RMI 2302 Nyce Exam 1

What is risk

Uncertainty regarding loss

What do organizations add to risk

preventing reaching goals

What does society add to risk

affecting a large portion of society

What is risk management

Scientific approach to dealing with risk

How can you classify risk

frequency- how often
severity- how bad

What is another word for frequency

risk likelihood

What is another word for severity

risk impact

What is expected value

frequency x severity

How do we measure risk

relative variation of actual vs. expected
variation of standard deviation

What are uncertainties regarding risk

doubting ability to predict future outcomes
differs across individuals when risk is the same- subjective
information does not alter risk, but can alter uncertainty

What are the categories of risk

pure vs speculative
static vs dynamic
fundamental vs particular
core vs secondary

Pure vs Speculative risk

pure- involve only 2 potential outcomes, loss or no loss
ex. leave class and car is there or it was stolen
speculative- you may have a loss or no loss but also a gain
ex. buying a share of google, can go up, down, or stay the same

Static vs Dynamic risk

static- unchanging through time
ex. chance of earthquake
dynamic- changing through time
ex. identity theft

Fundamental vs Particular risk

fundamental- affects large portion of population at a given time
ex. hurricane
particular- affects a single person or small group
ex. car accident

Core vs Secondary risk

core- inherent to the fundamental activities of organization
ex. UPS & risk of traffic accidents
secondary- not part of the core operations of an organization
ex. speculative derivative trading by UPS

Sources of risk

personal- related to individuals life
property- related to potential damage of physical property
liability- related to an individual being held liable for its actions or inactions
financial- related to the financial standing of an individual or organization

Exposure

person or property facing risk of loss

Peril

the immediate cause or loss

Harzard

condition affecting the frequency of the severity of loss

Moral hazard

behavioral

Morale hazard

indifference

Societal hazard

legal or cultural

What are attitudes toward risk

risk neutral, risk adverse, risk seeker

Risk neutral

indifferent, value of risky situation is expected loss

Risk adverse

prefer to avoid risk, willing to pay more than expected loss to avoid risk

Risk seeker

prefer risk, would pay more than expected return to engage in risky situation

What are the burdens of risk on society

need for larger emergency funds, loss of needed goods and services, fear and worry

What are the rules of risk management

don't risk more than you can afford to lose, don't risk a lot for a little, consider the odds

What are the risk management process steps

determination of objectives
identification of risks
evaluation of risks
consider the alternatives
implement the decision
evaluate and review

Determination of objectives

Post-Loss Objectives: Survival, Continuity of Operations, Earnings Stability, Continued Growth, Social Responsibility

Pre-loss objectives: economy, reduction in anxiety, meeting externally imposed obligations, social responsibility

Identification of risks

the preferred approach to risk identification is a combination approach
- interviews
- analysis of documents
- inspections

Evaluation of risks

loss frequency- probability distributions
loss severity- maximum possible loss, probable maximum loss
law of large numbers- enables us to work small premiums for larger uncertain loss

Consider the alternatives

loss control- reduced level of risky activity, increased precautions
loss financing- relation and self insurance, hedging, etc
internal risk reduction- diversification, investments in information

What is risk control

techniques aimed at reducing number of risks faced or amount of loss

What are the types of risk financing

planned vs unplanned
funded vs unfunded

Planned vs unplanned

You can create a retention plan (I will pay for any losses out of my savings account) or you can just wing it (if a loss occurs, I'll figure it out).

Funded vs unfunded

You can create an account and put money into it to pay for future losses (funded), or you can pay it out of cash flow or other sources not specifically earmarked for losses(unfunded).

How is risk viewed differently at a societal level

scientific view of risk
adds the time element

What happens when you add the time element in risk

information gets ignored
ex. is it fair for a younger person dying before an older person

What is the best alternative for the time element

using the number of days lost

What does risk reduction do

there is monetary and non-monetary, puts a value on human life

What are the rules of thumb to minimize risk

1. recognize you need a model- mental model(semiconsciously in mind)
- mathematical model (more precision)
2. acknowledge your models limits- incorrect(logic or assumptions are wrong, do not use this)
- incomplete (characteristic shared by all models, add to this)
3. expect the unexpected - some factors will be overlooked (changes in environment and interaction can create factors that are no longer relevant)
4. understand the use and user -models are evaluated as a triplet (model, application, user)
- workings of a model are transparent, consistently applied, results can be reproduces and verified by others
5. check the infrastructure - benefits are determined how innovation is introduced
- pace is different, can cause imbalance

Risk vs. Reward

the higher the risk the higher the reward

What is decision theory

Used to determine optimal strategies where a decision-maker is faced with several alternatives and an uncertain, or risky, pattern of future events

What are the steps of the decision making process

identification of various possible outcomes (no control)
identification of all courses of action (control)
determination of the pay-off function (combination of acts and outcomes)
choosing from among various alternatives on the basis of some criterion

Pay-off

represents the matrix of the conditional values associated with all the possible combinations of acts and events

Opportunity loss/regret

the amount of profit foregone by not adopting the optimal course of action, or that which would give the highest pay-off for each possible event.

