Uncertainty
Expected Value and Risk
Learning Objectives:
- Using probabilities, evaluate expected value.
- Interpret Mean as a measure of return and variance as a measure of risk.
The expected value of a random variable is the weighted average of all possible values this random variable can take. Expected value is another word for 'Mean' or 'Average'.
Possibility is something that may be true or might occur.
Probability is defined as the likelihood of something occuring or the chance of something happening.
Risk is when there is a possibility of loss or chance that actual return on investment may be different than the expected return. In investments, higher risk is expected to be compensated with higher returns. Standard deviation (an variance too) are associated with risk whereas mean is associated with expected return.
Solved Example: 9907-01
Which one of the following risks can be reduced by investing in project or acquiring other firms that have a negative correlation with the earnings of the firm?
A. Investment risk
B. Business risk
C. Financial risk
D. Portfolio risk
Correct Answer: D
Solved Example: 9907-02
Crashing is:
A. Abandoning the project
B. Completing the project with all possible haste
C. Reduction of duration for a few of the activities
D. Reducing the cost of the project with all needful modifications
Correct Answer: C