Risk & Risk analysisThe potential that a chosen action or activity (including

the choice of inaction) will lead to a loss (an undesirable outcome).

Risk exists because of the inability of the decision-maker to make perfect forecasts.

In formal terms, the risk associated with an investment may be defined as the variability that is likely to occur in the future returns from the investment.

Risk analysis is the process of defining and analyzing the dangers to individuals, businesses and government agencies posed by potential natural and human-caused adverse events

By. Dr. B. J. Mohite 9850098225

Techniques for Risk Analysis

Statistical Techniques for Risk AnalysisProbability Variance or Standard DeviationCoefficient of Variation

Conventional Techniques of Risk AnalysisPaybackRisk-adjusted discount rateCertainty equivalent

Probability

Probability may be described as a measure of someone’s opinion about the likelihood that an event will occur.

The probability estimate, which is based on a very large number of observations, is known as an objective probability.

Such probability assignments that reflect the state of belief of a person rather than the objective evidence of a large number of trials are called personal or subjective probabilities.

Variance or Standard Deviation

Simply stated, variance measures the deviation about expected loss of each of the possible threat.

Standard deviation is the square root of variance.Absolute Measure of Risk.

Coefficient of Variation

Relative Measure of RiskIt is defined as the standard deviation of the probability

distribution divided by its expected value:

The coefficient of variation is a useful measure of risk when we are comparing the projects which have(i) same standard deviations but different expected values, or (ii) different standard deviations but same expected values, or (iii) different standard deviations and different expected values.

Expected valueCofficient of variation = CV =

Standard deviation

Payback method / techniquePayback is one of the oldest and most common procedures used and the explicit recognition of risk in the project with an investment. This method, applied in practice, as is an attempt to measure the risk assessment in investment decision as a possible method Profitability. The payback method is the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows.

Decision criteria:The length of the maximum acceptable payback period is determined

by management. If the payback period is less than the maximum acceptable payback

period, accept the project.If the payback period is greater than the maximum acceptable

payback period, reject the project.

Payback Period: Pros and Cons of Payback Analysis

Pros The payback method is widely used by large firms to evaluate small

projects and by small firms to evaluate most projects. Its popularity results from its computational simplicity and intuitive

appeal. By measuring how quickly the firm recovers its initial investment,

the payback period also gives implicit consideration to the timing of cash flows and therefore to the time value of money.

Because it can be viewed as a measure of risk exposure, many firms use the payback period as a decision criterion or as a supplement to other decision techniques.

Cons The major weakness of the payback period is that the

appropriate payback period is merely a subjectively determined number. It cannot be specified in light of the wealth maximization

goal because it is not based on discounting cash flows to determine whether they add to the firm’s value.

A second weakness is that this approach fails to take fully into account the time factor in the value of money.

A third weakness of payback is its failure to recognize cash flows that occur after the payback period.

Risk adjusted discount rate

An estimation of the present value of cash for high risk investments is known as risk-adjusted discount rate. 

The risk adjusted discount rate approaches attempts to handle the problem of risk and uncertainty in a more direct and thoughtful way.

As we know investors are risk reluctant and so requires a reward for under taking a risky investment, the greater must be its expected return.

The Greater The Project Perceived Level Of Risk, The Greater Is The Risk Premium

Risk adjusted discount rate = risk free rate + risk premium

Advantages and disadvantages of risk adjusted discount rate 

disadvantagesThere is no easy way deriving a risk adjusted discount rate.

Capital asset pricing model provides a basis of calculating the risk adjusted discount rate. Its use has yet to pick up in practice.

It does not make any risk adjusted in the numerator for the cash flows that are forecast over the future years.

advantage It is simple and can be easily understood. It has a great deal of intuitive appeal for risk-averse

businessman. It incorporates an attitude towards uncertainty.

certainty equivalentUnder this techniques, the estimated cash flows are adjusted

by using risk free rate to assertain risk free cash flowThe expected cash flows of the project are converted in to

equivalent riskless amount The smaller certainty equivalent will be used in the case of an

expected cash inflows and the larger certainty equivalent used for payment

 For example, if an investor, according to his “best estimate” expects a cash flow of 60000 next year, he will apply an intuitive correction factor and may work with 40000 to be on safe side. There is a certainty-equivalent cash flow.

Draw backs of certainty equivalent

1. the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. This will no longer give furcated according to best estimate.

2. if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast or to make it ultra conservative.

3. by focusing explicit attention only on the gloomy out comes, chances are increased for passing by some good investments.