Chapter 2: Choice-involving Risk and Uncertainty

2.1Introduction
In business we are forced to make decisions involving risk—that is,
where the consequences of any action we take is uncertain due to
unforeseeable events.
 Definition. Risk refers to decision-making situations under which all
potential outcomes and their likelihood of occurrences are known to
the decision-maker.
 It implies from future uncertainty about deviation from expected
earnings or expected outcome.
 Uncertainty refers to situations under which either the outcomes or
their probabilities of occurrences are unknown to the decision-maker.
 Risk vs. Uncertainty
Risk: must make a decision for which the outcome is not known
certainly. Can list all possible outcomes & assign probabilities to the
outcomes.
 Conti...
A situation of winning or losing something worthy
Uncertainty: Cannot list all possible outcomes
 There is no knowledge about the future events.
 Cannot assign probabilities to the outcomes
 Sometimes we need to choose between risky ventures. In different
situations, people must choose the amount of risk they wish to bear.
 To analyze risk quantitatively, we need to know all possible
outcomes of a particular action & the likelihood that each outcome
will occur.
 In real economic life, many decisions are taken under risk &
uncertainty,
 For example investment decisions, decisions about consumption
through time, buying & selling insurance, investment in new
industries & countries, choosing new technologies, stock market
purchases and sales. 2
 Conti…
The decision under risk & uncertainty can be divided in:
1. Decision making under uncertainty, which can be divided in
to two approaches:
 The Bayesian approach, according to which people assign
subjective probabilities to uncertain events and these probabilities
follow the rules of mathematical probability theory.
 The approach by Knight (1921)& Keynes (1921) according
to this, people cannot assign subjective probabilities to
uncertain events.

3
 Probability is a numerical
measure of the likelihood
of an event occurring

Probability is concerning
numerical descriptions of how
likely an event is to occur, or how
likely it is that a proposition is true.

0 1.0
0.5
Probability:

The occurrence of the event is just likely as it is unlikely

4
Objective(OP) versus Subjective Probabilities(SP)

 Repeatable experiments (tossing a die, flipping a coin) generate

objective probabilities.
 Thus, OP is the probability an event will occur based on each
measure is based on a recorded observation or a long history of
contrast.
 Non-repeatable experiments necessarily involve assigning
hypothetical or subjective probabilities to particular outcomes.
 SP is a probability that allows the observer to gain insight by they
have learned & their own experience.
Expected Value
 In a risk situation choice can be viewed as a choice of the preferred
lottery or prospect.
 Individuals value different prospect or lottery of given risk
situation using expected value.
5
 Expected Value
• Expected value (or mean) of a probability distribution is:

 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
 The concept of expected value was first developed by 17th century
mathematicians, Pascal.
 The expected value of a lottery is the average of the monetary
prizes associated with the different outcomes, weighted by
their respective probabilities.
 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
6
 Probability Distribution for a New Product Launch

The following gives the subjective view of a manager

concerning the probability distribution for the first year’s
outcome of a new product launch.

Outcome Sales Revenue Probability

Complete success $10,000,000 0.1

Promising 7,000,000 0.3

Mixed response 3,000,000 0.2

Failure 1,000,000 0.4

7
 Computing Expected Value or E(v)

Suppose the decision maker faces a risky prospect than

has n possible monetary outcomes, v1, v2, . . . , vn,
predicted to occur with probabilities p1, p2, . . . , pn. Then
the (monetary) expected value is found by:

E (v)  p1v1  p2 v2  ...  pn vn

E(v) for the new product launch is given by:

E (v)  (0.1)($10)  (0.3)($7)  (.2)($3)  (0.4)($1)  $4.1 million

8
 Variance
 Variance is a measurement of the spread b/n numbers in a data
set. Investors use variance to see how much risk an inv’t carries
& whether it will be profitable.
 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
9
Identical Means but Different Variances (Figure 2.2)

10
 Standard Deviation(SD)
• SD is a measure of the risk that an investment will fluctuate from its
expected return.
• In investing, standard deviation is used as an indicator of market
volatility and thus of risk
• Standard deviation is the square root of the variance

