Question

If your company makes a particular decision in the face of uncertainty, you estimate that it will either gain $10,000, gain $1000, or lose $5000, with probabilities 0.40, 0.30, and 0.30, respectively. You (correctly) calculate the EMV as $2800. However, you distrust the use of this EMV for decision-making purposes. After all, you reason that you will never receive $2800, you will receive $10,000, $1000, or lose $5000." suppose you have the option of receiving a check for $2700 instead of making the risky decision described. Would you make the risky decision, where you could lose $5000, or would you take the sure $2700? What would influence your decision?

Answer 1

Quantitative risk assessment uses the concept of Expected Monetary Value (EMV) in case of risky projects. A positive EMV indicate positive opportunities while negative value indicates the losses and threats of continuing with the project. In order to compensate for negative EMV value the manager or investor has to keep a buffer equivalent to negative EMV value.

I would take a risky decision because of positive EMV value although there is a probability of loosing $5,000. But there is a high probability of winning in this case. Since i am not a risk averse i would accept the risk of getting a higher return.

In the second part when the person receives a check of $2,700 he/she might take the risk or not depending on whether he/she is risk seeker , risk neutral or risk averse.

For a risk averse investor the check amount would be sufficient as there is no uncertaininty in it. A risk averse investor does not love uncertainity.

Since i am a risk seeker i would love to be in the game of uncertainity. Although some factors could result in change of your risk appetite like age, loss of job/income, obligations etc. Depending on the situation it will be wise to analyze the situation.