RMI Exam 1 Study Guide Module 1 What is Risk Risk is uncertainty regarding loss What is riskier Jumping off a 1 story building or a 25 story building The 1 story building because we know we will die from the 25 story jump but we do not know what will happen when we jump on the 1 story building Risk is not danger it is the level of uncertainty What is the equation for expected value frequency x severity Uncertainty is doubt about our ability to predict future outcomes Categories of Risk o Pure vs Speculative Pure only 2 outcomes There will be a loss or there won t be a loss No way for gains Example car because it depreciates and can get in a accident Speculative loss or gain or none Example stock can go up down or stay the same o Static vs Dynamic Static Does not change through time Dynamic Changinf through time o Fundamental vs Particular Particular only affects one person or small group of people Example heart attack Fundamental large group of people Example flood o Core vs Secondary Core inside the business Example a medical company price of medicine goes up Secondary outside the business Example how much are golf balls for employees Common Hazards o Physical hazards property conditions o Intangible hazards attitudes or culture Moral hazard behavioral changes Morale hazard indifference Societal hazards legal or cultural Attitude Towards Risk o Risk neutral indifferent toward risk o Risk averse prefer to avoid risk Companies Individuals o Risk seeker prefer risk Burden of Risk on Society o Need for larger emergency funds o Loss of needed goods and services o Fear and worry Terms needed to know o Exposure person or property facing risk of loss o Frequency how often bad outcomes can occur Measured with probability finance o Severity how bad is it when the bad things happen Measured with o Standard Deviation how far from what we expected to happen from what actually happened Actual vs Expected o Uncertainty doubt about our ability to predict the future outcomes o Expected value frequency x severity o Peril the immediate cause of loss o Hazard condition affecting the frequency or severity of loss Sources of risks o Personal Example health divorce o Financial Example poor investments o Property Example house iPhone trademarks o Liability Example driving a car and hit someone else Module 2 Scientific View on Risk o Statistics or Probability Risk Reduction and Public Policy o Risk reduction has costs money and opportunity o Requires putting a value on human life What are you going to do What do you parents do o How do you balance risk reward If we drive 5mph on the highway the deaths would go down to near zero deaths but we lose time and economic output when traveling trucks can t send goods in timely manor Five rules to minimize risk 1 Recognize that you need a model 1 Decision about risk and return is informed by a mental model 2 Mental models may be an oversimplification 3 Mathematical modeling allows for more precision than human cognition 2 Acknowledge your models limitations 1 2 Incorrect model a model whose internal logic or underlying assumptions are themselves wrong a Stop using this model Incomplete model characteristic shared by all models basic model doesn t need to be unlearned 3 Expect the unexpected 1 Financial crisis causes a Efficient mortgage refinancing market b Low interest rates c Rising house prices 4 Understand use and user 5 Check the infrastructure 1 Models utility depends not just on the model itself but on 2 who is using it and what they are using it for Important characteristics of a model a Workings of model are transparent b Consistently applied c Results can be reproduced and verified by others 1 Changing infrastructure to accommodate every innovation that comes along is infeasible 2 Changes in infrastructure usually lag changes in products and services and that imbalance can be a major source of risk There is a time period in measuring risk o Number of days lost Risk reduction requires putting a value on human life Module 3 Decision theory is used to determine optimal strategies where a decision maker is faced with several alternatives Steps of the decision making process 1 Identification of various possible outcomes 2 Identification of all the courses of action 3 Determination of the pay off function 4 Choosing from among various alternatives on the basis of some criterion One stage decision making problems o Pay off tables represents the matrix of the conditional values associated with all the possible combinations o Laplace principle expected mean value of pay off for each strategy with the highest mean value is adopted Assumes all possible outcomes are equally as likely o Maximin principle find the minimum and pick the highest value o Maximax principle find the maximum and pick the highest value Pessimistic decision makers Optimistic decision makers o Maximum likelihood principle find the outcome that is most likely to occur then profit maximize Ignores information therefore it is not optimal o Expectation principle expected value multiply the probability by the outcome Uses the most information Multi stage decision making problems o Evaluate the decision proceeding in a backward manner by evaluating the best course of action at the later stages to decide o Decision tree o Rollback technique the solution to the problem is obtained by working backwards through the tree Module 4 Von Neumann and Morgenstern believed that decisions are made so as to maximize expected utility rather than expected monetary value o Utility index is designed for predicative purposes The utility function o Risk averse prefer to avoid risk Most people o Risk seeker prefer risk o Risk neutral indifferent toward risk o Utility functions are a function of wealth o Always increasing at a decreasing rate o Risk averse uses the square root utility function Reservation price or reserve price is a term referring to a limit on the price of a good or a service On the demand side it is the highest price that a buyer is willing to pay on the supply side it is the smallest price at which a seller is willing to sell a good or service Common pitfalls in decision making o Ignoring implicit costs If doing activity x means not being able to do activity y the value of doing opportunity y is an opportunity cost of doing x Skiing example o Failing to ignore sunk costs Insurance and interest are suck costs because you pay them no matter if you drive or don t drive o Measuring costs and benefits
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