Quantitative Techniques

and
Concepts in Finance

Presented by: Isabelle S. Bañadera

 Risk Management

 The identification, assessment and prioritization of

risks followed by coordinated and economical
application of resources to minimize, monitor and
control the probability and/or impact of unfortunate
events and to maximize the realization of
opportunities.
 Principles of Risk Management

 Create value
 Address uncertainty and assumptions
 Be an integral part of the organizational processes and decision making

 Be dynamic , transparent, tailorable and responsive to change

 Create capability of continual improvement and enhancement considering the best available
information and human factors

 Be systematic, structured and continually or periodically re-assessed

 Process of Risk Management

1. Establishing the Context

a. Identification of risk in a selected domain of interest
b. Planning the remainder of the process
c. Mapping out: Social scope or risk management
Identity and objectives of stakeholders
Basis upon which risks will be evaluated, constraints

d. Defining a framework for the activity and an agenda for identification

e. Developing an analysis of risks involved in the process
f. Mitigation or solution of risks using available technological human and organizational resources
2. Identification of potential risks
 Risk identification can start with the analysis of the source of problem or with the analysis of the
problem itself.

Common risk identification method

a. Objective based risk
b. Scenario based risk
c. Common risk checking
d. Risk charting

3. Risk assessment
 Elements of Risk Management

1. Identification , characterization and assessment of threats

2. Assessment of the vulnerability of critical assets to specific threats
3. Determination of risk ( the expected likelihood and consequences of specific types of
attacks on specific assets
4. Identification of ways to reduce those risks
5. Prioritization of risk reduction measures based on strategy
 Potential Risks Treatments
1. Risk Avoidance
 Preforming activity that could carry risks.

2. Risk reduction or optimization

 Involves reducing the severity of the loss or likelihood of the loss from occurring
 Finding a balance between the negative risk and the benefit of the operation or activity and between risk
reduction and effort applied

3. Risk Sharing
 Sharing with another party the burden of loss or the benefit of gain, from a risk and the measures to
reduce a risk.
4. Risk Retention
 Involves accepting the loss or benefit of gain from a risk when it occurs
 Areas of Risk Management

1. Enterprise risk management

2. Risk management activities as applied to project management
3. Risk management for megaprojects
4. Risk management of information technology
5. Risk management techniques in petroleum and natural gas
 Investment Risks

1.Business Risk

 The uncertainty about the rate of return caused by the nature of the business

2. Financial Risk

 The firm’s capital structure or sources of financing determine financial risk.

3. Liquidity Risk

Associated with the uncertainty created by the inability to sell the investment quickly for cash.
4. Default Risk
Related to the probability that some or all of the initial investment will not be returned

5. Interest Rate Risk

 Most commonly associated with bond price movements, rising interest rates cause bond prices to decline
and declining interest rate cause bond prices to rise.

6. Management Risk
 Decisions nmade by a firm’s management and board of directors materially affect the risk affected by
investors.

7. Purchasing Power Risk

 it is often more difficult to recognize that the purchasing power of the return you have earned on an
investment has declined(risen) as a result of inflation(deflation)
 Commonly Used Techniques and Models in
Assessing Investment Alternatives Under Risk or
Uncertainty
1. Probability
 Provides a method for mathematically expressing doubt or assurance about the occurrence of a
chance event.
 Varies from 0 to 1.

a) probability of 0 - Event cannot occur

b) probability of 1- Event is certain to occur
c) between 0 to 1- Indicates the likelihood of the event’s occurrence
 Basic terms used with probability

a. 2 events
• Mutually exclusive if they cannot occur simultaneously
b. Joint Probability for 2 events
• The probability that both will occur
c. Conditional probability of 2 events
• The probability that one will occur given that the other has already occurred.

d. 2 events are independent

• If occurrence of one has no effect on the probability of the other
• If their joint probability equals the product of their individual probabilities
• If the conditional probability of each event equals its unconditional probability
 Example
1. M & O Corporation is considering two new designs for ther kitchen utensil products- Product A &
Product B. Either can be produced using the present facilities. Each Product requires an increase in
annual fixed costs of P4,000,000. The products have the same seeling price of P1,000 and the same
variable cost per unit of 80

After studying past experience with similar products, management has prepared the ff probability
distribution
 Probability for

