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Managerial Economics in a Global Economy

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Presentation on theme: "Managerial Economics in a Global Economy"— Presentation transcript:

1 Managerial Economics in a Global Economy
Chapter 13 Risk Analysis PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

2 Risk and Uncertainty Risk Uncertainty
Situation where there is more than one possible outcome to a decision and the probability of each outcome is known Uncertainty Situation where there is more than one possible outcome to a decision and the probability of each outcome is unknown PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

3 Measuring Risk Probability Distributions
Chance that an event will occur Probability Distribution List of all possible events and the probability that each will occur Expected Value or Expected Profit PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

4 Measuring Risk Probability Distributions
Calculation of Expected Profit PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

5 Measuring Risk Probability Distributions
Discrete Probability Distribution List of individual events and their probabilities Represented by a bar chart or histogram Continuous Probability Distribution Continuous range of events and their probabilities Represented by a smooth curve PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

6 Measuring Risk Probability Distributions
Discrete Probability Distributions Project A; E(p) = 500, Low Risk Project B: E(p) = 500, High Risk PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

7 Measuring Risk Probability Distributions
Continuous Probability Distributions Project A: E(p) = 500, Low Risk Project B: E(p) = 500, High Risk PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

8 Measuring Risk Probability Distributions
An Absolute Measure of Risk: The Standard Deviation PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

9 Measuring Risk Probability Distributions
Calculation of the Standard Deviation Project A PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

10 Measuring Risk Probability Distributions
Calculation of the Standard Deviation Project B PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

11 Measuring Risk Probability Distributions
The Normal Distribution PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

12 Measuring Risk Probability Distributions
A Relative Measure of Risk: The Coefficient of Variation Project A Project B PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

13 Utility Theory Risk Averse Risk Neutral Risk Seeking
Must be compensated for taking on risk Diminishing marginal utility of money Risk Neutral Are indifferent to risk Constant marginal utility of money Risk Seeking Prefer to take on risk Increasing marginal utility of money PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

14 Utility Theory PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

15 Utility Function of a Risk Averse Manager
Utility Theory Utility Function of a Risk Averse Manager PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

16 Adjusting Value for Risk
Value of the Firm = Net Present Value Risk-Adjusted Discount Rate PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

17 Adjusting Value for Risk
PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

18 Adjusting Value for Risk
Certainty Equivalent Approach Certainty Equivalent Coefficient PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

19 Other Techniques Decision Trees Simulation
Sequence of possible managerial decisions and their expected outcomes Conditional probabilities Simulation Sensitivity analysis PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

20 PowerPoint Slides by Robert F. Brooker. Harcourt, Inc
PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

21 Uncertainty Maximin Criterion
Determine worst possible outcome for each strategy Select the strategy that yields the best of the worst outcomes PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

22 Uncertainty: Maximin The payoff matrix below shows the payoffs from two states of nature and two strategies. PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

23 Uncertainty: Maximin The payoff matrix below shows the payoffs from two states of nature and two strategies. For the strategy “Invest” the worst outcome is a loss of 10,000. For the strategy “Do Not Invest” the worst outcome is 0. The maximin strategy is the best of the two worst outcomes - Do Not Invest. PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

24 Uncertainty: Minimax Regret
The payoff matrix below shows the payoffs from two states of nature and two strategies. PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

25 Uncertainty: Minimax Regret
The regret matrix represents the difference between the a given strategy and the payoff of the best strategy under the same state of nature. PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

26 Uncertainty: Minimax Regret
For each strategy, the maximum regret is identified. The minimax regret strategy is the one that results in the minimum value of the maximum regret. PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

27 Uncertainty: Informal Methods
Gather Additional Information Request the Opinion of an Authority Control the Business Environment Diversification PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

28 Foreign-Exchange Risk
Foreign-Exchange Rate Price of a unit of a foreign currency in terms of domestic currency Hedging Covering foreign exchange risk Typically uses forward currency contracts PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

29 Foreign-Exchange Risk
Forward Contract Agreement to purchase or sell a specific amount of a foreign currency at a rate specified today for delivery at a specified future date. Futures Contract Standardized, and more liquid, type of forward contract for predetermined quantities of the currency and selected calendar dates. PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

30 Information and Risk Asymmetric Information Adverse Selection
Situation in which one party to a transaction has less information than the other with regard to the quality of a good Adverse Selection Problem that arises from asymmetric information Low-quality goods drive high-quality goods out of the market PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

31 Information and Risk Moral Hazard Methods of Reducing Moral Hazard
Tendency for the probability of loss to increase when the loss is insured Methods of Reducing Moral Hazard Specifying precautions as a condition for obtaining insurance Coinsurance PowerPoint Slides by Robert F. Brooker Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

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