Techniques for Risk Analysis, Statistical and Conventional techniques of risk analysis

1. Risk & Risk analysis
The potential that a chosen action or activity (including
the choice of inaction) will lead to a loss (an undesirable
outcome).
Risk exists because of the inability of the decision-maker to
make perfect forecasts.
In formal terms, the risk associated with an investment may
be defined as the variability that is likely to occur in the
future returns from the investment.
Risk analysis is the process of defining and analyzing the
dangers to individuals, businesses and government agencies
posed by potential natural and human-caused adverse events
By. Dr. B. J. Mohite 9850098225

2. Techniques for Risk Analysis
Statistical Techniques for Risk Analysis
Probability
Variance or Standard Deviation
Coefficient of Variation
Conventional Techniques of Risk Analysis
Payback
Risk-adjusted discount rate
Certainty equivalent

3. Probability
Probability may be described as a measure of
someone’s opinion about the likelihood that an event
will occur.
The probability estimate, which is based on a very
large number of observations, is known as an
objective probability.
Such probability assignments that reflect the state of
belief of a person rather than the objective evidence
of a large number of trials are called personal or
subjective probabilities.

4. Variance or Standard Deviation
Simply stated, variance measures the deviation about
expected loss of each of the possible threat.
Standard deviation is the square root of variance.
Absolute Measure of Risk.

5. Coefficient of Variation
Relative Measure of Risk
It is defined as the standard deviation of the probability
distribution divided by its expected value:
The coefficient of variation is a useful measure of risk when
we are comparing the projects which have
(i) same standard deviations but different expected values, or
(ii) different standard deviations but same expected values, or
(iii) different standard deviations and different expected values.
Expected value
Cofficient of variation = CV =
Standard deviation

6. Payback method / technique
Payback is one of the oldest and most common procedures used
and the explicit recognition of risk in the project with an
investment.
This method, applied in practice, as is an attempt to measure
the risk assessment in investment decision as a possible method
Profitability.
The payback method is the amount of time required for a firm to
recover its initial investment in a project, as calculated from cash
inflows.
Decision criteria:
The length of the maximum acceptable payback period is determined
by management.
If the payback period is less than the maximum acceptable payback
period, accept the project.
If the payback period is greater than the maximum acceptable
payback period, reject the project.

7. Payback Period: Pros and Cons
of Payback Analysis
Pros
 The payback method is widely used by large firms to evaluate small
projects and by small firms to evaluate most projects.
 Its popularity results from its computational simplicity and intuitive
appeal.
 By measuring how quickly the firm recovers its initial investment,
the payback period also gives implicit consideration to the timing of
cash flows and therefore to the time value of money.
 Because it can be viewed as a measure of risk exposure, many firms
use the payback period as a decision criterion or as a supplement to
other decision techniques.

8. Cons
 The major weakness of the payback period is that the
appropriate payback period is merely a subjectively
determined number.
It cannot be specified in light of the wealth maximization
goal because it is not based on discounting cash flows to
determine whether they add to the firm’s value.
 A second weakness is that this approach fails to take fully into
account the time factor in the value of money.
 A third weakness of payback is its failure to recognize cash
flows that occur after the payback period.

9. Risk adjusted discount rate
An estimation of the present value of cash for high risk
investments is known as risk-adjusted discount rate.
The risk adjusted discount rate approaches attempts to handle
the problem of risk and uncertainty in a more direct and
thoughtful way.
As we know investors are risk reluctant and so requires a reward
for under taking a risky investment, the greater must be its
expected return.
The Greater The Project Perceived Level Of Risk, The
Greater Is The Risk Premium
Risk adjusted discount rate = risk free rate + risk
premium

10. Advantages and disadvantages of risk
adjusted discount rate
disadvantages
There is no easy way deriving a risk adjusted discount rate.
Capital asset pricing model provides a basis of calculating the
risk adjusted discount rate. Its use has yet to pick up in
practice.
It does not make any risk adjusted in the numerator for the
cash flows that are forecast over the future years.
advantage
 It is simple and can be easily understood.
 It has a great deal of intuitive appeal for risk-averse
businessman.
 It incorporates an attitude towards uncertainty.

11. certainty equivalent
Under this techniques, the estimated cash flows are adjusted
by using risk free rate to assertain risk free cash flow
The expected cash flows of the project are converted in to
equivalent riskless amount
The smaller certainty equivalent will be used in the case of an
expected cash inflows and the larger certainty equivalent
used for payment
 For example, if an investor, according to his “best
estimate” expects a cash flow of 60000 next year, he will
apply an intuitive correction factor and may work with 40000
to be on safe side. There is a certainty-equivalent cash flow.

12. Draw backs of certainty equivalent
1. the forecaster, expecting the reduction that will be made in
his forecasts, may inflate them in anticipation. This will no
longer give furcated according to best estimate.
2. if forecasts have to pass through several layers of
management, the effect may be to greatly exaggerate the
original forecast or to make it ultra conservative.
3. by focusing explicit attention only on the gloomy out
comes, chances are increased for passing by some good
investments.