RMI2302 Exam 2 Study Guide Spring 2016 Individual Risk How much do I have to entice you to take on a risk Use expected utility Multiply probability by value and take the square root add up possible outcomes The entire basis of insurance is people willing to pay to avoid risk o How much do I have to offer you in order for you to undertake risk and abandon a certain reward Organizational Risk How much expected return do I have to get to get me to invest in something Use expected value not expected utility Most organizations project future cash flows from investments and opportunities o Look at how much money they have paid out of pocket this year and calculate the expected value of their returns Bring those cash flows back to present value Base it on cost of capital Cost of capital is lower when the investment is safer Cost benefit analysis How much is the cash worth today vs future cash flows off of that cash Is the investment today worth the return in the future Capital Asset Pricing Model CAPM Worried about systemic risk how firm performs relative to market other firms Never reward diversifiable risks individual risks that a company takes Efficient frontier As risk goes up Standard deviation expected return goes up Early on taking on a little bit of extra risk takes on a much higher reward Later more risk gives less and less return Line should never come back down should always be more reward for more risk Riskiness of bonds Typically the riskier the bond the higher the interest rate will be to entice you to purchase this bond Lower interest rates are usually the safest Government Society Many times the government is the only entity able to take on risk regardless of the reward Example Florida is taking on a lot of flood risk and not getting much reward for it It s tough to measure the reward associated with the risks the gov t takes on Bias If we don t understand the true probabilities of the events occurring but we assign our own subjective view to them A bias changes the outcome of the model Bias causes everybody individual as well as organizations to make decisions differently Age Bias People in certain age groups tend to interpret information about risk differently Cultural Bias Certain culture view of risk differs Experience biases People who have experienced a low probability high consequence event tend to overestimate its likelihood people who have not experienced one tend to underestimate Media biases Risks that garner a lot of media attention murder terrorism kidnapping etc are typically overestimated while other risks car accidents health risks tend to be underestimated Incentives How we get people to make decisions that are advantageous to us Things that motivate individuals to perform an action The unknown unknowns Some things are not known about and aren t considered because they aren t thought of Things we don t know that we don t know exists Financial Incentives most common If you do this I will give you this Example Buy 9 sandwiches the tenth is free Moral Incentives do the right thing Do it because it agrees with your sense of right and wrong Natural incentives curiosity fear anger pain joy happiness People do things because they want to Coercive Incentives negative reinforcement If you don t do this you won t get this Personal vs Social Incentives For the good of you individually or for the good of society Sometimes personal incentives are bad for society Law of unintended consequences There will always be some way that a product or service you sell will be used in a way that you NEVER thought of Political incentives Short term vs long term planning Want more of a long term planning type structure out of government Unfortunately they are only concerned about when they are in office and making their political career as good as possible Usually short term focus Discount rate The discount rate is higher when thinking in the short term The higher the discount rate the more important and valuable current consumption is than it is in the future Rather have the cash today then savings tomorrow Categories of risk at the individual level Property Liability Life Health Financial Why do we categorize risk So risk management techniques can handle them It is easier to manage risks when they are structured this way Some risks may appear in multiple categories Loss Exposures Any condition or situation that presents a possibility of loss regardless of whether the loss actually occurs Three Elements to a loss exposure Asset exposed to loss Cause of loss Financial consequence of loss Cause of Loss Claim lawsuit Someone has to claim that you did something wrong Typically through a law suit Cause of Loss Civil law Governs relationship among individuals There isn t a contract between people Treating each other the way you are supposed to be treating each other Cause of Loss Tort No relationship with one another Supposed to or required to do something Example Driving down the road and you re not paying attention and you wreck Cause of Loss Contract One party in a contract fails to hold up their end Cause of Loss Statutory One party fails to do what they re supposed to do based on what the statute says or the law says passed by a governing bodies Cause of Loss Criminal Law Breaking a law Cause of Loss Negligence I was supposed to do something and I failed to do so Example Speeding Not warning someone of danger on your property Types of Liability Property owners If you have a pool in your backyard and don t put a fence around it and someone drowns in it you re responsible Automobiles Involved in accident and you re at fault you are liable for costs Employer employee Employers can be held responsible for employees Parents and children Parents can be held responsible for their child s actions Animals If your dog bites someone you are responsible Risks throughout life 20s not many people relying on you your income 30s family life changing significant risk 40s you are grown up highest that risk will ever be 50s risk beginning to diminish 60s not as big an issue 70s not an issue What are smart pills Stimulant drugs such as Ritalin and Adderall have been developed to help manage ADHD Classified as Schedule II drugs by the DEA same as cocaine Illegal to take without a prescription federal offense Have proven successful in managing ADHD Evidence suggests helps many people focus and improves performance on learning tasks ex memorizing What is the risk of Smart pills Insomnia weight loss
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