Risk Analysis
Prof. Pallavi Ingale
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Topics
Risk and Uncertainty
General Risk Categories
Probability
Probability Distribution
Payoff Matrix
Expected Value
Insurance
Hedging
Diversification
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Risk
Risk a four-letter word
To make effective investment decisions,
one must understand risk.
Decision makers sometimes know with
certainty the outcomes associated with
each possible course of action.
Risk (Cont.)
Example:
A firm with Rs.100,000 in cash
Decision to make:
(1) Invest in a 30-day Treasury bill yielding 11%
interest
(2) Prepay a 15% bank loan
Which course of action to take?
Choose (1) => Rs. 917 interest income after 30 days
Choose (2) => Rs. 1250 interest expense savings
after 30 days
Choose (2) provides Rs. 333 additional for 1-month
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Definition of Risk and Uncertainty
- Risk/Uncertainty: Both concepts deal with
the probability of loss or the chance of
adverse outcomes
- Risk: All possible outcomes of managerial
decisions and their probabilities are not
completely known
- Uncertainty: The possible outcomes and
their probabilities are known
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General Risk Categories
Business Risk the chance of loss associated with a
given managerial decision; typically a by-product of
the unpredictable variation in product demand and
cost conditions
Market Risk the chance that a portfolio of investments
can lose money because of overall swings in
financial markets
Inflation Risk the danger that a general increase in
the price level will undermine the real economic value
of corporate agreements
Interest-rate Risk another type of market risk that can
affect the value of corporate investments and obligations
Credit Risk the chance that another party will fail
to abide by its contractual obligations
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General Risk Categories (Cont.)
Liquidity Risk the difficulty of selling
corporate assets or investments that have
only a few willing buyers or are otherwise not
easily transferable at favorable prices under
typical market conditions
Derivative Risk the chance that volatile
financial derivatives such as commodity
futures and index options could create
losses by increasing rather than decreasing
price volatility
Currency Risk the chance of loss due to
changes in the domestic currency value of
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foreign profits
Probability
- Probability: likelihood of particular outcome
occurring, denoted by p. The number p is
always between zero and one.
- Frequency: estimate of probability, p=n/N, where
n is number of times a particular outcome occurred
during N trials.
- Subjective probability: If we do not have
frequency, we often resort to informed guesses.
Subjective probabilities must follow the same rules
of the probability calculus, if we are dealing with
rational decision-makers.
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Probability Distribution
Discrete probability
distribution: deals with events
whose states of nature are
discrete. The event is the state
of the economy. The states of
nature are recession, normal,
and boom.
Event
State of Economy
P (probabilty)
Recession
0.2
Normal
0.6
Boom
0.2
Continuous probability
distribution: deals with events
whose states of nature are
continuous values. The event
is profits, and the states of
nature are various profit levels.
Payoff Matrix
A table that shows outcomes associated with each possible state of nature.
State of Economy
Project A
profit
Project B
profit
Probability of State of Economy
Recession
Rs. 4,000
Rs. 0
0.2
Normal
Rs. 5,000
Rs. 5,000
0.6
Boom
Rs. 6,000
Rs.12,000
0.2
Project A more desirable in a recession.
Project B more desirable in a boom.
In a normal economy, the projects offer the same profit potential.
Decision to Make:
A firm must choose only one of the two investment projects
(choose Project A or Project B). Each calls for an outlay of
Rs.
10,000.
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Expected Value
The payoffs of all events:
x1, x2, , xN
The probability of each event: p1, p2, , pN
Expected value of x:
N
EV ( x) x1 p1 x 2 p 2 ... x N p N xi pi
i 1
EV(x) is a weighted-average payoff, where the
weights are defined by the probability
distribution.
Use the payoff matrix in the previous slide,
together with the probability of each state of the
economy.
