PART 5-2 RISK ANALYSIS

RISK ANALYSIS

13-1 RISK AND UNCERTAINTY IN MANAGERIAL DECISION MAKING

Managerial decisions are made under conditions of certainty, risk or uncertainty. Certainty refers to the
situation where there is only one possible outcome to a decision and this outcome is known precisely.
For example, investing in treasury bills leads to only one outcome (the amount of the yield), and this is
know with certainty. The reason is that there is virtually no chance that the federal government will fail
to redeem these securities at maturity or that it will default on interest payment. On the other hand,
when there is more than one outcome to a decision, risk or uncertainty is present.

Risk refers to a situation in which there is more than one possible outcome to a decision and the
probability of each specific outcome is known or can be estimated. Thus, risk requires that the decision
maker know all the possible outcome occurrence. For example, in tossing a coin, we can get either a
head or a tail, and each has an equal chance of occurring.

Uncertainty is the case where there is more than one possible outcome to a decision and where the
probability of each specific outcome occurring is not known or even meaningful. This may be due to
insufficient past information or instability in the structure of the variables. In extreme forms of
uncertainty not even the outcome themselves are known. For example, drilling for oil in an unproven
field carries with it uncertainty if the investor does not know either the possible oil outputs or their
probability of occurrence.

In the analysis of managerial decision making involving risk, we will use such concepts as strategy,
states of nature and payoff matrix. A strategy refers to one of several alternative courses of action that
a decision maker can take to achieve a goal. For example, a manager may have to decide on the
strategy of building a large or small plant in order to maximize profits or the value of the firm. States
of nature refer to condition in the future that will have a significant effect on the degree of success or
failure of any strategy, but over which the decision maker has little or no control. For example, the
economy may be booming, normal, or in a recession in the future. The decision maker has no control
over the states of nature that will prevail in the future but the future states of nature will certainly affect
the outcome of any strategy that he or she may adopt. The particular decision may depend, therefore,
on the decision’s maker knowledge or estimation of how a particular future state of nature will affect
the outcome or result of a particular strategy. Finally, a payoff matrix is a table that shows a possible
outcomes or result of each strategy under each state of nature. For example, a payoff matrix may show
the level of profit that would result if the firm builds a large or small plant and if the economy will be
booming, normal or recessionary in the future.

13-2 MEASURING RISK WITH PROBABILTY DISTRIBUTIONS

Probability Distributions
The probability of an event is the chance or odds that the event will occur. For example, if we say that
the probability of booming conditions in the economy next year is 25%, this means that there is one
chance in 4 for this condition to occur. By listing all the possible outcomes of an event of the
probability attached to each. We get a probability distribution. For example, if only three states of the
economy are possible (boom, normal or recession) and the probability of each occurring is specified,
we have a probability distribution such as shown in Table below.

The concept of probability distribution is essential in evaluating and comparing investment projects. In
general, the outcome o profit of an investment project is highest when the economy is booming and
PART 5-2 RISK ANALYSIS

smallest when the economy is in a recession. If we multiply each possible outcome or profit of an
investment by its probability of occurrence and add these products, we get the expected value or profit
of the project. That is,

Thus, the expected profit of an investment is the weighted average of all possible profit levels that can
result from the investment under various states of economy, with the probability of those outcomes or
profits used as weights. The expected profit of an investment is very important consideration in
deciding whether or not to undertake the project or which of the two or more projects is preferable.

In the above example, we identified only three possible states of economy and obtained a step like
discreet probability distribution of profits. As we specify more and more different states of nature
(gradients of boom, normal business conditions, and recession - and their respective probabilities and
profits), each bar becomes thinner and thinner and approaches a vertical line in the limit. We will then
approach the continuous probability distribution. Note that the probability of Project A is again thinner
or less dispersed from its expected value than the probability distribution of Project B and that it
reflects the smaller risk associated with Project A than with Project B.

An Absolute Measure of Risk: The Standard Deviation

We have seen above that the tighter or less dispersed is a probability distribution., the smaller is the
risk of a particular strategy or decision. The reason is that there is a smaller probability that the actual
outcome will deviate significantly from the expected value. We can measure the tightness or the degree
PART 5-2 RISK ANALYSIS

of dispersion of a probability distribution by a standard deviation, which is indicated by the symbol ơ

(sigma). Thus the standard deviation (ơ) measures the dispersion of possible outcomes from the
expected value. The smaller the value of ơ, or the tighter or less dispersed is the distribution, and lower
the risk.

