DECISIONS UNDER RISK AND

UNCERTAINTY
Definition of Risk and Uncertainty

- Risk/Uncertainty: Both concepts deal

with the probability of loss or the
chance of adverse outcomes

- Risk: All possible outcomes of

managerial decisions and their
probabilities are not completely known

- Uncertainty: The possible outcomes

and their probabilities are known
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 General Risk Categories
Business Risk – the chance of loss associated with a
given managerial decision; typically a by-product of the
unpredictable variation in product demand and cost
conditions
Market Risk – the chance that a portfolio of investments
can lose money because of overall swings in financial
markets
Inflation Risk – the danger that a general increase in the
price level will undermine the real economic value of
corporate agreements
Interest-rate Risk – another type of market risk that can
affect the value of corporate investments and obligations
Credit Risk – the chance that another party will fail to abide
by its contractual obligations 3
 General Risk Categories (Con’t.)
Liquidity Risk – the difficulty of selling corporate
assets or investments that have only a few willing
buyers or are otherwise not easily transferable at
favorable prices under typical market conditions

Derivative Risk – the chance that volatile financial

derivatives such as commodity futures and index
options could create losses by increasing rather than
decreasing price volatility

Currency Risk – the chance of loss due to changes in

the domestic currency value of foreign profits

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Probability

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 Measuring Risk with Probability
Distributions
• Table or graph showing all possible
outcomes/payoffs for a decision and the
probability each outcome will occur.

• To measure risk associated with a

decision
• Examine statistical characteristics of the
probability distribution of outcomes for the
decision
Probability Distribution for Sales
 Expected Value
• Expected value (or mean) of a
probability distribution is:
n
E( X ) = Expected value of X =  pi X i
i =1

Where Xi is the ith outcome of a decision,

pi is the probability of the ith outcome, and
n is the total number of possible outcomes
 Expected Value
• Does not give actual value of the
random outcome
• Indicates “average” value of the outcomes
if the risky decision were to be repeated a
large number of times
 Variance
• Variance is a measure of absolute risk
• Measures dispersion of the outcomes
about the mean or expected outcome
n
Variance(X) =  X2 =  pi ( X i − E( X ))2
i =1

• The higher the variance, the greater the

risk associated with a probability
distribution
Identical Means but Different
Variances
 Standard Deviation
• Standard deviation is the square root of
the variance
 X = Variance( X )

• The higher the standard deviation, the

greater the risk
Probability Distributions with
Different Variances
 Coefficient of Variation
• When expected values of outcomes differ
substantially, managers should measure
riskiness of a decision relative to its expected
value using the coefficient of variation

• A MEASURE OF RELATIVE RISK

Standard deviation 
= =
Expected value E( X )
 Decisions Under Risk
• No single decision rule guarantees
profits will be maximized

• Decision rules do not eliminate risk

• Provide a method to systematically include
risk in the decision-making process
 Summary of Decision Rules Under
Conditions of Risk
Expected Choose decision with highest expected value
value rule

Mean-variance
rules GIVEN TWO RISKY DECISIONS A & B:
• If A has higher expected outcome & lower
variance than B, choose decision A
• If A & B have identical variances (or standard
deviations), choose decision with higher
expected value
Coefficient of If A & B have identical expected values, choose decision
variation rule with lower variance (standard deviation)

Choose decision with smallest coefficient of variation

Probability Distributions for Weekly
Profit
E(X) = 3,500 E(X) = 3,750
A = 1,025 B = 1,545
 = 0.29  = 0.41

E(X) = 3,500
C = 2,062
 = 0.59
 Expected Utility Theory
• Managers make risky decisions in a way
that maximizes expected utility of the
profit outcomes
E U(  ) = p1U( 1 ) + p2U( 2 ) + ... + pnU( n )

• Utility function measures utility associated

with a particular level of profit
• Index to measure level of utility received for a
given amount of earned profit
Manager’s Attitude Toward Risk
• Determined by the manager’s marginal
utility of profit:
MU profit = U(  ) 

• Marginal utility (slope of utility curve)

determines attitude toward risk
Manager’s Attitude Toward Risk
• Risk averse
• If faced with two risky decisions with equal
expected profits, the less risky decision is
chosen
• Risk loving
• Expected profits are equal & the riskier
decision is chosen
• Risk neutral
• Indifferent between risky decisions that have
equal expected profit
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Manager’s Attitude Toward Risk
• Can relate to marginal utility of profit
• Diminishing MUprofit
• Risk averse
• Increasing MUprofit
• Risk loving
• Constant MUprofit
• Risk neutral
Manager’s Attitude Toward Risk
Manager’s Attitude Toward Risk
Manager’s Attitude Toward Risk
 EXAMPLE
Example:
A firm with $100,000 in cash wants to decide either
to:
(1) Invest in a 30-day Treasury bill yielding 6%
interest, or to
(2) Prepay a 10% bank loan

Which course of action to take?