Event Product A Product B

( Units Demanded)

5,000 0.0 0.1

10,000 0.1 0.1

20,000 0.2 0.1

30,000 0.4 0.2

40,000 0.2 0.4

50,000 0.1 0.1

1.0 1.0
Management would like to know
1. Break event point for each product
2. Which product should be chosen; assuming the objective is to maximize expected operating income

FORMULA:
Contribution Margin Per unit= Selling Price less Variable Cost per unit
Break Even Point = Annual Fixed Cost/ Contribution Margin Per unit

1.Since both products have the same contribution margin per unit break even point for each product
will be the same

1,000 less 800 = P200 contribution margin per unit

4,000,000/200 = 20,000 units Break Even Point

 2.
Determine the expected demand for the 2 products

Product A Product B
Event Demand Probability Units Probablity Units

5,000 0.0 0 0.1 500

10,000 0.1 1,000 0.1 1,000
20,000 0.2 4,000 0.1 2,000
30,000 0.4 12,000 0.2 6,000
40,000 0.2 8,000 0.4 16,000
50,000 0.1 5,000 0.1 5,000

1.0 30,000 1.0 30,500

Compute the expected operating income of two products

Product A Product B

Sales 30,000,000 30,500,000

Variable Costs 24,000,000 24,400,000

Contribution Margin 6,000,000 6,100,000

Fixed Costs 4,000,000 4,000,000

Operating Income 2,000,000 2,100,000

2. Expected Value of perfect information

Perfect Information
 The knowledge that future state of nature will occur with certainty

Expected Value of Perfect information(EVPI)

 The difference between the expected value without perfect information and the return if the best
action is taken giving perfect information

EXAMPLE

If the yacht dealer will able to poll all potential customers and they truthfully stated whether they would
purchase a yacht this year.
What is EVPI?

The dealer expects to make 260,000 with perfect information about future demand and 225,000 if the
choice with the best expected value is made.

The expected value of perfect information :

35,000 = 260,000 less 225,000
 Probability(PR) State of Best Action Best Action Expected value
Nature Payoff ( PRxPayoff)

0.1 Demand = 0 Buy =0 0 0

0.5 Demand = 1 Buy = 1 200,000 100,000

0.4 Demand = 2 Buy = 2 400,000 160,000

260,000

The dealer expects to make 260,000 with perfect information about future demand and 225,000 if the
choice with the best expected value is made.

The expected value of perfect information :

35,000 = 260,000 less 225,000

* The dealer will not pay more than 35,000 for information about future demand because it would be
more profitable to make the expected value choice than to pay more for information.
 Risk

The variability of an asset’s future returns

Chance that some unfavorable event will occur

Present whenever future outcomes are not completely

certain or predictable
 Risk- Return Relationship
Investment risk

Related to the probability of actually earning less than the expected return

the greater the chance of low or negative returns, the riskier the investment

Very low risk investments also provide a very low return

 Probability and Probability Distribution
Probability
• The percentage chance that an event will occur
• Range between 0 and 10

If all possible events or outcomes are listed and the probability is assigned to each event
The listing is called PROBABILITY DISTRIBUTION

Example:
Outcome Probability
Win 0.6 60%
Lose 0.4 40%
1.0 100%
Probability distribution maybe objective or
subjective
a. Objective probability distribution
 generally based on past outcomes of similar events

b. Subjective distribution
 based on opinions or educated guesses about the likelihood that an event will
have a particular future outcomes
Probability distribution maybe discrete or continuous
a. Discrete probability distribution
an arrangement of the probabilities associated with the values of a variable that
can assume a limited or finite number of values( outcomes)

b. Continuous probability distribution

An arrangement of probabilities associated with the values of a variable that can
assume an infinite number of possible values(outcomes)
 Capital Asset Pricing Model
 Model based on the proposition that any stocks’ required rate of return is equal to the risk free rate of
a return plus a risk premium that reflects only the risk remaining after diversification

Formula:
Required rate of return= Risk Free rate + ( return in the market- risk- risk free rate) BETA

Example;
A particular stock has risk free rate of 5%, rate of turn on the market of 12% and beta ( qty of risk) 1.5.
whay would be the investors’ required rate of return

= 5% + (12%- 5%) 1.5

= 15.5%