Risk Analysis, Investment Decisions, and Portfolio Theory - Exam Questions

Question 1

Question 1

(a) Discuss three of the main risk factors that a UK-based building contractor is likely to encounter when working on construction projects in a remote part of the world .

(b) Outline the key differences between (i) and (ii); and outline the key differences between (iii) and (iv). Each of the four theories (i) to (iv) could be used by a contracts, operations or business manager when making investment decisions under conditions of uncertainty:

(i) Maximin rule

(ii) Minimax rule

(iii) Hurwicz’s criterion of realism

(iv) Laplace rule

(c) A marketing consultancy adds a “mark-up” of 10% on each job (this is to cover: risk, profit, overheads and changes in the economy).

(i) Determine the expected profit on any given job.

(ii) The Managing Director decides that recruiting additional social media staff will improve the consultancy’s probabilities of making a profit.

If the annual contract volume of the firm is €200m, determine the additional expenditure the consultancy could spend on new staff and still make the profit that they previously achieved.

Question 2

(a) With specific reference to engineering/construction projects discuss the key features of each of these three risk analysis methods:

(i) Sensitivity analysis

(ii) Scenario analysis

(iii) Expectation-variance criterion

(b) A retail project needs an immediate cash input of £4.0 million in return for the estimated cash flows.

(i) The expected Net Present Value (NPV).

(ii) The standard deviation of NPV

(iii) The probability of NPV being less than zero assuming a normal distribution of return.

(iv) Interpret the figure calculated in (iii).

Question 3

(a) Discuss (making reference to the Allais Paradox) why expected utility may be a true reflection of the way people decide on gambles rather than expected monetary value.

(b) A building contractor is providing an estimate to a potential client for carrying out a construction project. The contractor views that if they offer to undertake the work for £150k there is a 0.2 probability that the potential client will agree to the price; a 0.5 probability that a price of £100k would be agreed; and a 0.3 probability that the potential client will reject the offer.

If the contractor offers to undertake the work for £100k they anticipate, there is 0.3 probability that the potential client will accept the price; a 0.6 probability that the potential client will negotiate so that a price of £80k will be agreed; and a 0.1 probability that the potential client will reject the offer.

Question 2

(i) Determine the price that the contractor should quote in order to maximise the expected payment that they receive from the client. (7 marks)

(iii) Suppose that after questioning the company is able to make the following three statements: “I am indifferent between receiving £120k for certain; or entering a lottery that will give me a 0.9 probability of winning £150k and a 0.1 probability of winning £0.” “I am indifferent between receiving £80k for certain; or entering a lottery that will give me a 0.75 probability of winning £150k and a 0.25 probability of winning £0.”

“I am indifferent between receiving £100k for certain; or entering a lottery that will give me a 0.85 probability of winning £150k and a 0.15 probability of winning £0.”

Question 4

Outlook plc is considering the production of a new automobile item with a five year product lifetime. In order to manufacture this item it would be necessary to build a new production facility (factory). You have been appointed as a consultant to advise the senior management of the firm. After considering all possible alternatives, it becomes clear that management have only three possible strategies (I, II & III).

This faces two types of market conditions (a) high demand with a probability of 0.7 or (b) low demand with a probability of 0.3. If the demand is high, the company can expect to receive an annual cash flow of $2.5m for each of the next five years. If the demand is low the cash flow would consist of a loss of $0.5m each year. (This is because of inefficiencies and large fixed costs).

II: Build a small facility (at an approximate cost of $3.5m) This strategy faces the same market conditions types as Strategy I (i.e. (a) and (b)). The cash flow over the five–year period for the small facility is $0.25m if the demand is low; and $1.5m if the demand is high.

Strategy III: Delay building the manufacturing facility

This strategy consists of leaving the decision for one year (while more information is collected). The resulting information can be positive or negative (with estimated probabilities of 0.8 and 0.2 respectively). At the end of the 12 months, management may decide to build either a small facility or a large facility at the same cost as at present, providing the information is positive. If the resulting information is negative management would decide not to build any facility at all.

Question 3

Given positive information the probabilities of high and low demand change to 0.9 and 0.1 respectively (regardless of which facility is built). The annual cash flows for the remaining four-year period (for either facility type) are the same as those given for strategies I and II.

(a) Draw a Decision Tree to represent the alternative courses of action open to Outlook plc.

(b) Determine the expected return for each possible course of action and, therefore, decide the best course of action for the management of Outlook plc.

(c) A building firm offers a discount to Outlook plc if they agree to have a large facility constructed immediately. Determine the percentage discount necessary to change the best course of action.

Question 5

(a) Describe what is meant by each of the three terms below and then the difference between (i) and (iii)

(i) Transaction risk

(ii) Economic risk

(iii) Translation risk

(b) Inflation is 5% per annum (pa) in the UK and 2% pa in the USA and it is expected to remain at these rates. Nominal interest rates are 8.15% pa in the UK and 5.06% pa in the USA. The spot exchange rate is $1.50/£.

(i) Determine the real interest rate in the UK and USA. Explain whether your answers are what you would expect according to the International Fisher relation.

(ii) Determine the one year forward exchange rate.

(iii) Determine what the spot rate in one year’s time will be according to purchasing power parity.

(ii) Determine what the spot rate is expected to be in one year’s time according to the expectations hypothesis giving reasons for your answer.

Question 6

(a) Portfolio theory aims to assist investors in creating an efficient portfolio; and diversification is a strategic device for dealing with risk. Sensible companies diversify their investments, products & services. Given these statements, comment on how companies might spread the risk of declining trade and profitability. In your answer make reference to three of these six company types: large construction firm, supermarkets, financial institutions, confectionary, greetings card, automobile manufacturers.

In discussing portfolio theory, what does a correlation coefficient of +1 indicate?

How do negative correlations generally provide greater diversification benefits?

Studies have shown that specific risks can be eliminated by investing in how many holdings?

Explain why auction theory is a direct application of utility theory.

Sealed-bids are common in construction. They generally attract more bids than via an “English Auction “. Explain why this is?