OTHER METHODS OF DEALING WITH RISK AND UNCERTAINTY

SENSITIVITY ANALYSIS
1. Sensitivity analysis is very useful when attempting to determine the impact of the actual outcome of a particular variable will have if it differs from what was previously assumed. By creating a given set of scenarios, the Accountant can determine how changes in one variable(s) will impact the target variable.
  1. Advantages
    1. There is no complicated theory to understand.Easy to understand and execute
    2. It indicates the critical variables for which additional information may be obtained. The decision maker can consider actions which may help in strengthening the "weak spots" in the project.If the project is accepted those weak areas are clearly monitored by the management
      1. Weak Spots can be identified !!
    3. Information will be presented to management in a form which facilitates subjective judgement to decide the likelihood of the various possible outcomes considered.
  2. Dis-Advantages
    1. It indicates how far the variable will change it does not give information regarding the probability of that change
      1. Only impact for a degree of change is analysed but probability for such a change is ignored in sensitivity analysis
        "Impact tested - probability ignored"
    2. It gives away the management a choice of decisions that can be made but fail to give exactly what decision to choose from
    3. Only try to analyse a result of a change in one variable at a time .change of multiple variables are ignored ,whereas that is the case in the original business scenario
      1. " Change of Multiple variables ignored "
SIMULATION
1. Monte Carlo Simulation
  1. A problem solving technique used to approximate the probability of certain outcomes by running multiple trial runs, called simulations, using random variables.
    1. Disadvantages
      1. It is not a end exercise for taking decisions it is a technique for analysis possible outcomes for a given project
        Not a decision making tool a decision making assisting tool
      2. Models can be extremely complex to understand
        Complexity
      3. the time and cost involved in thier construction may or may not exceed the benefits derived
        Requires more time and cost
  2. Monte Carlo simulation is named after the city in Monaco, where the primary attractions are casinos that have games of chance. Gambling games, like roulette, dice, and slot machines, exhibit random behavior.
EXPECTED VALUES
1. Anticipated value for a given Decision. In statistics and probability analysis, expected value is calculated by multiplying each of the possible outcomes by the likelihood that each outcome will occur, and summing all of those values. By calculating expected values,Accountants can choose the scenario that is most likely to give them their desired outcome.
  1. this method is suited for a decision maker who is risk neutral (i.e one who neither takes risk or avoids risk but always willing to accept a neutral return from the decisions made )
    1. Advantages
      1. Calculations are relatively simple
      2. The information is reduced to single number which makes the decisions very easy
      3. Takes uncertainty into account by considering the probability of each possible outcome and using this information to calculate an expected value
    2. Disadvantages
      1. The EV gives no indication of the dispersion of possible outcomes about the EV, i.e. the risk. Thus no indication of risk is not measured in the expected value
      2. The probabilities used are usually very subjective.
      3. The EV is merely a weighted average and therefore has little meaning for a oneoff project.
        The use of EV in one of decison is questionable
      4. The EV may not correspond to any of the actual possible outcomes.
  2. The figure obtained through expected value analysis can be used as a basis of investment decision .The principle here is that if the decision is repeated again and again the investor would sometime get the expected value as a result .
MAXIMAX ,MAXIMIN & MINIMAX REGRET
1. Maximax
  1. suitable for optimistic i.e A risk taking investor -
  2. choosing the best results assuming that the best will happen
  3. Maximizing the maximum return investor must expect
2. Maximin
  1. The method adopted by a pessimist investor who does not wish to take risk
  2. It states that the decision maker should select the course of action whose worst outcome is better than the worst outcomes of all other courses of action possible in given circumstances.
  3. "maximizing the minimum return the investor must expect "
  4. loses out on the opportunity of making big profits.
3. Minimax Regret
  1. The method used in decision making to minimize the maximum regret or oppurtunity cost o taking the wrong decision
  2. These are carried out by decision makers who are worried about taking a wrong decision
  3. Minimising the opportunity cost of a decison that a investor might be exposed to by taking a wrong decision
DECISION TREES

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OTHER METHODS OF DEALING WITH RISK AND UNCERTAINTY

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	Created by Shahid Musthafa about 11 years ago