RSK2601 EXAM STUDY NOTES & SUMMARY

RSK2601 EXAM STUDY NOTES & SUMMARY. Defining risk?  Risk is the deviation or variability of actual results from desired or expected results  The principle in the business world is -that if risk increases, the possible return that is desired will also increase.  Risk management consists of three distinct dimensions: o Generating and utilizing opportunities in situations where a business has distinct advantages in accomplishing beneficial results with improved chances of success (upside management) o Introducing controls to prevent or restrain losses as a result of the constraints posed by the operating environment of the business (downside management) o Exercising methods and techniques to reduce the variance between anticipated financial outcomes and actual results (uncertainty management) 2. Risk and uncertainty?  Uncertainty arises from a person's imperfect state of knowledge about future events.  Perceived uncertainty : depends on information that person can use to evaluate the likelihood of outcomes and the ability to evaluate this information  Uncertainty consists of the following two elements: o uncertainty whether an event will take place o if the event does occur what the outcome thereof will be  The definition of risk as the deviation of an actual outcome from the expected result or outcome implies the following: o Uncertainty surrounds the outcome of the event. The decision maker is uncertain about the outcome, and the actual outcome may therefore deviate from the expected outcome. If the outcome was certain and only one outcome was possible, there would be no uncertainty and no deviation from the expected result and therefore no risk for the decision maker. o The degree of uncertainty surrounding the event determines the level of risk. The more uncertain the decision maker is, firstly, about whether the event will take place, and secondly, of what the outcome will be, the greater the possible deviation of the actual from the expected result. o The degree of risk can therefore be interpreted in terms of the frequency with which an event will occur and the probability that it will display a particular outcome. This event represents the deviation from the expected outcome.  The following summarises our discussion of risk: o Risk is the deviation of the actual from the expected result. o Risk implies the presence of uncertainty. o There may be uncertainty about the occurrence of an event and uncertainty about its outcome. o The degree of risk is calculated as the frequency with which an event, namely the deviation from the expected outcome, occurs and the probability that it will display this particular outcome. 3. The theory of probability and how it can be applied to risk management? The degree of risk depends on the frequency with which an event occurs and the probability that it will display a certain outcome. The probability of an event occurring refers to its long-term frequency of occurrence. All events have a probability of between 0 and 1. Formula : chance of occurrence Number of occurrences(no of cars damaged) Total number ofpossible outcomes(total cars∈fleet)  Probabilities have the following two basic properties: o The number of successes cannot be more than the number of possible outcomes. Therefore the maximum value of P is 1. o The number of successes cannot be a negative value. Therefore the minimum value of P is 0. If all possible events (or outcomes) are listed and a probability is assigned to each event, the listing is called a probability distribution. 3.1 Probability distributions 3.1.1 Measures of central tendency 3.1.2 Measures of variation 3.1.2.1 Standard deviation To calculate the standard deviation: Step 1: Calculate the expected value .Bear in mind that the calculation of the expected value is only required in circumstances where the probabilities of the possible outcomes differ and the expected value will therefore differ from the mean. Where the probabilities do not differ, only the mean needs to be calculated because its value will be the same as the expected value. Step 2: Subtract the expected value from each of the possible outcomes. Step 3: Square the resulting difference. Step 4: Sum the squared differences. Step 5: Divide the sum by the total number of measurements (probabilities) to obtain the variance. Step 6: Calculate the square root of the variance. This is the standard deviation. 3.1.2.2 Coefficient of variation: The coefficient of variation is a measure of relative dispersion that is useful in comparing the risk of probability distributions with differing expected returns. Standard deviation Expected value The higher the coefficient of variation, the greater the risk will be.