[ P5 ] The handling of risk and uncertainty

                       The handling of risk and uncertainty                                               

                                                         ---Relevant to Paper P5

 

        Though the changes to the Paper P5 syllabus are not fundamental, there are still some areas of greater emphasis according to the syllabus of 2011 and 2012. Of these areas, the handling of risk and uncertainty is an increasing part of all aspects of business which is in line with ACCA’s increased educational focus on risk management.

        According to the new syllabus of 2012, The topic of risk and uncertainty is also emphasized which states that the candidates should “Assess the impact of different risk appetites of stakeholders on performance management; Apply different risk analysis techniques in assessing business performance such as maximin, maximax, minimax regret and expected values”.

        This article intends to show you how the candidates can handle risk and uncertainty in management decision making using an example of Question 1 in the exam of Dec 2011.

Scenario:

        Mackerel is a listed defence contractor and is considering developing a vehicle for the army during the economic downturn. It takes the company two years to develop the vehicle. The government has stated that 500/750/1000 units can be bought depending on defence commitments. The shareholders of the company prepare three types of proposals based on earnings volatility. All of these types have the same variable costs but different fixed costs and profitability.

Risk manager’s assessment of likely government order:

Probability

Demand            Type 1      Type 2     Type 3

500                     85%         25%         20%

750                     10%         50%         50%

1,000                   5%          25%         30%

   

Requirements:

(a). Analyse the risks facing the management of Mackerel and discuss how the management team’s attitude to risk might affect their response.

(b). Evaluate the project using metrics and methods for decision-making under risk and uncertainty and assess the suitability of the different methods used.

(c).  Recommend an appropriate choice of method of assessing the project.

 

Analysis:

        This is a typical question considering risk and uncertainty. In requirement (a) the risks should be explained which should be identified in the scenario. The effects of the management’s attitude towards risk (You should know risk seeker, risk neutral and risk averse) .

        In requirement (b), you should use various methods such as maximax, maximin, minimax regret and expected values to evaluate the project.

        In requirement (c), give your recommendation based on the analysis in (a) and (b).

 

Answer points:

(a)

        The risks (Find these in scenario):

        1.The fluctuating demand of the customer(government)

        2. The uncertainty of profitability

        3. The uncertainty of costs

        The effects of risk appetite:

        1. Risk seekers: They are interested the best outcomes and seek to maximise their returns(maximax).

        2. Risk averse: They assume worst outcome and try to minimize the effect (maximin or minimax regret).

        3. Risk neutral: They choose projects that yield the best expected value.

 

(b)

        Risk seekers uses maximax method so that type 1 should be chosen as it has a maximax profit of $9.1m.

        Risk averse decision makers use maximin or minimax regret method so that type 1 should be chosen with a maximin profit of $4.6m and minimax regret.

        Risk neutral decision makers will choose the project with the maximum expected value so that type 2 should be chosen with a maximum expected value of $5.6m.

        (Appendix of calculations is omitted here)

 

(c)

        Recommendations:

        The choice will depend on the risk appetite of the company. Since the company may be risk averse, the type 1 should be chosen.

 

Summary of the question:

        The question reflects how the issue of risk and uncertainty can be examined. You have to identify various kinds of risk and uncertainty in the scenario, then have a core knowledge of risk appetite (risk seekers, risk averse and risk neutral) and the effects. Then you should know how to use various risk analysis techniques (maximax, maximin, minimax regret and expected values) to assess the project. Some candidates do know the contents of risk appetite, but knows little about its impacts and related analysis techniques. Risk seekers aim to maximize their returns while with no regard to risks so they tend to choose projects with the possible maximum return (this is the method of maximax). Risk averse decision makers avoid risks so they need to ensure the project’s outcome is the best in worst cases (that is to maximize the minimum return, the maximin method). Pessimistic decision makers aim to minimize the maximum regret from making wrong decisions(minimax regret method which is the most difficult to understand and calculate). Risk neutral does not take an optimistic or pessimistic stance. They will choose the option that yields the maximum expected value.