S2 - uncertainty

Question 1

how is risk measured

Answer 1

measured by the variability of outcomes
Standard deviation
Fundamental to all analyses are the agents preferences - risk and return

Question 2

what are the key concepts

Answer 2

expected value of a random variable is the probability that different outcomes will occur multiple by the resulting payoffs
Sum of all probabilities = 1
Variance is the sum of the probabilities that different outcomes will occur multiplied by the squared deviations form the mean of the random variable
= q1(x1-Ex)^2 + q2(x2-Ex)^2 + … + qn(xn-Ex)^2

Question 3

what is utility

Answer 3

function of wealth
Marginal utility of wealth
Consumer faces 50:50 chance of losing a certain amount of wealth
Ex = 1/2U(W0) + 1/2U(W1)

Question 4

what is risk aversion

Answer 4

Implies that the uncertainty of a risky outcome reduces utility
Consumer prefers a certain payoff to the same expected payoff with a risky outcome
Diminishing marginal utility of wealth
expected wealth in both alternatives is the same but the expected utility of the certain alternative is higher
Consumer surplus gained by insuring certain alternative

Question 5

what is risk neutral

Answer 5

a consumer is indifferent between all alternatives offering the same expected value
Risk itself does not affect utility directly
As long as expected values are the same, a risk neutral person is indifferent towards risk
Constant marginal utility of wealth - expected wealth and utility is same for certain and uncertain

Question 6

what is risk loving

Answer 6

increasing marginal utility of wealth makes the risky alternative preferable
A 50/50 chance of gain or loss has a higher expected utility than the certainty

Question 7

what is decision tree analysis

Answer 7

Sequential decisions are made
Probabilities of different outcomes may be conditional on previous events
Objective is to calculate expected monetary values
Decision nodes numbered squares
State of nature nodes lettered circles
Backwards induction analyse payoffs
Calculate expected NPVs at each state of nature node

Question 8

criticisms of decision tree

Answer 8

simplifies decision making by restricting decision and state of nature variables to discrete values
Methodology doesn’t provide a definitive decision rule
Provided a measure of stand alone risk but market risk is crucial
Relationship between stand alone risk and market risk depends on the correlation between the projects returns and the returns on other assets
Risk adjusted cost of capital addresses this problem
Estimates this correlation so that the effect on market risk can be estimated and reflected in the cost of capital that is used to discount cash flows

Question 9

what is the basic valuation model

Answer 9

Sum of: Profit t / (1+i)^t
n is number of states, t is time period
required returns are related to level of risk perceived to be associated with a particular investment so we need to account for risk by adjusting the discount rate
If standard deviation of profits increases, the discount rate also increases

Question 10

what is certainty equivalence

Answer 10

how much money must an agent receive to make them indifferent between a certain sum and the expected value of a risky sum?
Risk adjusted model is considered superior because it includes risk and is easy to apply
CE methods requires analysis of the decision maker to discover their preferences toward risk