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Sir there is a past exam question that which one of the following is true if a decision is made using expected value?
a) The risk is minimized for a set level of return
b) The risk is minimized irrespective of the level of return
c) The risk is maximized for a given level of risk
d) The return is maximized irrespective of the level of riskCorrect answer is D but I cannot understand. Can you please explain?
When using the expected value criteria we choose the option that gives the highest (i.e. maximum) expected value.
The expected value approach is risk neutral – it ignores the risk involved (the risk that the actual return will be higher or lower than the expected return).
Have you not watched my lectures on decision making under uncertainty, because I explain this in the lectures?
Sir but can’t the answer be here b) The risk is minimized irrespective of the level of return?
No, because it is not true!!! The risk is ignored just as I wrote in my previous reply and as I explain in my free lecture.
An outcome of either 10 or 90 is a lot more risky than an outcome of 45 or 55 because they spread is a lot greater. Expected values ignore this – if both outcomes had a 0.5 probability then we would be indifferent between the two projects because the EV would be the same.
Please watch the lectures – I am not going to type them all out here!!
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