risk aversion

Examples of risk aversion in the following topics:

• Risk Aversion

  • Risk aversion describes how people react to conditions of uncertainty and has implications for investment decisions.
  • Risk aversion can be applied to many different situations, including investments, lotteries, and other situations with uncertain outcomes.
  • Because organizations are composed of individuals, risk aversion at the individual level plays a role in organizational decision making.
  • People fall under different categories of risk aversion.
  • A risk-averse, or risk avoiding person would take the guaranteed payment of 50, or even less than that (40 or 30) depending on how risk averse they are.

• Risk and Return Considerations

  • Risk aversion also plays an important role in determining a firm's required return on an investment.
  • Risk aversion is a concept based on the behavior of firms and investors while exposed to uncertainty to attempt to reduce that uncertainty.
  • Risk aversion is the reluctance to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff.
  • For example, a risk-averse investor might choose to put his or her money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value.
  • Risk aversion can be thought of as having three levels:

• Measuring Risk

  • Risk aversion also plays an important role in determining a firm's required return on an investment.
  • Risk aversion is a concept based on the behavior of firms and investors while exposed to uncertainty to attempt to reduce that uncertainty.
  • Risk aversion is the reluctance to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff.
  • For example, a risk-averse investor might choose to put his or her money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value.
  • Risk aversion can be thought of as having three levels:

• Introduction Governments and Open Source

  • Government agencies tend to be unusually risk-averse.
  • This need for publicity is the complement of being risk-averse: elected officials and those who work for them understand that most people aren't paying much attention most of the time — therefore, those who work in government want to ensure that in the few moments when people are paying attention, they see something good.

• Approaches to Assessing Risk

  • Since planned actions are subject to large cost and benefit risks, proper risk assessment and risk management for such actions are crucial to making them successful.
  • As risk carries so many different meanings, there are many formal methods used to assess or to "measure" risk.
  • The field of behavioral finance focuses on human risk-aversion, asymmetric regret, and other ways that human financial behavior varies from what analysts call "rational".
  • In a financial institution, enterprise risk management is normally thought of as the combination of credit risk, interest rate risk or asset liability management, market risk, and operational risk.
  • In project management, risk management can include: planning how risk will be managed, assigning a risk officer, maintaining a database of live risks, and preparing risk mitigation plans.

• Managing Marketable Securities

  • Marketable securities are an investment option for organizations with strong liquidity and some potential strategic purposes in risk aversion.
  • It is also worth noting that these types of investments can be used to hedge various types of risks.
  • Perhaps the most interesting marketable securities (and often the highest risk) are derivatives.
  • However, at the business level, derivatives have unique value due to the ability to hedge against various risks.
  • Hedging against foreign currency risk - When operating in a global market different than that of the home office, it is common to encounter the risk of fluctuating currencies.

• Answers to Chapter 9 Questions

  • Investors are usually risk averse.
  • Thus, investors increase their demand for the low-risk bonds and decrease their demand for the high-risk ones.
  • Consequently, bond prices increase for the lower-risk bonds but decrease for the higher-risk bonds.
  • Furthermore, the interest rates are lower for the low-risk bonds and higher for the high-risk bonds.
  • Thus, the securities have the same risk, liquidity, information costs, and taxes.

• Determine a Course

  • A good decision maker will always try to eliminate personal biases and understand his personal risk tolerance when determining a course.
  • Selection criteria might include total cost, time to implement, risk, and the organization's ability to successfully implement the decision.
  • People may be unable to eliminate all of their biases, especially when it comes to their tolerance for risk.
  • Prospect theory is based on the notion that people think about decisions in terms of potential gains and losses and tend to be more averse to losses than they are favorable to gains.
  • In other words, people are more sensitive to possible risk than to possible gain.

• Defining the Security Market Line

  • The Y-intercept of the SML is equal to the risk-free interest rate.
  • Recall that the risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.
  • The slope of the SML is equal to the market risk premium and reflects the risk return trade off at a given time.
  • The idea of a security market line follows from the ideas asserted in the last section, which is that investors are naturally risk averse, and a premium is expected to offset the volatility of a risky investment.
  • The y-intercept of this line is the risk-free rate (the ROI of an investment with beta value of 0), and the slope is the premium that the market charges for risk.

• Stress

  • To be slightly more specific, Frank Knight and Peter Drucker define entrepreneurship in terms of risk-taking.
  • Risk - Measured statistically and often planned for, risks are simply the probabilities of unfavorable outcomes compared to the desired objectives.
  • Ambiguity - A risk that is not measurable, ambiguity is the scenario in which objectives and relative risks are known, but not the likelihood of an outcome.
  • The objective is known, but the context of risk is completely unknown.
  • Any of these three risk scenarios are stressful for many people, and it it is important to understand your own risk aversion before entering into a small business ownership situation.