Risk Analysis Topics - Risk and Uncertainty - General Risk Categories - Probability - Probability Distributions - Payoff Matrix - Expected Value - Variance and Standard Deviation (Measurement of Absolute Risk) - Coefficient of Variation (Measur€ment of Relative Risk)\ Topics (Con't) - Risk Attitudes Risk Aversion Risk Neutrality Risk Loving (Taking) - Utility Theory and Risk Analysis - Risk Premium - Decision-Making Under Risk - Certainty Equivalent - Game Theory - Maximin Decision Rule - Minimax Regret Decision Rule Readings + Hirschey, Chapter 17 + Lecture notesMotivation + 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. Motivation (Con't.) Example: A firm with BDT 10,00,000 in cash Decision to make: (1) Invest in a 91-day Treasury bill yielding 5.66% interest (2) Prepay a 15% bank loan ‘Which course of action to take? Choose (1) => 14,307 interest income after 91 days Choose (2) => 37,916 interest expense savings after 91 days } Choose (2) provides 23,609 additional 3-months return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 \L SUncertaint their probab The possible outcomes and ies are known 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 (Con'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 Curreney 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: ae P(probabilty) i State of Economy deals with “events” whose “states of a nature” are discrete. The “event” is a. the state of the economy. The “states Normal, 06 of nature” are recession, normal, and Boom 02 ‘boom. + Continuous probability distribution: M=ret 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), |’ = 7 - The lower the CV, the lower the relative risk. Project A EV(A) = $5,000 n= $632.46 Project B EV(B) = $5,400 © n= $3,826.23 Coefficient of variation CV=—> = 0.1265 a= Frm 7 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. | 2 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 10Utility Theory and Risk Analysis TPlcally, consumers and investors display risk-averse behavior, specially hen 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 Total uty oy Inseasing marin hyo mony: i fase i stat mary mone, 16 eereet “ Diminsning 1 ‘marginal uty (HU) ot mon ae tisk averter Risk averter: diminishing MU Risk neutral: constant MU Risk lover: increasing MU a ‘$5,000 $10,000 $18,000 $20,000 Income or wealthExamples of utility functions Let w = income (or profit) or more generally wealth, w > 0 uote wet ta MUO UGw)=Inw 1 MU (y= UGw)=w? 2 MU(w)=20 Uw)=3w+10 MU(o)=3 Which utility function is consistent with risk-seeking behavior? Which utility function is consistent with risk neutrality? Which utility function is consistent with risk aversion? Under risk aversion behavior, the decision rule is to maximize expected utility. EV[U(risky option)] = U(w,)p; + U(wa)p2 + Umn)Pa Also, it is important to find the level of income, profits, or wealth, that is consistent with the utility level of the expected value of utility assdeiated with the risky option. Call this level of wealth we ‘The difference between the expected value of the risky option and w is the risk premium. Risk premium = EV(risky option) - w* 12™, where w represents total wealth, It Joshua ‘surance next year, his wealth is $500,000 curs, and $300,000 if an earthquake occurs, ‘ealth is attributable to the loss of his house (2) Is Joshua risk averse, risk loving, or risk neutral? Find the BV of not buying insurance (the risky option). (c) Find EV[U(risky option)). (4) Find the wealth that results in the utility level associated with the expected value of utility of the risky option. (e) Find the risk premium. 2 (@) Is Joshua risk averse, risk loving, or risk neutral? Uae MU diminishes with increases in w. Joshua is risk averse (b) Find the BV of not buying insurance. Evirisky option) = ($500,000).9) + ($300,000)(.1) 7 $480,000 (c) Find EV[U(risky option). EV{U(risky option)) = $500, 000.9). /$300,000(.1) EV[U(risky option)] = $636.40 + $84.77 = $691.71 (4) What level of wealth is consistent with the utility level of the EV[U(risky option)]? eee ee w" $477,716 (€) Risk premium, EV(risky option) ~ w’ = $480,000 - $477,716 Risk premium = $2,284, =“ 13Graphical Analysis {U(300,000)=707.11 (0.9U1S00,000)+0.10(300,000)=691.17 300,000) 547.72 Seon a7.716 woMT0 360,900 risk premium Decision-Making Under Risk + Possible briteria 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 02 ‘$4,000 ‘$0 Normal 06 ‘$5,000 $5,000 Boom 0.2 $6,000 Senet EVIA}-88,000 EV(B)+85,400 Thinking: Which project will you choose based on this criterion? Y What is ignored using this criterion? Minimizing Variance/Standard Deviation Event (State of Economy) P Profit Project | Project B Recession 02 | $4,000 0 Normal 06 | $5,000 55,000 Boom 02 | $6,000 $12,000 47869248 o,~s3,0a020 Thinking: YWhich proj ject will you choose based on this criterion? What is ignored using this criterion? 30 HsCoefficient of Variation: Standard Deviation Divided by the Expected Value = Protect a ac Project 8 x B Expected value $5,000 | $5,400 Standard deviation $632.46 | 3382635, Goeiiient of Variation | 0.265 | 0.7086 Think: ¥ Which project will you choose based on this criterion? YWhat is ignored? i m 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. Ifyou find yourself indifferent between the two alternatives, $760,000 is your certainty equivalent for the risky expected return of $560,000. tt in or riskless amount of $100,000 provides exactly the A cert oF ri) /80 chance to earn $1,000,000 (or $0) 2m our case, $100,000 « $500,000 => risk aversion, Certainly Equivalent Adjustment Factor = @ = Equivalent Ge Expected Value of the Risky Venture Inourcase, @ = $100,000=.2, $500,000 term eee of one dollar inthis risky venture is equal to 20€ in certain dollar terms, &~ Equivalent Certain Sum Expected Value of the Risky Venture a Then Implics Fauivalent certain sum < Expected Value of the @<1 Risk aversion Risky Venture Fauivalent certain sum = Expected Value ofthe G1 Risk indifference Risky Venture (or neutrality) Fauivalent certain sum > Expected Value ofthe @f>1 Risk reference Risky Venture (or taking)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). 2s Maximin Decision Rule (tre 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. 18Minimax Regret Decision Rule nis decision Tule focuses on the opportunity loss ASSociated with a decision tather than on its worst Possible outcome) “ decisic sociated with a wrong iference between © best outcome for each state of [ Maximin and Minimax Regret Decision Rules Event (State of Economy) Project A 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? jpbased 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. fa i 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 Payoft Recession '$4,000-$4,000+80 $4,000-80-$4,000 4,000 Nommat '5,000-5,000-50_$5,000-5,000-50, $5,000 Boom '12,000-56,000-85,000 $12,000-512,000-50 12,000 ‘Maximum possible egret 86,000 $4,000 Project A Project ‘Therefore, by the minimax regret decision rule, choose project B. ° 20 >What's Next? * Preparation for Exam 1 + Exam I Covers: ~ Algebra review ~ Demand analysis ~ Risk analysis 21