 X  Variance( X )
• The higher the standard deviation, the greater the risk

11
 Coefficient of Variation(CV)
 CV is a measure used to assess the total risk per unit of return of an
investment.
 When expected values of outcomes differ substantially, managers
should measure riskiness of a decision relative to its expected value
using the coefficient of variation
Standard deviation 
A measure of relative risk  
Expected value E( X )
 The lower the value of the coefficient of variation, the more
precise the estimate.
Decisions Under Risk
 No single decision rule guarantees profits will actually be
maximized
 Decision rules do not eliminate risk
 Provide a method to systematically include risk in the decision
making process 12
Summary of Decision Rules Under Conditions of Risk

Expected value
rule Choose decision with highest expected value
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
• If A & B have identical expected values, choose
decision with lower variance (standard deviation)
Coefficient of
variation rule Choose decision with smallest coefficient of
variation

13
 Which Rule is Best?
For a repeated decision, with identical probabilities each
time
Expected value rule is most reliable to maximizing
(expected) profit
Average return of a given risky course of action
repeated many times approaches the expected value of
that action
For a one-time decision under risk
No repetitions to ―average out‖ a bad outcome
No best rule to follow
Rules should be used to help analyze & guide decision
making process
14
 Expected Utility Theory(EUT)
 EUT is an account of how to choose rationally when you are not
sure which outcome will result from your act.
 Its basic slogan is: choose the act with the highest expected
utility
 Actual decisions made depend on the willingness to accept risk
 Expected utility theory allows for different attitudes toward
risk-taking in decision making
Managers are assumed to derive utility from earning profits
 The EU model relies on the hypothesis that if the individual
possesses – or acts a von Neumann-Morgenstern utility
function(VNM) over a set of outcomes, & when he faces
alternative lotteries over these outcomes he chooses that lottery
which maximizes the expected value of this utility.
15
 Expected Utility Theory(EUT)
 VNM is an extension of the theory of consumer preferences that
incorporates a theory of rational behaviour toward risk variance.
 This approach was advocated by John von Neumann & Oskar
Morgenstern(1944) that leads us to a formal mathematical
representation of maximization of expected utility.
 Expected value is the sum of the products of the various utilities
& their associated probabilities.
 The individual thus chooses the lottery for which the expected utility
is the highest,
 Where the expected utility of a lottery 𝐿 = (𝑋1 , 𝑝1 , … 𝑋𝑛 , 𝑝𝑛 )
 𝐸𝑈 𝐿 = 𝑛𝑖=1 𝑈 𝑋𝑖 𝑃𝑖 𝑖 = 1,2, … 𝑛
 Given pi the probability of the outcome xi and U(xi) its utility. The
expected utility of a lottery is then the expected value of the utilities of
the possible outcomes.
 Managers make risky decisions in a way that maximizes expected
utility of the profit outcomes
16
 Expected Utility Theory

• Similarly;
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

 Example consider the two lotteries L1 & L2

illustrated above. Assume that the utility function is
of the form U(x) = √x, where x is the monetary value
of the outcome.
17
 Expected Utility Theory
• Example consider the two lotteries L1 & L2 illustrated two
lotteries L1 = ($60, ½;$0, ½) and L2 = ($40, ½;$20, ½). .
Assume that the utility function is of the form U(x) = √x,
where x is the monetary value of the outcome.
• The expected utility of L1 is then equal to;
𝐸𝑈 𝐿1 = ½ ∗ 60 = $3.87 𝑎𝑛𝑑
𝐸𝑈 𝐿2 = ½ ∗ 40 + ½ ∗ 20
= $3.16 + $2.23
= $5.39.
Based on this utility function, the consumer’s risk
behaviour can be evaluated by comparing his or her
utility of the expected value of the lottery with that of
the utility of the lottery. A consumer may be risk averse,
risk-lover (i.e., risk-taker) or risk-neutral. 18
 Individuals Attitude Toward Risk
Aversion: In economics & finance, risk aversion is the
tendency of people to prefer outcomes with low
uncertainty to those outcomes with high uncertainty.
Even if the average outcome of the latter is equal to or
higher in monetary value than the more certain outcome.
 Risk aversion explains the inclination to agree to a
situation with a more predictable, but possibly lower
payoff, rather than another situation with a highly
unpredictable, but possibly higher payoff.
fears losses and seeks sureness and hence prefers a
certain income to a risky income even with the same
expected value.
19
 The Certainty Equivalent (CE)

The CE is the
amount of money for
certain that makes
the individual
exactly indifferent to
the risky prospect.