Choose (1) => $493 interest income after 30 days
Choose (2) => $822 interest expense savings after 30
days

Choose (2) provides $329 additional 1-month return

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 Probability Distribution
Event P (probabilty)
State of Economy
• Discrete probability distribution:
deals with “events” whose “states Recession 0.2
of nature” are discrete. The “event”
is the state of the economy. The Normal 0.6
“states of nature” are recession, Boom 0.2
normal, and boom.

• Continuous probability
distribution: deals with “events”
whose “states of nature” are
continuous values. The “event” is
profits, and the “states of nature”
are various profit levels.

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 Payoff Matrix
A table that shows outcomes associated with
each possible state of nature.
State of Economy Project A Project B Probability of State of Economy
Recession $4,000 $0 0.2
Normal $5,000 $5,000 0.6
Boom $6,000 $12,000 0.2

Project A more desirable in a recession.

Project B more desirable in a boom.
In a normal economy, the projects offer the same profit potential.
Decision to Make:
Which of the two investment projects must a firm chose? Each of the
projects calls for an outlay of $10,000. 28
 Expected Value
• The payoffs of all events: x1, x2, …, xN
• The probability of each event: p1, p2, …, pN
• Expected value of x:
N
EV ( x) = x1 p1 + x2 p2 + ... + x N p N =  xi pi
i =1

EV(x) is a weighted-average payoff, where the weights are

defined by the probability distribution.

• Use the payoff matrix in the previous slide, together with the
probability of each state of the economy.

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Expected profit of Project A and B under different
economic states of nature

EV ( A) = $4,000 • 0.2 + $5,000 • 0.6 + $6,000 • 0.2 = $5,000

EV ( B) = $0 • 0.2 + $5,000 • 0.6 + $12,000 • 0.2 = $5,400

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Variance and Standard Deviation
• Variance and Standard Deviation: measuring risk
The payoffs of all events: x1, x2, …, xN
The probability of each event: p1, p2, …, pN
• Expected value of x:
N
EV ( x) = x1 p1 + x2 p2 + ... + x N p N =  xi pi
i =1

• Variance:
2 2 2 N 2
 = ( x1 − EV ) p1 + ( x 2 − EV ) p 2 + ... + ( x N − EV ) p N =  ( xi − EV ) pi
2
i =1

• Standard deviation: square root of variance

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For project A, what are the variance and standard deviation?
EV(A) = $5,000
Variance (σ2) = ($4,000-5,000)2 (.2) + ($5,000-$5,000)2 (.6) + ($6,000-
$5,000)2 (.2)
(σ2) = ($1,000)2 (.2) + ($0)2 (.6) + ($1,000)2 (.2)
(σ2) = $400,000 (units are in terms of squared dollars)
σA = $632.46
For project B, what are the variance and standard deviation?
EV(B) = $5,400
Variance (σ2) = ($0-5,400)2 (.2) + ($5,000-$5,400)2 (.6) + ($12,000-
$5,400)2 (.2)
(σ2) = 5,832,000 + 96,000 + 8,712,000 (units are in terms of squared
dollars)
(σ2) = 14,640,000 (units are in terms of squared dollars)
σB = $3,826.23
Project B has a larger standard deviation; therefore it is the riskier
project
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 Risk Measurement
• Absolute Risk:
- Overall dispersion of possible payoffs
- Measurement: variance, standard deviation
- The smaller variance or standard deviation, the
lower the absolute risk.

• Relative Risk
- Variation in possible returns compared with the
expected payoff amount
- Measurement: Coefficient of Variation (CV),
- The lower the CV, the lower the relative risk.