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Expected profit of
Project A and B under
different economic
states of nature
EV ( A) 4,000 * 0.2 5,000 * 0.6 6,000 * 0.2 5,000
EV ( B ) 0 * 0.2 5,000 * 0.6 12,000 * 0.2 5,400
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Risk Measurement
Absolute Risk:
- Overall dispersion of possible payoffs
- Measurement: variance, standard deviation
The smaller variance or standard deviation, the
lower the absolute risk.
Relative Risk
- Variation in possible returns compared with the
expected payoff amount
- Measurement: coefficient of Variation (CV),
- The lower the CV, the lower the relative risk.
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Risk Attitudes
Risk Aversion
characterizes decision makers who seek to avoid or minimize risk.
Risk Neutrality
characterizes decision makers who focus on expected returns and
disregard the dispersion of returns.
Risk Seeking (Taking)
characterizes decision makers who prefer risk.
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Risk Attitudes
Scenario: A decision maker has two choices, a sure thing
option, and both yield the same expected value.
and a risky
Risk-averse behavior:
Decision maker takes the sure thing
Risk-neutral behavior:
Decision maker is indifferent between the two choices
Risk-loving (or seeking) behavior:
Decision maker takes the risky option
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Decision-Making Under
Risk
Possible Criteria to consider:
- Maximize expected value
- Minimize variance or standard deviation
- Minimize coefficient of variation
- Incorporate risk attitudes: certainty equivalent
- Maximin criterion
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Maximizing Expected Value
Event (State of Economy)
Profit
Project A
Project B
Recession
0.2
$4,000
$0
Normal
0.6
$5,000
$5,000
Boom
0.2
$6,000
$12,000
EV(A)=$5,000 EV(B)=$5,400
Thinking:
Which project will you choose based on this criterion?
What is ignored using this criterion?
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Minimizing Variance/Standard
Deviation
Event (State of Economy)
Profit
Project A
Project B
Recession
0.2
$4,000
$0
Normal
0.6
$5,000
$5,000
Boom
0.2
$6,000
$12,000
= $632.46
A
= $3,826.23
Thinking:
Which project will you choose based on this criterion?
What is ignored using this criterion?
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Coefficient of Variation: Standard Deviation Divided by the
Expected Value
Expected value
$5,000
$5,400
Standard deviation
$632.46
$3,826.23
Coefficient of Variation
0.2265
0.7086
Think:
Which project will you choose based on this criterion?
What is ignored?
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Incorporating Risk Attitudes: Certainty Equivalent
Suppose that you face the following choices:
(1) Invest $100,000
From a successful project you receive $1,000,000.
If the project fails, you receive $0.
The probability of success is 0.5.
EV(investment) = ($1,000,000)(0.5) + ($0)(.5) = $500,000.
(2) You do not make the investment and keep $100,000.
If you find yourself indifferent between the two alternatives,
$100,000 is your certainty equivalent for the risky expected
return of $500,000.
A certain or riskless amount of $100,000 provides exactly the
same utility as a 50/50 chance to earn $1,000,000 (or $0).
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In general, any risky investment with a certainty equivalent less than the
expected dollar value indicates risk aversion.
In our case, $100,000 < $500,000 => risk aversion.
Certainly Equivalent Adjustment Factor =
Expected Value of the Risky Venture
In our case,
= Equivalent Certain Sum
$100,000 = .2.
$500,000
The price of one dollar in this risky venture is equal to 20 in certain dollar
terms.
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=Equivalent Certain Sum
Expected Value of the Risky Venture
If
Then
Implies
Equivalent certain sum < Expected Value of the
Risky Venture
Equivalent certain sum = Expected Value of the
Risky Venture
Equivalent certain sum > Expected Value of the
Risky Venture
<1
Risk aversion
=1
Risk indifference
(or neutrality)
>1
Risk preference
(or taking)
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Game Theory
- Game Theory dates back to the 1940s by John
von Neuman (Mathematician) and Oskar
Morgenstern (Economist)
- Game Theory is a useful decision framework
employed to make choices in hostile
environments and under extreme uncertainty.