To find the value of standard deviation (ơ) of a particular probability distribution, we follow three steps
below.

Measuring Probabilities with the Normal Distribution

The probability distribution of many strategies or experiments follow a normal distribution, so that the
probability of a particular outcome falling within a specific range of outcomes can be found by the area
under the standard normal distribution within the specified range. The figure of the standard deviation
normal distribution is given in Figure 13-3. This is a bell-like distribution, symmetrical about its zero
mean, with standard deviation of 1 and with the area under the curve representing a total probability of
1.
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13-3 UTILITY THEORY AND RISK AVERSION

Most manages, faced with two alternative projects of equal expected value of profits but different
coefficients of variation or risk, will generally prefer the less risky project. While it is true that some
mangers may very well choose the more risky project and some are indifferent to risk, most managers
are risk averters. The reason for this is to be found in the principle of diminishing marginal utility of
money. The meaning of diminishing constant, and increasing marginal utility of money can be
explained with the aid og Figure 13-4.
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PART 5-2 RISK ANALYSIS

13-4 ADJUSTING THE VALUATION MODEL FOR RISKS

Risk-Adjusted Discount Rates
One method of adjusting the valuation model to deal with n investment project subject to risk is to use
risk -adjusted discount rates. These reflect the manager’s or investor’s trade-off between risk and
return, as shown f example, by the risk-return trade-off functions of Figure 13-7.

The indifference between the expected and required rate of return on a risky investment and the rate of
return on a riskless asset is called risk-premium on the risky investment.
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13-5 OTHER TECHNIQUES FOR INCORPORATING RISK INTO

DECISION MAKING
Decision Trees
Managerial decision involving risk re often made stages, with subsequent decisions and events
depending on the outcome of earlier decisions and events. A decision tree shows the sequence of
possible managerial decisions and their expected outcome under each set of circumstances or stated of
nature. Since the sequence of decision and events is represented graphically as the branches of a tree,
this technique has been named “decision tree”. the construction of decision tree begins with the
earliest decision and moves forward in time through a series of subsequent events and decisions. At
every point that a decision must be made or a different event can take place, the tree branches out until
all the possible outcomes have been depicted. In the construction of decision trees, boxes are use to
show decision points, while circle shows states of nature. Branches coming out of boxes depict the
alternative branches coming out of circles show the various states of nature that affect the outcome.
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SIMULATION
Another method for analyzing for analyzing complex, real-world decision making situations involving
risk is simulation. The first step in simulation is the construction of mathematical model of the
managerial decision-making situations that we seek to stimulate. For example, a aerospace engineer
constructs a miniature model plane and wind tunnel to test the strength the resistance of the model
plane to change in wind speed and direction. This modeling mimics the essential features of a
real-world situations and allows the engineer to stimulate the effect o changes in wind speed and
direction on a real aircraft. Similarly, the firm might construct a model for the strategy of expanding the
output of a commodity. The model would specify in mathematical form the relationship between the
output of the commodity and its price; output, input prices, and cost of production; output and
depreciation; output, selling costs, and revenue; output, revenues and taxes and so on. The manager
could then substitute likely values or best estimates for each variable into the model and estimates the
firm’s profit. By then, varying the value of each variable substituted into the model, or profit of the
firm. The simplest type of simulation is often referred to as sensitivity analysis.

13-6 DECISION MAKING UNDER UNCERTAINTY

The Maximum Criterion
The maximum criterion postulates that the decision maker should determine the worst possble outcome
of each strategy and then pick the strategy that provides the best of the worst possible outcomes. The
maximum criterion can be illustrated by applying it to the example in Table 13-4, where the firm could
follow the strategy of introducing a new product that would provide a return of $20,000 if it succeeded
or lead to a loss of 10,000 if it failed, or choose not to invest in the venture, with zero possible return or
loss. This matrix is shown in the table 13-6. Note that no probabilities are given because we are now
dealing with uncertainty. That is, we know assume that the manager does not know and cannot estimate
the probability of success and failure of investing in the new product. Therefore, he or she cannot
calculate the expected payoff or return and risk of investment.

