1.

Explain the three managerial risk-taking options of risk taker, risk

neutral and risk averse with the help of utility function

Encountering situations without having faced risks is unthinkable in managerial

decisions making process. Individuals as well as companies often face and
encounter situations that involve risks.

What is Risk

Risk is an uncertainty about the future that means that the future may or may not
be according to the plan taken . Future is uncertain so is the investment but there
are many types of individuals or institutions or companies among them some are
inclined about taking risks for greater gain by using the strength of knowledge of
uncertainties ,some other are not willing to take risks and make their decisions
according to their plan and some remain silent or neutral about taking risks.

Let's take an example where someone currently have a solid job but aren't all that
happy with it. He is looking for something superior. A fantastic opportunity that he
uncover is posted in a different city. The pay is significantly higher than what he is
currently making, but in order to take advantage of the chance, he must relocate.
It's dangerous in this circumstance since he has no idea what will happen if he
moves. Excellent if everything goes according to plan! Along with a better job and
a greater salary, he'll probably make some new acquaintances and coworkers.

But what if things don't work out as planned? What if, six months later, he is fired
for no other reason than that he is unhappy at work, dislike his supervisor, dislike
his coworkers, or simply perform poorly? Whoa, it sounds like he is talking about
needing to look for a job again, but all that trouble and money he spent on moving
wasn't worth it.

So , individuals or any other entities take risks according to their preferences about
risks that are on the way to be encountered.
Risk Preferences depicts the degree of willingness of an individual’s to take risks
based on the surface of satisfaction related with the outcome or expected utility in
the future.

Expected utility is the probability weighted average of the total utility the yields
uncertain outcome.

It can be calculated using a simple equation that is known as the utility function.

( ) ( ) ( ) ( ) ( )

Where

E (U) = Expected Utility

P (A) = Probability of Outcome A

P (B) = Probability of Outcome B

U (A) = Utility of Outcome A

U (B) = Utility of Outcome B

Current Income = $50,000

Outcome A: Things don't go as planned, and he would lose his new work within
three months. This leaves him with no yearly income and the stress of having to
look for a new career for the next six months. There is a 30% chance that this may
occur.

Outcome B: Everything goes well, and he maintain your $80,000 new job. There
is a 70% chance that this will occur.

Here,

P (A) = Probability of Outcome A = 30%

P (B) = Probability of Outcome B = 70%

U (A) = Utility of Outcome A = $0

U (B) = Utility of Outcome B = $80000

So the expected utility

E (U) = .3*0 + .7*80000 = $56000

He will surely grab the new job as his current salary accounts at $50000

Types of Risks Preferences are

1. Risks Averse
2. Risks Neutral
3. Risks Taker

1. Risks Averse
 When given the same predicted benefit, a risk-averse person would
rather have a guaranteed outcome than an uncertain one
 When given the same predicted benefit, a risk-averse person would
rather have a guaranteed outcome than an uncertain one.
 A risk-averse individual shows declining marginal value. That is, the
rise in utility from an extra $10 in income is less for every $10
increase in income.
 The risk-averse type is the most common risk preference type.
 It is more important to avoid losing $10,000 than it is to gain $10,000.
 U(W) = W , where a is greater than 0 but less than 1
 This is a concave function.
2. Risks Neutral
 A risk-neutral individual does not care whether the outcome is certain
or uncertain as long as the expected utility remains the same.
 A neutral individual is empathetic between a certain outcome and an
uncertain outcome with the same expected utility .
  For every $10 increase in income, the increase in utility from that
extra income is the same.
 Avoiding losses is equally as important as receiving gains for a
neutral individual.
 it is equally as important to avoid losing $10,00 as it is to gain $10,00.
 U(W)= W
 the function will generate a linear line.

