Performance Management & Control

Lecture 6:
Decisions Under Risk

Erfan Ovee Nomaan

 Topics

• Risk – definition • Credit Rating

• Risk and Uncertainty • Rating Methodologies
• Risk-analysis techniques • Rating of debt instruments
 Risk - definition
Risk denotes the precise probability of specific eventualities.
• Risk is independent from value and eventualities may
have both beneficial and adverse consequences.
• In finance, risk is the probability that an investment's
actual return will be different than expected. This includes
the possibility of losing some or all of the original
investment.

(Drury, 2018)
 Risk and Uncertainty
• Uncertainty: The lack of complete certainty, that is, the existence of more
than one possibility. The "true" outcome/state/result/value is not known.
• Measurement of uncertainty: A set of probabilities assigned to a set of
possibilities. Example: "There is a 60% chance this market will double in five
years"
• Risk: A state of uncertainty where some of the possibilities involve a loss,
catastrophe, or other undesirable outcome.
• Measurement of risk: A set of possibilities each with quantified probabilities
and quantified losses. Example: "There is a 40% chance the proposed oil well
will be dry with a loss of $12 million in exploratory drilling costs“

(Drury, 2018)
 Corporate Response: 1
Bureaucracy:

• Development of formal rules and procedures that override

personal preferences and experiences

• Some negative aspects:

• Alienates individuals
• Easily becomes overly rigid and specialized

(Drury, 2018)
 Corporate Response: 2

Externalisation
• Making use of expertise provided by the third parties, either:
• Required by law (regulators, auditors) or
• Optional but widely used (credit rating agencies)

(Drury, 2018)
 Risk Analysis

• When a company analyzes a potential project, it is

forecasting potential not actual cash flows for a project.
• Forecasts are based on assumptions that may be incorrect
- it is therefore important to perform a sensitivity analysis
on its assumptions to get a better sense of the overall risk
of the project the company is about to take.

(Drury, 2018)
 Risk-analysis techniques

• Sensitivity analysis
• Scenario analysis
• Monte Carlo simulation

(Drury, 2018)
 Sensitivity Analysis
• Sensitivity analysis is simply the method for determining how sensitive
our NPV analysis is to changes in our variable assumptions.
• To begin a sensitivity analysis, we must first come up with a base-case
scenario.
• From there, we can change various assumptions we had initially made
based on other potential assumptions. NPV is then recalculated, and the
sensitivity of the NPV based on the change in assumptions is
determined.
• Depending on our confidence in our assumptions, we can determine how
potentially risky a project can be.

(Drury, 2018)
 Scenario Analysis
• Scenario analysis takes sensitivity analysis a step further. Rather than just looking at
the sensitivity of our NPV analysis to changes in our variable assumptions, scenario
analysis also looks at the probability distribution of the variables.
• Like sensitivity analysis, scenario analysis starts with the construction of a base case
scenario.
• From there, other scenarios are considered, known as the "best-case scenario" and the
"worst-case scenario".
• Probabilities are assigned to the scenarios and computed to arrive at an expected
value.
• Given its simplicity, scenario analysis is one the most frequently used risk-analysis
techniques.

(Drury, 2018)
 Monte Carlo Simulation
• Monte Carlo simulation is considered to be the "best" method
of sensitivity analysis.
• It comes up with infinite calculations (expected values) given a
number of constraints. Constraints are added and the system
generates random variables of inputs.
• From there, NPV is calculated. Rather than generating just a
few iterations, the simulation repeats the process numerous
times.
• From the numerous results, the expected value is then
calculated.

(Drury, 2018)
 Credit Rating

• It is an opinion of the rating agency about the ability and willingness of an

issues to meet its future financial obligation in full and on time
• It is NOT a recommendation, nor a guarantee that the debt will be paid off
• It is forward looking

(Drury, 2018)
 Importance of Credit Rating

• A credit rating for an issuer takes into consideration the

issuer's ability to pay back a loan), and affects the interest
rate applied to the particular security being issued.
• The rating dictates also what investors can or cannot do;
for example:
• Money market funds cannot have more than 5% of their assets in
low-rated commercial paper or
• Some investors cannot invest in non-investment grade securities.

(Drury, 2018)
 Credit rating agency (CRA)
• A credit rating agency (CRA) is a company that assigns
credit rating for issuers of certain types of debt obligations as
well as the debt instruments themselves.
• In most cases, the issuers of securities are:
• companies,
• SPV (Special Purpose Vehicle)s or Special Purpose Entity (SPE)
• state and local governments,
• non-profit organisations, or
• national governments.
These securities can then be traded on a secondary market.
(Drury, 2018)
 Rating Methodologies

Main methodologies:

• Analyst driven rating

• Model driven rating
• Combination of the two above

(Drury, 2018)
Analyst Driven Process

(Drury, 2018)
Model driven rating

(Drury, 2018)
 Reference

Drury, C. (2018). Management and cost accounting. 10th ed. Andover:

Cengage Learning
 Topics for next week’s class

• Week 7: Pricing Decisions and Profitability Analysis , Transfer Pricing