 Risk averse: If faced with two risky decisions with equal

expected profits, the less risky decision is chosen.
 Suppose the person currently has 20,000 she is considering
a business which will increase her wealth to 30,000 if the
business succeeds but reduce her wealth to 100,000 if it
fails. 20
 The Certainty Equivalent (CE)

 Each success and failure has

equal probability of 0.5. A
utility for each state is given as
follows.
U(20,000) = 16, U(10,000) = 10,
U(30,000) = 18
E(u)= 0.5U(30) + 0.5U(10)
= 0.5(18) + 0.5(10) = 14
 Note that: Risk aversion prefers  U(20) > E(U), for U(20) is 16
a certain income to a risky and E(U) is 14. Because of this
income with the same expected the risk averse consumer
value. accepts this gamble.
21
 Individuals Attitude Toward Risk
 For a risk-averse consumer the utility of the expected value
of wealth, u(20), is greater than the expected utility of
wealth, .5u(10)+.5u(30).
The risk averse consumer has a concave utility curve.
The slope of a utility curve gets flatter as wealth increases.
The reason is marginal utility of income decreases with
increasing level of wealth.
This implies that the gain in utility from a given amount of
additional wealth is smaller than the loss in utility from a
comparable loss in wealth.
That is why such a person always refuses to accept a
gamble whose expected value is less than expected utility.
22
 Individuals Attitude Toward Risk
II. Risk loving: Expected profits are equal & the more risky
decision is chosen.
He or she does not mind losing as much and hence
prefers the decision of a risky income to the certain
income even with the same expected value.
The risk lover consumer has a convex utility function. The
slope of the utility function gets steeper and steeper as
wealth increases.
For such consumer, marginal utility increases with
increasing level of wealth. The gain in utility from a given
amount of additional wealth is greater than the loss in
utility from a comparable loss in wealth.
That is when such a person always accepts a fair gamble.
23
 Individuals Attitude Toward Risk
 For a risk-lover consumer the utility of the expected value
of wealth, u(20), is less than the expected utility of wealth,
.5u(10)+.5u(30).
This is a situation where the utility from a given amount of wealth (income) is less than
the expected utility.

Utility
u (wealth)
u(30)=18

1 u (10)   2 u (30)
.5u(10)+.5u(30
1 1
u(20) =8
E(U)=  3  (18)
2 2

u(10)=3 1.5  9  10.5

10 20 30 Wealth 24
 Individuals Attitude Toward Risk
III. Risk neutral: Indifferent between risky decisions that
have equal expected profit. It is indifferent between a certain
income and uncertain income with the same expected
value.
 For a risk neutral consumer utility of the a decision is
indifferent to the utility of the expected value of the
decision. The decisions are identical under maximization of
expected utility or maximization of expected profit

25
 Conti….
Generally marginal utility of profit
 Diminishing Muprofit: Risk averse
 Increasing Muprofit : Risk loving
 Constant Muprofit : Risk neutral
According to expected utility theory, decisions are made
to maximize the manager’s expected utility of profits,
Such decisions reflect risk-taking attitude

26
 Risk spreading
Risk spread is a business strategy employed by insurance
companies.
It involves selling insurance covering the same risk in one
period or selling a huge number of policies with different
coverage in many areas.
Spreading out risk in this way allows insurers to avoid
paying claims that threaten to ruin their financial health, as
could happen if all of their risks were not diversified.
An insurance company, or insurer, is a business that agree
to pay the cost of potential future losses in exchange for
regular fee payments

27
 Diversification
 It is a strategy used by investors to manage risk. By
spreading your money across d/t assets & sectors, the
thinking is that if one area experience turbulence, the others
should balance it out.
It's the opposite of placing all your eggs in one basket.
• The practice of undertaking many risky activities, each on a
small scale, rather than a few risky activities(or just one) on
a large scale.

28
 Diversification
He minimizes the risks of uncertainty, by diversifying his
holding. When one puts his effort in different types of
(unrelated) activities, the loss from badly performing
activities can be compensated by gain from well performing
activities.
By this method one can minimize his/her risk, this method
of minimizing risk is said to be diversification.
 Example: Consider a person thinking of investing Br. 1000 in
two companies, one is heater producing and the other is air
conditioners producing company. The share of stock for both
companies currently is sold for Br. 100 each. The next season is
equally likely to be hot or cold. If the next season turns out to be
cold, the securities of the heaters company will be worth Br.200
each and securities of Air Conditioners Company will be worth
of Br.50 each. 29