To apply the maximum criterion to this investment, the manager first determines the worst possible
outcome of each strategy (row). This is -- $10,000 in the case of failure for the investment strategy and
0 for the strategy of not investing. These worst possible outcomes are recorded in the last o maximum
column of the table. Then he or she picks the strategy that provides the best (maximum) of the worst
(minimum) possible outcomes (maximin). This is the strategy of not investing, which is indicted by the
asterisk next to its 0 return or loss in the last column of the table. Thus, the maximum criterion picks
the strategy of not investing, which has the maximum of the minimum payoffs.

The Minimax Regret Criterion

Another specific decision rule under certainty is the minimax regret criterion. This postulates that the
decision maker should select the strategy that minimizes the maximum regret or opportunity cost of the
wrong decision, whatever that state of nature that actually occurs. Regret is measured by the difference
between the payoff of a given strategy and the payoff of the best strategy under the same state of nature.
The rationale for measuring regret this way is that if we have chosen the best strategy for the
particular state of nature that has actually occurred, ten we have no regret. But if we have chosen other
strategy under the specific state of nature that has occurred and the payoff of the strategy chosen. After
determining the maximum regret for each strategy under each state of nature, the decision maker then
chooses the strategy with the minimum regret value.
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Other Methods of Dealing with Uncertainty

Besides the above formal investment criteria, there are number of less formal methods that are
commonly used by decision makers to reduce uncertainty or the dangers arising from uncertainty.
Some of these are the acquisition of additional information, referral to authority, attempting to control
the business environment and diversification.

Decision makers often attempt to deal with uncertainty by gathering additional information. This can
go a long way toward reducing uncertainty surrounding a particular strategy or event and the dangers
arising from it. Gathering more information is costly, however, and the manager should treat it as any
other investment.

The decision maker can sometimes deal with uncertainty by requesting the opinion of a particular
authority (such as Internal Revenue Service o tax questions, Securities and Exchange Commission on
financial investment, Labor Relations Board on labor questions, or a particular professional association
on matters of a particular competence).

Another method by which decision makers sometimes seek to deal with uncertainty is by trying to
control the business environment in which they operate. Thus, firms often attempt to gain monopoly
control over a product by means of patents, copyrights, exclusive franchises, and so on. Competition
through imitation as well as antitrust laws, however, severely limit firms’ attempts to gain monopoly
power, especially in the long run.

Diversification in the types of products produced , in the composition of security portfolios, and in
different line of business by a conglomerate corporation is another important method by which
investors attempt to reduce risk. In such cases, if the demand for one product, the return on one
particular asset, or the profit on on line of business falls, the the existence of the fir, the profitability of
the entire portfolio, and the survival of he corporation, respectively, are not endangered. Diversification
is an example of the old saying “Do not put all your eggs in one basket”, and it is common way of
dealing with uncertainty.

13-7 FOREIGN- EXCHANGE RISKS AND HEDGING

Many experts have traditionally recommended as much as forty percent of a portfolio to be in foreign
securities. Investing in foreign securities, however, gives rise to a foreign exchange risk because the
foreign currency can depreciate o decrease in value during the time of the investment.

Hedging refers to the covering of a foreign exchange risk. Hedging is usuall accomplished with a
forward contract. This is an agreement to purchase or sell a specific amount of a foreign currency at a
rate specified today for a delivery at a specific future date.

Hedging can also be accomplished with a future contract. This is a standardized forward contract for
predetermined quantities of the currency and selected calendar dates.
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13-8 INFORMATION AND RISK

Asymmetric Information and the Market for Lemons
One party to a transaction often has less information than the other party with regard to the quality of
the product or service. This is the case of Asymmetric information. An example for this is the market
for “lemons” ( i.e., a defective product, such as used car, that will require a great deal of costly repairs
and is not worth its price).

The Insurance Market and Adverse Selection

The problem of adverse selection arises not only in the market for used cars, but in any market
characterized by asymmetric information, such as the market for individual health insurance. Here, the
individual knows much more about the state of their health than an insurance company can ever find
out, even with a medical examination. As a result, when an insurance company sets the insurance
premium for the average individual, unhealthy people are more likely to purchase insurance than
healthy people. Because of this adverse selection problem, the insurance company is forced to raise the
premiums, thus making it less advantageous for healthy people to purchase insurance.

The Problem of Moral Hazard

Moral Hazard refers to the increase in profitability of an illness, fire, or other accident when a
individual is insured than when she is not. With insurance, the loss of an illness, fire, or other accident
is shifted from the individual to the insurance company. Therefore, the individual will take precautions
to avoid the illness, fire or other accidents, and when a loss does occur, she will tend to inflate the
amount of the loss.