PRICING UNDER RISK AND UNCERTAINTY

INTRODUCTION
Real world is full of uncertainties and risk.

People face uncertainty as regards to future income. e.g. Taking loan to buy or build a house, factory or a car and plan to pay for them out of their future incomes.

 People have often to choose how much risk to bear. e.g. Investment of money in savings a/c. or banks deposits or investment in shares of some company or in mutual funds. To make a choice among these alternatives, we need to measure the risk so as to compare the riskiness of alternative choices.

THE CONCEPT OF RISK AND UNCERTAINTY

RISK :

The risk refers to a situation when the outcome of a decision is uncertain but when the probability of each possible outcome is known or can be estimated.

 UNCERTAINTY : The uncertainty refers to the situation when there is more than one possible outcome of a decision but where the probability of occurrence of each particular outcome is not known or even cannot be estimated.

In Decision Making Involving Risk and Uncertainty the three terms are quite often used.

(i) strategy , (ii) state of nature and (iii) outcome.

(i) STRATEGY : A strategy refers to one of several alternative courses of actions or plans that can be implemented to achieve the desired goal.

(ii) STATE OF NATURE : It refers to the conditions that prevail in future and which have a significant effect on the success or failure of the strategy.

(iii) OUTCOME :

It refers to the results which are usually in the form of profit that come about as a result of implementation of a strategy.
Risk refers to the amount of variability in the outcome as a result of the adoption of a particular strategy.

MEASURING RISK : PROBABILITY OF AN OUTCOME

To measure the degree of risk, we need to know the probability of each possible outcome of a decision. The probability means the likelihood of occurring of an event. Thus, if probability of an outcome occurring is or .25 this means that there is 1 chance in 4 or 25% chance for the outcome to occur.

There are two concepts of probability depending on how it is measured

(i) Frequency concept of probability :

It is based on past information. If a situation is repeated over a large number of times , say M, and if outcome , say X , occurs m times , then

P(X) = m/M
(ii) Concept of subjective probability :
It is based on personal judgement , experience or knowledge.

MEASURING RISK WITH PROBABILITY DISTRIBUTION

Probability distribution describes the occurrence of all possible outcome of an event and probability of occurrence of each outcome. It is worth noting that the sum of probabilities of all possible outcomes must equal unity because probabilities of all outcomes together must equal certainty.

 Table 35.1 : We give all possible cash flows that will occur from an investment project A in the next years and the probabilities of their occurrence.

 Table 35.2 : We give the cash flows that will occur in the next year and their associated probabilities from an investment project B.

Figure 35.1

Figure 35.2

The concept of probability distribution is required for evaluating and comparing investment projects when managers have to take decision under conditions of risk. From the probability distribution of outcomes , we can calculate two values which are essential for decision making under conditions of risk.

They are :

(1) expected value of all possible outcomes (cash flows) and (2) a value that measure the degree of risk involved (variability of an outcome) .

(1) EXPECTED VALUE : If there are two possible outcomes with payoffs of X1 and X2 and the probability of each possible outcome denoted by P1 and P2 , then the expected value of investment is given by

E(X) = P1X1 + P2X2

Similarly , if there are n possible outcomes , then the expected value is E(X) = P1X1 + P2X2 + P3X3 + _ _ _ _PnXn

(2) RISK AND PROBABILITY DISTRIBUTION :

In addition to the expected value , the probability distribution of outcomes also helps us in measuring risk involved in a project . The variability of outcomes measures the degree of risk involved in any choice of a project or strategy from the various lternative projects or strategies.

The greater the variability or dispersion of various outcomes from the expected value of payoffs means the greater risk involved. The variability of outcomes may be measured by the average deviation of actual values of payoffs of various outcomes from the expected value of payoff with probability of each being used as weights.

Let X1and X2 are the payoffs of two outcomes and the probability of each is P1 and P2 , then the average deviation (V) as a measure of risk is given by

Most widely used measure of dispersion or variability is the standard deviation.

Since expected value E(X) is also written as mean , the standard deviation is also written as

STANDARD DEVIATION AND PROBABILITY DISTRIBUTION

Probability distribution of outcomes is assumed to be one of standard normal distribution which is symmetric around the expected value and also there is 50% possibility that outcome will be above the expected value and there is 50% possibility that outcome will be less than 50. The probability of a particular outcome occurring depends on how many standard deviation it is away from expected value. In the probability distribution given in Table 35.3 , the expected value (mean) from all five outcomes is Rs. 50 lakhs and standard deviation is

Table 35.3

Table 35.4

Fig 35.3

CONTINUOUS PROBABILITY DISTRIBUTION AND NORMAL CURVE

MEASURING PROBABILITY OF OUTCOME LYING WITHIN PARTICULAR RANGE

In Table 35.1 we are interested to know what will be the probability of cash flow of Rs. 62 lakhs from the project A will be within range of Rs. 50 lakhs and Rs. 60 lakhs. Assuming that cash flows are normally distributed with expected value equal to Rs. 50 lakhs and standard deviation of 10.59. We first find the value of Z as under

THE COEFFICIENT OF VARIATION

The Relative measure of risk : When the expected values of two projects are equal or very close to each other , the S.D. is an appropriate measure of riskiness of projects. However, when the expected values of the investment projects are quite different , then we make use of coefficient of variation which is a relative measure of risk.

The coefficient of variation measures risk relative to the expected values of the projects i.e. cov measures risk per rupee of the expected value. Coefficient of variation is obtained from dividing the s.d. of probability distribution by the expected value(mean).
Coefficient of variation :

Table 35.5

DECISION MAKING UNDER RISK

For making a rational decision , the following 3 things should be determined : (1)The expected values of payoffs associated with various outcomes be calculated. (2) The degree of risk of various strategies be measured by estimating the standard deviation of the average deviation of payoffs of various outcomes from the expected value. (3) Information about the decision maker regarding his preference towards risk be obtained.

e.g. Suppose an individual is considering two types of investment , say A and B . Each type of investment requires an initial cost of Rs. 1 lakh and have a life of 5 years. The monetary return on these two types of investment depends on the rate of inflation in the next 5 years.

Table 35.6

ATTITUDE TOWARDS RISK

ASSUMPTIONS : To explain the preference towards risk we will consider a single composite commodity , namely , money income. An individuals money income represents the market basket of goods that he can buy. It is assumed that the individual knows the probabilities of making or gaining money income in different situations. But the outcomes or payoffs are measured in terms of utility rather than rupees.

RISK AVERTER :

Figure 35.4

For a risk averse individual marginal utility of money diminishes as he has more money.

RISK SEEKER : For a risk seeker individual marginal utility of money increases as money with him increases. Fig 35.5

RISK NEUTRAL : For a risk neutral individual marginal utility of money remains constant as he has more money. Fig 35.6

MANAGEMENT OF RISK : REDUCING RISK

We have seen now above that though some individuals are risk-seekers , most of the individuals are risk-averse and try to reduce risk or uncertainty they face. There are three methods by which individuals or consumers can reduce risk. They are :
(1)DIVERSIFICATION (2) INSURANCE (3) GATHERING MORE INFORMATION

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