Psychology of Risk

The manager of a business has a 'responsibility' to plan, organise and control the business - to direct business activities to achieve the goals of the business
1. Managers have a responsibility to the 'stakeholders' in the business
Utility Theory
1. Utility theory provides an explanation for the fact that people make different choices under risk
2. It is possible, though not always practical, to derive a decision maker's utility function and to apply that function to choices concerning risk
3. As the decision maker is the person making the choice under risk, his or her utility will ultimately measure the expected gain or loss from the risky choice
Methods used to obtain a person's utility function
1. Single attribute (uni-dimensional utilities), for example MONEY!
2. Multi-attribute utilities - including things other than money
Certainty Equivalent (CE)
1. The amount exchanged with certainty that makes the decision-maker indifferent between this exchange and some particular risky prospect
Risk Premium
1. This concept is closely related to the Expected Monetary Value (EMV) and the Certainty Equivalent (CE). It is defined as the difference between the expected monetary value and the certainty equivalent
  1. Risk Premium = Expected Monetary Value - Certainty Equivalent
2. Risk Aversion
  1. Does not imply that the decision-maker is unwilling to take risks. However the decision-maker must be compensated for taking risk, and that the amount of compensation required increases as the risks increase
3. Risk Neutral
  1. Such a decision-makes gives little attention to the risk weighting, and is assumed to maximise EMV as the choice criteria
4. Risk Preferring
  1. Risk preferrer would be willing to risk a loss in the anticipation of gaining a higher outcome
Rational Management of Risk
1. Maximisation of expected values
2. Avoidance of catasrophe
3. Ignoring remote possibilities

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Psychology of Risk

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	Created by pntalarico almost 11 years ago