- Use of maximin decision rule
- Use of minimax regret decision rule
(opportunity loss).
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Maximin Decision Rule
The decision maker should select the alternative
that provides the best of the worst possible
outcomes. Maximize the minimum possible
outcome.
The maximin criterion focuses only on the most
pessimistic outcome for each decision alternative.
The maximin criterion implicitly assumes a very
strong aversion to risk and is quite appropriate for
decisions involving the possibility of catastrophic
outcomes.
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Minimax Regret Decision
Rule
This decision rule focuses on the opportunity loss
associated with a decision rather than on its worst possible
outcome.
The decision maker should minimize the maximum
possible regret (opportunity loss) associated with a wrong
decision after the fact. Minimize the difference between
possible outcomes and the best outcome for each state of
nature.
Opportunity loss => the difference between a given payoff
and the highest possible payoff for the resulting state of
nature. So, find the maximum payoff for a given state of
nature and then subtract from this amount the payoffs that
would result from various decision alternatives.
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Maximin and Minimax
Regret Decision Rules
Event (State of
Economy)
Profit
Project A
Project B
Recession
$4,000
$0
Normal
$5,000
$5,000
Boom
$6,000
$12,000
Thinking:
Which project will you choose?
- Based on Maximin Decision Rule?
- Based on Minimax Regret Decision Rule?
What is ignored in the respective decisions?
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Maximin Decision Rule
Example
Minimum possible outcome for project A is $4,000.
Minimum possible outcome for project B is $0.
Therefore by the maximin decision rule, choose project A.
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Minimax Regret Decision
Rule
Calculate the opportunity loss or regret matrix
Project A
Project B
Maximum
Payoff
$4,000-$4,000=$0
$4,000-$0=$4,000
$4,000
Normal
$5,000-$5,000=$0
$5,000-$5,000=$0
$5,000
Boom
$12,000-$6,000=$6,000
$12,000-$12,000=$0
$12,000
$6,000
Project A
$4,000
Project B
State of Nature
Recession
Maximum possible regret
Therefore, by the minimax regret decision rule,
choose project B.
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Preparation
for Exam I
Whats
Next?
Exam I Covers:
- Algebra review
- Demand analysis
- Risk analysis
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Real-world Limitations to Efficient
Risk Allocation
Transactions costs
Incentive problems
moral-hazard: having insurance against some risk causes
the insured party to take greater risk or to take less care in
preventing the event that gives rise to the loss.
adverse selection: those who purchase insurance against
risk are more likely than the general population to be at risk
Three Dimensions of Risk
Transfer
The simple way of risk transfer: selling the asset
that makes the owner exposed to risk.
The three dimensions of risk transfer: hedging,
insuring, and diversifying.
Hedging
The action taken to reduce ones exposure to a loss
but also causing the hedger to give up the
possibility of a gain.
Example: farmers
Other examples
Insuring
Paying a premium to avoid losses but retaining
the potential for gain.
Example: import/export business
Other examples: health insurance, traveling
to Jiuzhaigou.
Diversifying
Holding similar amounts of many risky assets
instead of concentrating all of your investment in
only one.
Example: investing in the biotechnology business
initial capital: $100,000
probability of success: 50%
uncertainty: quadrupling the investment or losing the
entire investment
independence of successes
Further Points on
Diversification
Reduce chances of either big gains or losses
Perfect correlation: do not reduce risk
Aggregate uncertainty: not reduced
genius, dunce and average investors: Good
luck or skill?
Attitudes towards Risk
Three Types
Risk Averter
Risk Lover
Risk-Neutral
Risk Averter
Choice: Certain outcome
Risk Lover
Choice: Uncertain outcome
Risk-Neutral
Maximization of expected wealth
Regardless of risk
Measures of Risk
1.
Dispersion of Probability Distribution
Profit from the Decision
2.
Example:
Jones Corporation
Investment Decision
for a new plant