3. Risks Taker
 Neglecting the higher value of uncertainties compared to certainties
where gain is greater than that of the loss of uncertainties , a risks
lover individual’s always inclines about the greater gain that
persuades him to take the risks.
 A risk-loving person exhibits increasing marginal utility.
 the chance of winning big versus losing it all is worth more than a
certain outcome
 Losses are not a headache to them
 U(W) = W a [ where a is greater than 1]
 This is a convex function.
2. Construct a decision tree on whether to play golf or not based on the
following outlook on the weather
 Decision Tree

Based on Outlook Of weather

Overcast Rainy Day

Sunny

Windy Yes Humidity

False True High Normal

No Yes
Yes No
s
ess
 3. based on the following data, which project you will choose to invest your
money in?

Explain why.

E(X) = 3,500 Standard deviation of A = 1,025, Relative Risk = 0.29

E(X) = 3,750 Standard deviation of B = 1,545, Relative Risk = 0.41

E(X) = 3,500 Standard deviation of C = 2,062, Relative Risk = 0.59

Here,

Expected value of A is $3500 with the variance of 1025 and relative risk is .29

Where in case B , it is seen that the expected value is higher than that of A and the
variance and relative risk is also higher . For case C it is seen that the expected
value is same as A but the standard deviation is much greater than that of A and B
respectively

So,

I would take Case A for investment though in case B the EV is greater than A but
the variance and relative risk factor is much higher than A .

It is imperative to take decision for the investment in Case A.

I Would prefer Case A for investment as it has lower risk factor equals to .29
which is much lower that B and C . It is imperative to take lower value of
standard deviation for consideration in investment along with lower value of
relative risk.

The higher the standard deviation, the greater the risk

4. What is the difference between risk and uncertainty? Describe one
method of decision analysis under uncertainty and one under risk.

Risk & Uncertainty

Risk is a matter that reveals the outcome of a decision which known to the
decision maker to some extent. Every decisions has an outcome which may
or may not be congenial to the decision maker.
On the other hand
Uncertainty refers that the outcome in totally unknown of an action that is
taken by the decision maker.

Risk Uncertainty
Risk is a matter that reveals the Uncertainty refers that the outcome
outcome of a decision which in totally unknown of an action that is
known to the decision maker to taken by the decision maker.
some extent
Probabilities are known to some Probabilities are unknown
extent.
It is predictable It is not predictable
Risk is not difficult to quantify or Uncertainty is difficult to quantify or
assess due to a lack of information assess due to a lack of information
Maximum Expected Laplace criterion,
Value,Maximum UtilityMost maximin,maximax,Hurwicz and
Probable Outcome, Composite Minimax regret are the method of
Criteria, Analysis Methods are the decision making under uncertainty.
methods of decision making under
risks
Decision making under Risk using Maximin conditions

Artificial intelligence (AI) decision-making under uncertainty can be facilitated by

the application of the Maximin criterion. Using this method, decision-makers can
choose the optimal course of action in situations when the likelihood of each result
is unknown or cannot be determined. According to the Maximin criterion, the most
crucial factor to take into account while making a decision is its worst-case
scenario. It implies that decision-makers have to weigh the worst-case scenario for
every choice they make.

Imagine Mr X and a friend are playing a game where you have to select between
two options: Option B offers a 50/50 chance of earning either Rs. 10 or Rs. 0,
while Option A guarantees X a win of Rs. 5. If X employ the Maximin method,
Option A will be X’s choice since it offers the biggest minimum payout (Rs. 5/-) in
contrast to Option B, which offers a minimum payout of Rs. 0/- in the event that X
lose the coin toss.

Decision making under uncertainty using Maximum Expected Value

When evaluating and comparing several options, decision-makers may start by

using the maximum expected value method. Using this method, the key is to
identify the choice with the highest predicted value. The sum of all possible
outcomes and their associated probabilities yields the anticipated value. Decision-
makers can then choose the option that has the best chance of benefiting them or
rewarding them. When decision-makers are seen as risk-neutral—that is, neither
risk-avoiders nor risk-seekers—and are just interested in optimizing their expected
gains, this approach can be helpful. By basing judgments on the likelihood
associated with each conceivable result, decision-makers can use the maximum
expected value technique to choose the best course of action to help them achieve
their intended goals