RMI Exam 2 Study Guide Module 6 Results of Decision Making Risk Reward Employers want employees who can make critical decisions Understanding the relationship goes a long way toward that skill o People who are most successful understand the relationship Individual Risk and Reward Measured using expected utility not expected value How much reward is necessary to induce you to take risk o Ex Receiving 5 for certain or taking a gamble What does the expected payoff for the gamble have to be in order to take that instead of the 5 for certain How much are you willing to pay to avoid risk o This is why we have insurance We pay the companies to take the risk for us o Ex We have 5 of wealth with a 50 50 chance of ending up with 1 or 9 How much reward is necessary to get an individual to take the risk You know the number by changing it from 1 and 9 to higher values like 2 and 10 This creates a higher expected utility and value Organizations Risk and Reward Use expected value not utility No natural aversion to risk Opportunity cost or cost of capital is reward Most organizations project future cash flows from investments opportunities o How much do I have to take out and what s the expected return on it Discount those cash flows back to present value based on cost of capital o Discount rate how much they use to bring cash flows back to present value based on cost and capital Cost of capital is commensurate with riskiness of firm o Ex If you were to buy a 10 year bong in the united states you would get an average of 2 62 return on it Higher returns entice buyers to buy but are most risky Good economy countries are mostly low risk and your most likely to get a return on your investment Look at cost benefit example very simple to understand in lecture o On the sheet required rate of return is only caring about wealth in the present It only hinders future income The riskier the firm is the higher that cost of capital is o The higher the capital the more important present cash is compared to future cash In finance we don t care about the risk just care about the success compared to the market o CAMP Efficient Frontier Only reward systematic risk how well a portfolio performs Do not reward diverse risk Don t just buy a share of Wal Mart but other corporations as well Shows us that if you take a portfolio of investment opportunities how we measure the risk is based on standard deviation or volatility How the returns move up and down As the volatility gets higher our expected return should be higher Early on by looking at the graph taking a little risk early on has much higher reward than when you take an additional risk You can make the same reward by taking on less risk because you are more efficient The line represents the optimal combination of risk and reward Government Society Measuring reward to society is difficult o What are the rewards of having a national park Many times government is the only entity able to take on risk regardless of reward o Flood risk with no reward No insurance company wants to be involved Bias What is Bias o Subjective different from objective because its more individualized Changes outcome of model o Many sources of bias o People make different decisions due to our bias Different models occur than what we expect Types of Bias Age Biases People make different decisions based on risk reward o Older people are much more conservative than younger people Certain types of sub groups that tend to take more or less risk Personal Winning lottery you overestimate the chances of it Cultural Biases Experience Biases happening again visa versa Gender Biases Media Biases o Fox News vs NBC News Incentives that are advantageous to us Men and women make decisions differently How the media views and reports things Now that we know how people make decisions how do we get them to make decisions o Incentives Things that motivate us to perform an action o Incentives can be at any level Ex Kids to do homework or make them clean their room Types of Incentives Financial Most common Moral Natural o Mowing lawn for 20 Doing something because it s the right thing to do in your mind Doing something because you want to try o Curiosity fear anger pain joy happiness Coercive Negative reinforcement o If you don t do Then you can t have Good of you or good of society Personal vs Social Study of economics is the study of how the incentive system Beware Law of unintended consequences bad things can happen o Cloning biomedical technology steroids Political incentives o Short term vs Long term planning Long term concern for country is what we want but the president only wants good during his term not another presidents term The higher the discount rate the more valuable current savings are than o Discount Rate the future Module 7 Risk and Individuals Overview of Risk for Individuals Lots of ways of looking at risk at the individual level o Property liability life health financial o Why do we categorize categories Risk Management for Individuals Loss exposure that loss actually occurs 3 elements to a loss exposure o Asset exposed to loss what can be lost o Cause of loss o Financial consequences of the loss Risk management techniques Categories may not be mutually exclusive they may appear in multiple o Any condition or situation that presents a possibility of loss regardless of whether Property Risk stuff you own Asset exposed to loss o Real property Land buildings crops o Personal property Furniture jewelry art autos watercraft Causes of loss o Fire theft storm accidents lost anything you can think of Financial Consequences Insurance in risk management o Reduction in property value Owning a building and a fire occurs o Increased expenses Build a new house when the fire happens o Cost income When renting to people and the fire happens Liability being held responsible for actions Asset exposed loss o Money other financial assets o General pain and suffering damages Special auto accident Punitive punishment Punishment payments Cause of loss o Claim Lawsuit Claim that you did something wrong o Civil law U S criminal law civil among individuals criminal crimes o Tart contract statutory Contract failing to do agreements Si Law says T No relationship not paying attention while driving o Negligence Supposed to do something but failed to do so Ex Not obeying the speed limit Financial Cost o Defense cost o Monetary damages Specific Types of Liability Property Owners Make sure that property is safe to others o
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