Risk

Analysis
 Risk Definitions
Risk is chance of Losses

Risk is the possibility of

unfortunate occurrence

Unforeseen events, eventualities

Occurrence of economics Loss

Unpredictability

Probability of some happening

that is unwanted and unavoidable
 Concepts of Risk and Uncertainty

•Economics Risk and Uncertainty

Economics risk is the chance of loss because all possible outcomes
and their probability of occurrence are unknown
Uncertainty exist because the outcomes of managerial decision
cannot be predicted

•General Risk Categories

•Business Risk is the chance of loss
•Marker risk is the chance of loss because of swings in the financial
Markets
Types of Risk
 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
 General Risk Categories (Cont’t.)

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 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.
 Probability Distribution

• Discrete probability distribution: Event P (probabilty)

State of Economy
deals with “events” whose “states of
nature” are discrete. The “event” is Recession 0.2
the state of the economy. The “states Normal 0.6
of nature” are recession, normal, and Boom 0.2
boom.

• 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 Project B Probability of State of Economy

Recession $4,000 $0 0.2
Normal $5,000 $5,000 0.6
Boom $6,000 $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
$10,000.
 Expected Value/Profit

• 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.
 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

 Variance and Standard Deviation

• Variance and Standard Deviation: measuring risk

The payoffs of all events: x1, x2, …, xN
The probability of each event: p1, p2, …, pN
• Expected value of x: EV ( x)  x p  x p  ...  x p   x
N

1 1 2 2 N N i pi
i 1

• Variance: 2 2 2 N 2
 2  ( x1  EV ) p1  ( x 2  EV ) p 2  ...  ( x N  EV ) p N   ( xi  EV ) pi
i 1

• Standard deviation: square root of variance

For project A, what are the variance and standard deviation? EV(A) = $5,000

Variance (σ2) = ($4,000-5,000)2 (.2) + ($5,000-$5,000)2 (.6) + ($6,000-$5,000)2

(.2)

(σ2) = ($1,000)2 (.2) + ($0)2 (.6) + ($1,000)2 (.2)

(σ2) = $400,000 (units are in terms of squared dollars)

σA = $632.46

For project B, what are the variance and standard deviation? EV(B) = $5,400

Variance (σ2) = ($0-5,400)2 (.2) + ($5,000-$5,400)2 (.6) + ($12,000-$5,400)2 (.2)

(σ2) = 5,832,000 + 96,000 + 8,712,000 (units are in terms of squared dollars)

(σ2) = 14,640,000 (units are in terms of squared dollars)

σB = $3,826.23

Project B has a larger standard deviation; therefore it is the riskier project

 Risk Management

• 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), CV  EV
- The lower the CV, the lower the relative risk.
Project A
EV(A) = $5,000
σA = $632.46

Project B
EV(B) = $5,400
σ B = $3,826.23

Coefficient of variation

CVA = = 0.1265

CVB = = 0.7086

Coefficient of variation measures the relative risk; the

variation in possible returns compared with the expected
payoff amount.
 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.
 Risk Attitudes
Scenario: A decision maker has two
choices, a sure thing and a risky option,
and both yield the same expected value.

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
 Utility Theory and Risk Analysis

Typically, consumers and investors display risk-averse behavior, especially

when substantial sums of money are involved. Risk aversion is the general
assumption behind decision models in managerial economics.

Examples to the contrary:

State-run lotteries
Casinos (gaming)

Today, U.S. consumers spend more on legal games of chance than on movie
theaters, books, amusement attractions, and recorded music combined!
Source: Wall Street Journal, Ann Davis, September 23, 2004.
Risk Attitudes

Risk averter: diminishing MU

Risk neutral: constant MU
Risk lover: increasing MU
 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
 Maximizing Expected Value

Event (State of Economy) P 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?
 Minimizing Variance/Standard Deviation

Event (State of Economy) P 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 = $3,826.23

Thinking:
Which project will you choose based on this criterion?
What is ignored using this criterion?
 Coefficient of Variation: Standard Deviation
Divided by the Expected Value

A B
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?
 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).
 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.
 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.
Maximin and Minimax Regret Decision Rules

Event (State of Profit

Economy)
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?
 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.

 Minimax Regret Decision Rule
Calculate the opportunity loss or regret matrix

State of Nature Project A Project B Maximum

Payoff

Recession $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

Maximum possible regret $6,000 $4,000

Project A Project B
Therefore, by the minimax regret decision rule,
choose project B.
 BETA as measure of Risk

Beta: Meaning

•We cannot measure market risk or systematic risk but we can have
a measure of these risk with the help of beta.

•With the help of beta we can approximately tell how much a

particular stock will move if we know how much the whole stock
market is going to move.

•Thus, beta tells us what the volatility is in a particular stock with

respect to movements in the stock market.
 BETA as measure of Risk
The beta (β) of an investment security (i.e. a stock) is a measurement of its
volatility of returns relative to the entire market. It is used as a measure of
risk and is an integral part of the Capital Asset Pricing Model (CAPM. ... A
company with a higher beta has greater risk and also greater expected
returns.
Risk Management
Risk Management Framework