D. Risk and uncertainty in the short term

Question 1

What is the difference between risk and uncertainty?

Answer 1

risk

• quantifiable
• outcomes have probabilities so can apply maths

uncertainty

• unquantifiable
• outcomes cant be mathematically modelled as probabilities are unknown

Question 2

What is the expected value (EV)?

Answer 2

average result of all possible outcomes

-e.g if outcome is performed 1000 times

Question 3

How is the expected value calculated?

Answer 3

sum of (p multiplied by x)

X=future outcomes
p=probability of the outcome occurring

weighted average of all possible outcomes

Question 4

What is on the axis of a histogram?

Answer 4

outcomes vs probability

-each bar represents an outcome

Question 5

What are the advantages of EV?

Answer 5

• takes account of risk
• easy decision rule: single number
• simple to calculate

Question 6

What are the disadvantages of EV?

Answer 6

• subjective
• not useful for one-offs
• ignores attitude to risk (assumed risk neutral)
• answer may not be possible
• ignores the spread of outcomes

Question 7

What does the EV NOT represent?

Answer 7

• most likely outcome (one with highest probability)

- may not even represent a possible outcome

Question 8

What are the 3 types of decision makers?

Answer 8

risk seeker
risk neutral
risk averse

Question 9

What is a risk neutral decision maker?

Answer 9

• consider all possible outcomes
• select strategy that maximises the EV
• focus on the EV

Question 10

What is a risk seeking decision maker?

Answer 10

• select strategy with best possible outcome
• regardless of likelihood
• ignore EV

Question 11

What is a risk averse decision maker?

Answer 11

• avoid risk

- select lower, but more certain outcome than higher payoff

Question 12

What is the basis of utility theory?

Answer 12

individual’s attitude to certain risk profiles will depend on the amount of money involved
-shows that basing options solely on EV ignores range of possibilities

Question 13

What is a pay-off table?

Answer 13

illustrates all possible profits/losses

Question 14

What is the maximax rule?

Answer 14

select option that maximises the maximum pay-off

-for optimists/risk lovers

Question 15

What is the maximin rule?

Answer 15

option that maximises the minimum possible pay-off

-for pessimist/risk averse

Question 16

What is the minimax regret rule?

Answer 16

minimises maximum regret

• i.e opportunity loss/ shortfall from maximum contribution
• regret table:max demand at each choice then pick minimum

Question 17

What is perfect information?

Answer 17

forecast is correct

• 100% accurate prediction
• choose most beneficial action

Question 18

What is imperfect information?

Answer 18

not 100% correct

Question 19

How can value of information be caluclated?

Answer 19

expected profit (outcome) WITH the info 
less expected profit (outcome) WITHOUT the info

Question 20

What is a decision tree?

Answer 20

diagrammatic representation of a decision problem, where all possible courses of action are represented and every possible outcome of each course of action is known

Question 21

What is a joint probability?

Answer 21

where outcome of one event depends on the outcome of a preceding event

Question 22

What do squares and circles represent in a decision tree?

Answer 22

square: represent a decision point i.e can choose a course of action
circle: change outcome point i.e subject to probabilities

Question 23

How are decision trees used in decision making?

Answer 23

• calculate EV at each outcome point from right to left
• choose best option at each decision point
• recommend course of action to management

Question 24

What are the benefits of using a decision tree?

Answer 24

• maps out clearly decisions in uncertainty
• shows how interrelated events are
• clearly annotates tree with probabilities, cash floes and EVs

Question 25

What other factors should be taken into account when considering decision tree-type problems?

Answer 25

- assumes risk neutrality - sensitivity analysis:values are subjective - oversimplification:to make trees manageable, has to be simplified - suffers limitations of EV

Question 26

What is standard deviation?

Answer 26

compares actual outcomes to expected value | -measure of volatility:how far they deviate

Question 27

How does the standard deviation aid decision making?

Answer 27

higher SD means more risk and volatility

Question 28

What is the coefficient of variation?

Answer 28

measures the relative size of risk for projects that have varying SDs -smaller coefficient=less dispersed and less risky

Question 29

How is the coefficient of variation calculated?

Answer 29

- find SD:square of the deviations from the mean | - divide by mean or EV

Question 30

What is the peak of a normal distribution curve?

Answer 30

the mean

Question 31

How is data split in the bell shaped curve?

Answer 31

50% to the right, 50% to the left

Question 32

What are the characteristics of a normal distribution curve?

Answer 32

- continuous probability distribution - probabilities are represented by areas under the curve - total area under curve=1 - curve is symmetrical and bell shaped - width of the curve is measured in terms of SD - mean, median and mode are at the centre of the curve

Question 33

What is the z score?

Answer 33

allows us to calculate the proportion of the distribution meeting certain criteria for any normal distribution -i.e we can determine probabilities

Question 34

How is z score calculated?

Answer 34

difference/SD | -deduct z score from 0.5

Question 35

What is sensitivity analysis in decision making?

Answer 35

- takes each uncertain factor in turn - calculates the change that would be necessary in that factor before the original decision is reversed - established which estimates are more critical

Question 36

What is the sensitivity analysis process?

Answer 36

- best ESTIMATES made and a decision arrived - each variable analysed in turn to see EFFECTS of change on estimate - estimates for each variable can then be reconsidered to assess the LIKELIHOOD of the decision being wrong

Question 37

What are the strengths of sensitivity analysis?

Answer 37

- info presented to mgmt in a form which facilitates subjective judgement to decide the likelihood of the various possible outcomes considered - identifies area which are crucial to the success of the project so they can be monitored

Question 38

What are the weaknesses of sensitivity anlaysis?

Answer 38

- assumed that changes to variables can be made independently. Can simulate to make more than one change - only identifies how far a variable needs to change; does not look at the probability of such a change - provides information on the basis of which decisions can be made but it does not point to the correct decision directly