RMI2302 Risk in Business and Society Study Guide Exam 2 Exams are more PowerPoint based than reading The exam and therefore this study guide covers modules 6 9 Module 6 Results of Decision Making Models and Biases Overall Objectives Contrast risk and reward tradeoffs at all levels individual organizational and societal Types of biases Classify incentives Effect politics has on expected value calculations Understand the relationship between risk and reward associated with each decision Understanding this can help you make critical decisions Individuals Organizations Measured with expected utility How much reward is necessary to induce you to take the risk How much are you willing to pay to avoid risk This is actually the entire basis of insurance people willing to pay to avoid risk Use expected value No natural risk aversion Opportunity cost or cost of capital Most project future cash flows from investments or opportunities Discount those cash flows back to present value based on cost of capital Cost of capital in commensurate with riskiness of firm The riskier an investment is the more incentive someone needs to invest in it In class he referred to government bonds of multiple countries saying how countries with more stable governments such as Japan don t have to issue such a high rate of return because people can feel more certain in getting their investment back the returns Japan pays the lowest rate of return on a ten year bond Less stable governments such as Nigeria have to issue a much higher rate of return because people feel less certain in getting their investment back Nigeria pays the highest rate of return on a ten year bond So in this case the cost of borrowing the cost of capital is significantly higher for Nigeria than Japan Cost benefit analysis You need to know all of the costs and benefits associated with making a decision To do so tally us all of the costs and the benefits with present value remember depreciation isn t a cash flow it is strictly an accounting entry for tax purposes Think of the price of something the maintenance costs anything the company is paying out of pocket Also think of all the benefits the company will have with this new thing including insurance premiums increased income etc Need a required rate of return or discount rate in order to calculate all future estimates to present value If the total of all the benefits of the decision calculated into present value is higher than the costs of the decision also calculated into present value then go for it do whatever this decision is all about The higher the required rate of return is the more important cash is today CAPM capital asset pricing model This is used to determine the rate of return of an asset This asset is a non diversifiable risk This model takes the asset s sensitive to non diversifiable risk systematic risk how things move with the market into account therefore rewarding the systematic risk Never rewards diversifiable risks which are the individual risks that a company takes Looking at how the firm is doing compared to the rest of the market how it performs relative to the market Efficient frontier How you measure the risk of the portfolio is by its volatility or standard deviation As the volatility gets higher are respected returns should be higher We should be rewarded for taking on additional volatility The risk return curve is similar to risk averse for utility This means there are bigger returns at first and then it lessens For any given amount of risk there s an estimated return The efficient frontier the line shows what the price of risk is what the predicted returns should be There should always be a little bit of reward for taking on a risk The efficient frontier is a good graph representation of the risk reward tradeoff Government Society Measuring the reward for society to take on risk is difficult Many times government is the only entity able to take on risk regardless of reward An example of this is flood risk because it s the government is the only entity that can cover it because it happens a lot all over the place so no insurance company wants to handle flood risks Bias Subjective view probability different from objective If we don t truly understand the risk of something we assign it what we think it should be Many sources Alter the decision making The problem arises when people are making decisions significantly different than the model Types include age cultural personal experience gender and media how the media interprets things An example of this is that the news doesn t cover deaths by things like heart disease but cover newsworthy rarities like a guy being hit by an asteroid Incentives Motivate individuals to perform the action that we want Most common incentives are financial But also moral do the right thing natural curiosity fear joy etc coercive negative reinforcement and personal vs social is it good for someone individually or for society Typically what s good for one person may not be the best for society Economics is essentially the study of incentives The systems that are in place to make people do things Beware of the law of unintended consequences You can develop something for one reason but people may use them for other things ex drug abuse Start manipulating things Political incentives What you want out of your government is more of a long term goal but the politicians are usually only concerned about their term making short term goals the priority This affects the discount rate In this case the discount rate is high because they are willing to sacrifice good things in the future for the present Module 7 Risk and Individuals Overall Objectives Categorize individual risks Analyze risks along the elements of a loss exposure Risk and reward of smart pills Ethical considerations with cognitive enhancements Categories of risk at individual level Property Liability Life Health Financial Categories aren t necessarily exclusive some risks may appear in multiple categories Categorizing is important because the risk management techniques can be different for different categories but remain similar within the category Risk Management for Individuals Loss Exposure regardless of whether that loss actually occurs Any condition or situation that presents a possibility of loss Three Elements to a loss exposure o Asset exposed to loss o Cause of loss o Financial consequences of the loss Property Liability Asset exposed to loss real property such as land
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