What are the pay-off matrix requirements

must not be a sequence of events
courses of action and events must be clearly determined
events of actions must be distinct, mutually exclusive and collectively exhaustive

Laplace principle

do not know the probabilities, assume all outcomes are equal

Maximin/Minimax principle

for risk adverse people, figure out the worst possible outcome in each scenario and pick best WORST case

Maximax/Minimin principle

for optimistic people, figure out the best case scenario, pick out the BEST possible outcome

Maximum likelihood principle

figure out which scenario is most likely to occur and then make the choice that maximizes profit with that scenario

Expectation principle

take the probability X outcome and add them altogether

Multi-stage decision proccess

rollback technique- proceeding in a backwards manner, decide later stages then earlier stages

Expected value

= probability X outcome add altogether

What is the importance of understanding individual decision making

individuals tend to be risk adverse, they prefer the sure thing rather than an uncertainty

What is the difference between organizational and individual decision making

organizational uses expected value
individuals use expected utility

What is the utility theory

utility is a function of wealth
increasing in wealth
increasing at a decreasing rate

What is a utility function

probability X utility of the outcome
square root function

What is certainty equivalent

what the square root is, where you take the risk

What are the common mistakes in decision making

ignoring implicit costs- if doing x means not being able to do y, the value of y is an opportunity cost to x
failing to ignore sunk costs- may be relevant, but are not and should be ignored
measuring costs and benefits as proportions rather than absolute dollar amounts- driving to save $10 on $20 and $10 on $1010 should be answered the same because it is the same amount
failure to understand average-marginal distinction- must compare the benefit and cost of an additional unit of activity

What is the invisible hand

The idea that people pursuing their own self-interest actually benefit the public at large, making decision based on own best interest
ex. i do not have to get vaccinated if everyone else does

Decision makers delimma

do not experience sediments that motivate people to vote, return lost wallets, etc
care only about personal material costs and benefits

Postive vs Normative questions

normative- what should be
ex. should we protect x
positive- what will the consequences be
ex. what will happen to x

Households

many households work for someone else
wages/salaries are how we get compensated

Income

not evenly distributed, rich get richer and poor get poorer
spend money on taxes
personal saving
personal consumption expenses (service we spend most money on)

What are forms of business

sole proprietorship- what most businesses are
corporations- biggest

Advantages for corporations

most effective for raising money
limited liability
expand easily due to attracting capital
life dependent of owners and capital

What is the principle agent problem

when principals and agents interests are not aligned, owners want maximum company profit and stock price, but agents want power, high pay regardless of company performance

principals

stockholders

agents

hired by stockholders to run business

What is the governments role

-Provide Legal Structure
-Maintaining Competition
-Redistributing Income
-Reallocating Resources
-Promote Stability

Provide legal structure

Sets legal status of business enterprise
Ensure rights of ownership
Enforcement of contracts
Establishes the rules

Maintain competition

efficient competition= high competition
monopoly= controlling supply

Redistributing income

transfer payments- provide relief (welfare checks)
market intervention- gov modifies prices (minimum wage
taxation- gov uses income tax to take more from the rich so it narrows after-tax income differences

Reallocating resources

-Externality - occurs when some of the cost or the benefits of a good are passed on to someone other than the immediate buyer or seller.
-Negative externality - Production or consumption costs inflicted on a third party without compensation
-Correcting negative externalities
--Legislation
--Specific taxes - tax confined to a particular product
-Positive externality - externality that appears as a benefit to other producers/consumers, like immunizations or education.
-Correcting positive externalities
--Subsidize consumers (low-interest loans for college)
--Subsidize suppliers (public colleges)
--Provide goods via the government (postal service)

Promote stability

when total spending matches economy's production capacity the prices are stable
stability is achieved when addressing unemployment and inflation

How do we balance competing goals

if the free market worked well, we would not have to worry about the government protecting ourselves from ourselves
government could focus on externalities
in economic perspective people get "different pieces of the pie"

How do we maximize with measurment

Bentham- urged politicians to design policies that maximized peoples happiness
treat to libertarians- replaces the individualized version of well being
"happy slave"- poor your whole life and happy, does that make it okay

Is there a simple answer for happiness

no, in policy decisions there needs to be a balance between number of competing objectives when making these decisions
education, freedom, well-being is measured would we get a better idea of what we really want the government to do