Risk and Certainty

Topics: Decision theory, Risk, Decision making Pages: 7 (940 words) Published: June 14, 2013
Chapter 3: Risk and Uncertainty

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Table of Contents
01. Risk vs. uncertainty
Risk vs. uncertainty Sources of uncertainty

03. Click to add sub title
- Description of - Description of - Description of - Description of the contents the contents the contents the contents

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Readings
• Required: Textbook (Chapter 3) • Recommended: Alan and Griffiths (Chapter ) • Further readings:

Risk versus Uncertainty

01

Risk versus Uncertainty

Risk refers to outcome where the range of potential future outcomes is known from pass experience

Risk versus Uncertainty

Uncertainty refers to outcomes where estimates have been made but no probabilities can be attached to the expected outcomes

Sources of Uncertainty

Macroeconomics Risks

Uncertainty

Political change

Supply Conditions

Invention and innovation

Market demand

Sources of Uncertainty
• Changing market demand:
– Depends on consumer tastes and incomes – These changes may be predictable or unforeseen

Sources of Uncertainty
• Changing supply conditions:
– Increases or decreases in the price of raw materials – Shortages or gluts of important components – Uncertainty on the supply side lies in decisions made by competitors or new entrants about investment in new capacity

Sources of Uncertainty
• Invention and Innovation:
– The outcome of such a strategy is uncertain because the outputs and usefulness of the innovations are unknown – Leader or follower

Sources of Uncertainty
• Macroeconomics risks:
– Are linked not to changes in the market but to the economy as a whole – Economic activity tends to be cyclical with periods of growth followed by periods of decline

Sources of Uncertainty
• Political change:
– Changes of government may lead to adverse conditions for business in general and some businesses in particular

Incorporating time and uncertainty into decision making
• Expected value:
– Is the outcome anticipated when the range of pay-offs have attached to them some estimate of objective probability or subjective likelihood of potential outcome – ������������������ = ������������ × ������������ + ������������ × ������������ + ������������ × ������������

Incorporating time and uncertainty into decision making

Incorporating time and uncertainty into decision making
• Coefficient of Variation:

Incorporating time and uncertainty into decision making

Incorporating time and uncertainty into decision making
• Time and discounting

Incorporating time and uncertainty into decision making
• Decision Trees:
– Choices are not made between a limited number of independent projects but between a series of interacting and interdependent outcomes – The sequence of choices can be shown using a decision tree in which decisions are seen as branching out from one another

Incorporating time and uncertainty into decision making

Attitudes to Risk and Uncertainty

02

Attitudes to Risk and Uncertainty
Risk - averse
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Risk - neutral

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Risk - seeking

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Attitudes to Risk and Uncertainty

Attitudes to Risk and Uncertainty

Attitudes to Risk and Uncertainty

Indifference curve analysis of Risk and Return
• Indifferent curve:
– Show different combinations of risk and return that give an individual an equal level of satisfaction or utility – To analyze the choice between expected...
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