Chapter 11 - The treatment of uncertainty and risk in decision making

Question 1

What is the difference between risk and uncertainty?

Answer 1

Risk is quantifiable; possible outcomes have associated probabilities
Uncertainty is unquantifiable, and the outcome cannot be mathematically modelled

Question 2

Investment appraisal often involves a degree of uncertainty and risk. How could we deal with it?

Answer 2

Adding a risk premium to the discount rate in order to compensate for risk:
Using payback period technique
Sensitivity analysis
Using probability distributions to give an indication of risk
Monte carlo simulation - a computerised system that extends sensitivity analysis

Question 3

How do we calculate sensitivity margin?

Answer 3

NPV/ PV of flow under consideration

Question 4

What does the expected value summarise?

Answer 4

All different possible outcomes by calculate a single weighted average

Question 5

What is the Monte Carlo simulation?

Answer 5

Computerised system that extends sensitivity analysis
Uses random numbers and probability statistics
Model identifies key variables in a decision

Question 6

What is value at risk a measure of?

Answer 6

How the market value of an asset or of a portfolio of assets is likely to decrease over a certain time

Question 7

What is perfect information?

Answer 7

Forecast of the future outcome is always a correct prediction

Question 8

What is imperfect information?

Answer 8

The forecast is usually correct, but can be incorrect

Question 9

What is conditional probability?

Answer 9

Probability of an event whose calculation is based on the knowledge that some other event has occurred

Question 10

What is a stress test?

Answer 10

A way of analysing a business to consider how well it could cope in difficult conditions.