Answer 8

MAXIMAX

Question 9

What risk model would someone who is “Risk Averse” look to implement?

Answer 9

MAXIMIN

Question 10

What risk model would someone who is “Regret Averse” look to implement?

Answer 10

MINIMAX REGRET

Question 11

What risk model would someone who is “Risk Neutral” look to implement?

Answer 11

Expected Monetary Value

Question 12

When a number of potential investments are on offer, what will the MAXIMAX model suggest?

Answer 12

It will suggest choosing the option with the best possible “best outcome”

Question 13

When a number of potential investments are on offer, what will the MAXIMIN model suggest?

Answer 13

It will suggest choosing the option with the best possible “worst outcome”

Question 14

When a number of potential investments are on offer, what will the MINIMAX Regret model suggest?

Answer 14

It will suggest the option with the lowest posssible highest opportunity cost for all of the possible outcomes.

Question 15

Expected monetary value is more effective when based on what type of probability:

A. Subjective probability
B. Objective probability

Answer 15

B. Objective probability

When there is a data set that validifies the probability from past event

Question 16

A Panel of experts come together and decide that the probability of a Liverpool beating everton is 99%. is this:

A. Obejective probability
B. Subjective probability

Answer 16

B. Subjective probability

Question 17

What are some limitations of Expected Monetary Value?

There are 3.

Answer 17

1. It assumes that the probabilities used to calcuate are accurate.
2. Only reliable when Objective information is used.
3. Expected value is an average of all possible outcomes, not what we actually expect to happen.

Question 18

What are the 4 stages of the decision tree method?

Answer 18

1. Draw the tree
2. Assign the probabilities
3. Calculate the monetary value of each possible outcome.
4. The backwards pass

Question 19

What are the 2 types of nodes in a decision tree?

Answer 19

1. Event Node
2. Decision Node

Question 20

How does the backwards pass stage of a decision tree work?

Answer 20

Carry the monetary values back to each node. If it is an event node calculate the expected value (of all possible outcomes) using the probabilities. If it is a decision node carry back the best option and put a barrier (/) on each of the other oprions to show they will be rejected.

Question 21

A square node in a decision tree represents a?

Answer 21

A decision node.

Question 22

A circle node in a decision tree represents a?

Answer 22

Event node.

Question 23

What are some 4 limitations of a decision tree?

Answer 23

1. The “answer” is an expected value and is a weighted average of all possible oucomes resuting from a decision and does not represent the actual outcome.
2. The use of expected values implies a risk neutral attitude.
3. The analysis is only as accurate as the data estimates used in the making of the decision tree.
4. It only considers the financial side to a decision, when i reality many other factors may need to be considered. Especially in a public organisation.

Question 24

What does Sensitivity analysis measure?

Answer 24

It measures the responsivness of the final outcome to a change in a single variable.

Question 25

What 2 ways can we overcome opitimism bias?

Answer 25

1. Reduce estimates of benefits
2. Increase estimates of costs

Question 26

What is the formula to calculate the sensitivity of a certain factor in a NPV calculation?

Answer 26

Sensitivity = NPV / PV of uncertain cashflow