BUSF_A01.qxd

Appendix 3• Suggested answers to review questions

6.1 The two main limitations are:

lIt assumes that only one of the variables will differ from its predicted value, in

other words sensitivity analysis is too static. In reality the variables will probably

all differ from prediction to some extent.

lIt is difficult to interpret the results. This would be equally true even if the first

limitation were overcome by using a scenario-building approach.

6.2 Approach (a) has the advantage in that all possible outcomes, and their probability

of occurrence, can be identified. This will give you a feel for the distributions of pos-

sible outcomes, or it will enable you to calculate the standard deviation.

The number of possible outcomes could, in real life, be vast, which would make

such an approach untenable.

Approach (b) is much more practical because it will be relatively easy to carry out

the calculations. Since averages are used throughout, it is not possible to gain any

feel, or deduce statistics, about the spread of possible outcomes and, therefore, of the

risk involved.

6.3 Specific riskis peculiar to the project, but not necessarily to other projects. Combining

projects in a portfolio will enable this risk to be eliminated.

Systematic riskis present in all projects, to some extent or another, and so cannot

be diversified away by portfolio investment. This type of risk tends to be caused by

macroeconomic factors.

It is helpful to distinguish between these two types of risk because the decision

maker will be able to judge the extent to which total risk can be eliminated by invest-

ing in a portfolio of projects.

6.4 Utility is a measure of the degree of satisfaction that will be derived by an indi-

vidual as a result of having a particular amount of something desirable, such as

wealth.

6.5 In non-technical terms, a risk-averse person will only accept risk where this is

rewarded. Because such people derive a decreasing utility from each additional £1

of wealth, they require an increased reward for each additional increment of risk

undertaken.

It is fairly obvious that most human beings are risk-averse, certainly where more

than trivial amounts are involved.

6.6 The expected value of the wager is £50. A risk-lover would be prepared to pay more

than £50 to enter the wager. How much more than £50 depends on the degree of

risk-loving that characterises this person, that is, what is the shape of her or his

personal utility of wealth curve.

7.1 It needs to be assumed that returns are symmetrically distributed around the

expected value, and that investors are risk-averse.

Evidence tends to suggest that investment returns from quoted securities are

close to showing a normal distribution, which is a symmetrical distribution. Obser-

vation also tends to show that most people are risk-averse.

7.2 The first statement is correct; the second one is not. The relationship is very much

more complicated and depends, among other things, on the coefficient of correlation

between the securities in the portfolio.

Chapter 6

Chapter 7

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