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8/8/2019 Decision Rules Under Conditions of Risk
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Presented By:
Omkar Inamdar
( Roll No. 70)
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` Risk Must make a decision for which the outcome is not
known with certainty
Can list all possible ou
tcomes & assign probabilities tothe outcomes
` Uncertainty Cannot list all possible outcomes
Cannot assign probabilities to the outcomes
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` Table or graph showing all possible
outcomes/payoffs for a decision & 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
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` Expected value (or mean) of a
probability distribution is:
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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
n
i i
i
E( X ) p X !
! ! 1
Expected value of X
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` Does not give actual value of the random
outcome
` Indicates average value of the outcomes if therisky decision were to be repeated a large
number of times
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` Variance is a measure of absolute risk
` Measures dispersion of the outcomes about the meanor expected outcome
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n
x i i
i
p ( X E( X ))W!
! ! 2 2Variance(X)
The higher the variance, the greaterthe risk associated with a probabilitydistribution
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` Standard deviation is the square root of thevariance
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The higher the standard deviation,the greater the risk
xW ! Variance(X)
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` When expected values of outcomes differ
substantially, managers should measure
riskiness of a decision relative to its
expected value using the coefficient ofvariation Ameasure of relative risk
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E( )
W
Y ! !
Standard deviation
Expectedvalue
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` 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
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Expected
value rule
Mean-
variance
rules
Coefficient of
variation rule
Choose decision with highest expected value
Given two risky decisions A & B:
If A has higher expected outcome & lowervariance than B, choose decision A
If A & B have identical variances (or standarddeviations), choose decision with higherexpected value
If A & B have identical expected values,
choose decision with lower variance (standarddeviation)
Choose decision with smallest coefficient ofvariation
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` 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
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` 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 & guidedecision making process As much art as science
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` 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 more risky decision is
chosen
` Risk neutral Indifferent between risky decisions that have equal
expected profit
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