LECTURE 11 TUTORIALS (UNCERTAINTY)

1. What is the common mathematical tool used to measure the degree of risk and the likely profit
(outcome) from a risky undertaking?-__________Probabilty______________________

2. When making decisions under uncertainty, what are the 2 things people consider or depend on
whether they take risky option over non risky option?

a. _Individual’s attitude towards risks_________

b. __expected values or payoffs of various options_____see the summary_________

3. What are the four ways in which people try to avoid risk? State each of them.
a. _Just say no._________________
b. ______Obtain more information____________________________
c. _______Diversify_________________________________
d. _____Insure_________________________________

4. When investing under uncertainty, people’s investment decision will depend on 5 things. List each of
them.
Whether a person makes an investment depends on the:
a. uncertainty of payoff_______________
b. expected return_____
c. individuals attitude towards risk____________________
d. interest rate____________
e. cost of altering the likelihood of a good outcome____refer to the summary__

5. Please observe the example of making decisions under uncertainty provided in the lecture given
below.
Example: Greg schedules an outdoor event
If it doesn’t rain, he’ll make $15 in profit (e.g. $150,000)
If it does rain, he’ll make -$5 in profit (loss) (e.g. -$5,000)
There is a 50% chance of rain.
Greg’s expected value (outdoor event):

• Variance (outdoor event):

 • Standard deviation = $10  (√σ2 =√100)

: Greg schedules an indoor event

If it doesn’t rain, he’ll make $10 in profit (e.g. $100,000)
If it does rain, he’ll make $0 in profit
There is still a 50% chance of rain.
Greg’s expected value (indoor event)… is the same!

Variance (indoor event)… is much smaller:

Standard deviation = $5  (√σ2 =√100)

Much less risky to schedule event indoors!

What is the relationship between the value of standard deviation and riskiness?

Positive relationship—the high the value of standard deviation, the high the risk or as the value of
standard deviation increases so is the risk.

6. The rules for neutral risk takers and averse risk takers are as follows:
Risk-neutral
Owner invests if the expected value of the return from investment is positive.
Risk-averse
Owner invests if the expected value of the investment exceeds the expected value of not investing

a. To whom (what type of risk taker) does the decision tree above belongs and what made you
think so?
The decision tree belongs to the neutral risk taker because of the fact that the expected value of
investing is a positive ($100) and the expected value of not investing is zero ($0).
b. To whom (what type of risk taker) does the decision tree below belongs and what made you
think so? (Note: The original graph was not correct. We provide the answer for corrected graph below)
The decision tree belongs to the averse risk taker because of the fact that the expected value of
investing ($50) exceeds the expected value of not investing ($30).
7. List the 3 main reasons why many individuals make choices under uncertainty that are inconsistent
with the predictions of expected utility theory.
a. Difficulty assessing probabilities
b. Behavior varies with circumstances
c. Prospect theory

8. People’s mistaken beliefs about the probability that an event will occur that arises from the false
beliefs that past events affect current independent outcomes is called__gambler’s fallacy __.

9. The theory when people are making decisions under uncertainty they are concerned about gains
and losses in wealth rather than the level of wealth called_____Prospect theory_____________.