CV =
EV
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Project A
EV(A) = $5,000
σA = $632.46
Project B
EV(B) = $5,400
σ B = $3,826.23


Coefficient of variation CV =
EV
A
CVA = EV ( A) = 0.1265

B
CVB = = 0.7086
EV ( B )

Coefficient of variation measures the relative risk; the

variation in possible returns compared with the
34 expected
payoff amount.
 REDUCING RISK
• Growth of state lotteries appears to
suggest that sometimes people choose
risky alternatives that suggest risk loving
rather than risk averse behaviour.
• Most people spend relatively small
amounts on lottery tickets and casinos.
• When important decisions are involved,
people are risk averse.
• Three ways consumers and businesses
commonly reduce risk:
• Diversification
• Insurance
• Obtaining more information

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 1. DIVERSIFICATION
• “Don’t put all your eggs in one basket”
• Suppose you are selling appliances on a
commission basis.
• Diversify what you sell. Assume you have the
opportunity to sell either heaters only or air-
conditioners only.
• How would you apportion your time to minimise
the risk involved?
• Diversification helps to minimise risk.
• Suppose there is a 0.5 probability that it will be a
relatively hot year and a 0.5 probability that it will
be cold.
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 1. DIVERSIFICATION…
Hot weather Cold weather
Air-conditioner sales $30 000 $12 000
Heater sales $12 000 $30 000

Diversification implies that:

𝐸(𝑌) = 𝑝𝑟1(𝑌1) + 𝑝𝑟2(𝑌2)
𝐸 𝑌 = 0.5 30 000 + 0.5 12 000
𝐸 𝑌 = 15 000 + 6000 = $21 000

• If the weather is hot you earn $15 000 from air-conditioners and $6 000 from heaters
and vice versa if the weather is cold.
• In this case, diversification eliminates all risk.

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The stock market
• Diversification is also important for stock market investors.
• Diversify stock so that if others do not perform you salvage something from those that
perform better.
• Putting all your money in a single stock is like “putting all your eggs in one basket”
(risking everything in one endeavour). Bad publicity about the company leads to a fall
in the share price and loss of capital (value) by the investor.
• Risk is reduced –although not eliminated- by investing in a portfolio of 5 or 10 different
stocks.
• You may also diversify by buying mutual funds shares in mutual funds.
• Mutual funds are organisations that pool funds of individual investors to buy a large
number of different stocks
• There are thousands of mutual funds available today for both bonds and stocks.
• Mutual funds are popular because they reduce risk through diversification and because
their fees are typically much lower than the cost of putting together your own portfolio
of stocks.

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2. INSURANCE

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 2. INSURANCE…
• Problems
• If insurance firms charge premiums that are
equal to the losses suffered, this is deemed fair.
• However, at times they charge higher premiums
than the expected losses to cover expenses etc.
• For this reason, they need to be regulated
heavily to see if they are treating their customers
fairly.
• Disasters and insurance-earth quakes,
hurricanes, floods etc.

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 3 THE VALUE OF
INFORMATION
• People make decisions based on limited information
• If better information were, available people would make
better predictions and reduce risk.
• Information is a valuable commodity that people have to
pay for to get it.
• The value of complete information is the difference
between the expected value of a choice when information
is complete and the expected value of a choice when
information is incomplete.
• Even though market forecasting is imperfect, it may be
worth investing in a marketing study that provides a
reasonable forecast of next year’s sales.
• Companies hire consultants to do market surveys for them
and also to carry out other types of research so that they
can make informed decisions, which are less risky. 41
 Decision-Making Under Risk
• Possible Criteria to consider:

- Maximize expected value

- Minimize variance or standard deviation

- Incorporate risk attitudes

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 Maximizing Expected Value
Event (State of Economy) P Profit

Project A Project B
Recession 0.2 $4,000 $0

Normal 0.6 $5,000 $5,000

Boom 0.2 $6,000 $12,000

EV(A)=$5,000 EV(B)=$5,400

Thinking:
✓Which project will you choose based on this criterion?

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Minimizing Variance/Standard Deviation

Event (State of Economy) P Profit

Project A Project B
Recession 0.2 $4,000 $0
Normal 0.6 $5,000 $5,000
Boom 0.2 $6,000 $12,000
 A = $632.46  B = $3,826.23

Thinking:
✓Which project will you choose based on this criterion?

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 Coefficient of Variation: Standard Deviation Divided
by the Expected Value

A B
Expected value $5,000 $5,400
Standard deviation $632.46 $3,826.23
Coefficient of Variation 0.2265 0.7086
Think:
✓Which project will you choose based on this criterion?
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Suppose that two investments have the same three payoffs, but the
probability associated with each payoff differs, as illustrated in the table
below:

Payoff Probability (Investment A) Probability (Investment B)

$300 0.10 0.30
$250 0.80 0.40
$200 0.10 0.30

(a) Find the expected return and standard deviation of each

investment.
(b) Jill has the utility function U = 5I, where I denote the payoff.
Which investment will she choose?
(c) Ken has the utility function U = 5 I . Which investment will he
choose?
(d) Laura has the utility function U = 5 I 2. Which investment will she
choose?
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THE END

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