Making Decisions Under Conditions of Risk and Uncertainty

Conditions of risk and uncertainty frame most decisions rendered by management.

KEY POINTS
Uncertainty and risk are not the same thing !hereas "ncertainty dea#s $ith %ossi&#e
o"tcomes that are "nkno$n' risk is a certain ty%e of "ncertainty in(o#(ing a rea# %ro&a&i#ity
of #oss for a gi(en o"tcome Risks can &e acco"nted for more com%rehensi(e#y than
"ncertainty
Decision making "nder conditions of risk sho"#d seek' $here(er %ossi&#e' to identify'
)"antify' and a&sor& risk
The )"antity of risk is e)"a# to the s"m of the %ro&a&i#ities of a risky o"tcome *or
(ario"s o"tcomes+ m"#ti%#ied &y the antici%ated #oss as a res"#t of the o"tcome
The a&i#ity of a firm to a&sor&' transfer' and manage risk $i## often define
management,s risk a%etite so that once risks are identified and )"antified' decisions may &e
made as to $hether risky o"tcomes may &e to#erated and to $hat e-tent
TERMS
force ma.e"re
/n "na(oida&#e catastro%he' es%ecia##y one that %re(ents someone from f"#fi##ing a #ega#
o&#igation /n "nforeseea&#e act of nat"re
hedge
/ contract or arrangement red"cing one,s e-%os"re to risk
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The manageria# #andsca%e is often defined &y sit"ations of risk and "ncertainty The decision0
making %rocess is an attem%t to red"ce' mitigate' or e(en remo(ed risks and "ncertainties /s
s"ch' the decisions of managers im%act the e-tent to $hich risks and "ncertainties remain
Uncertainty has a fair#y #inear effect on decision making in that it de#ays it !hen confronted
$ith "ncertainty' managers $i## attem%t to %"t off decisions "nti# "ncertain circ"mstances
&ecome more certain
It is im%ortant to note that "ncertainty and risk are not the same thing' &"t &oth %#ay an
im%ortant ro#e in the decision0making %rocess Uncertainty is a %ro&a&i#istic state $here
m"#ti%#e o"tcomes are %ossi&#e yet "nkno$n Risk is a state of "ncertainty $here&y %ossi&#e
o"tcomes in(o#(e #osses of (arying degrees de%ending on the act"a# o"tcome
Decision making $ithin a risk management conte-t sho"#d therefore seek' $here(er %ossi&#e'
to identify' )"antify' and a&sor& risk Identifying risk entai#s an a$areness of c"rrent &"siness
risks that might &e facing the organi1ation 2"siness risks are ty%ica##y c#assified as fo##o$s3
1. Strategic risks3 These are ind"stria# risks that arise from com%eting in a s%ecific
ind"stry and can inc#"de macroeconomic risks *the a#ignment of &"yers and se##ers consistent
$ith the %rinci%#es of s"%%#y and demand+' transaction risks *the o%erationa# risks from M4/
acti(ity' di(est"res' or %artnershi%s+' and in(estor re#ations risk *the risks associated $ith
comm"nicating effecti(e#y $ith the in(estment comm"nity+
2. 5inancia# risks3 These are deri(ed from %otentia# #osses in the financia# acco"nts of a
&"siness They can inc#"de risks from in(esting ca%ita#' risks to %rinci%a# or interest (a#"e' or
risks to other &"siness re#ated transactions
6 O%erationa# risks3 Risks that arise d"ring the day0to0day o%erations of the &"siness
This (aries considera&#y amongst different ind"stries
7 8ega# risks3 The e-tent of a &"siness, com%#iance $ith a## a%%#ica&#e #a$s $o"#d
dictate the o(era# im%act of #ega# risks on decision making
5. Other risks3 Us"a##y risks associated $ith force majeure This is diffic"#t to acco"nt
for and inc#"de $ithin decision0making criteria
Once management has identified the a%%ro%riate risk category that may im%act "%on a certain
decision' it may go a&o"t )"antifying these risks In other $ords' management $i## ascertain
the costs inc"rred if a risky o"tcome $ere to ha%%en This can &e mathematica##y da"nting for
many ty%es of risk' es%ecia##y financia# risk' &"t genera##y s%eaking risk is e)"a# to the s"m of
the %ro&a&i#ities of a risky o"tcome *or (ario"s o"tcomes+ m"#ti%#ied &y the antici%ated #oss
as a res"#t of the o"tcome This is simi#ar to %erforming a sensiti(ity ana#ysis if the "ni(erse
of o"tcomes is kno$n
The a&i#ity of a firm to a&sor&' transfer' and manage risk is critica# in management,s decision0
making %rocess $hen risky o"tcomes are in(o#(ed This $i## often define management,s risk
a%etite and he#%s determine' once risks are identified and )"antified' $hether risky o"tcomes
may &e to#erated 5or e-am%#e' many financia# risks can &e a&sor&ed or transfered thro"gh
the "se of a hedge' $hi#e #ega# risks might &e mitigated thro"gh "ni)"e contract #ang"age If
managers &e#ie(e that the firm is s"ited to a&sor& %otentia# #osses in the e(ent the risky
o"tcome is triggered' then they $i## nat"ra##y ha(e a #arger a%etite for risk gi(en their
ca%a&i#ities to manage it