2. The concept of risk involves the measurement of probability.
there are three approaches to measuring probability.
• Theoretical
• Empirical
• Subjective
3. These probabilities are sometimes referred to as ex-ante
probabilities, because they can be estimated from a purely
theoretical point of view, with no need for observation. Such
probabilities can therefore be calculated before any experiments or
trials are conducted. Tossing a coin or throwing a die are classic
examples
4. EMPIRICAL
These are sometimes referred to as ex-post probabilities, because
they can only be estimated from historical experience. This is
something that actuaries and insurance companies do; by amassing
large amounts of data relating to car accidents .
5. SUBJECTIVE
In practice, managers often have to resort to estimating
probabilities subjectively, for the simple reason that they are
dealing with circumstances that have never occurred exactly
before. They usually have some background of relevant past
experience to help them make such estimates, but they cannot rely
on the purely objective empirical approach.
6.
7. a. Stand-alone risk
The measurement of risk can first be considered from the point of view of an
individual project. There are various sources of risk and uncertainty in this
context:
1. The initial capital cost of the project; in practice this may be spread over
2. several years, increasing uncertainty.
3. The demand for the output from the project.
4. The ongoing operational costs of the project.
5. The cost of capital.
8. b. Within-firm risk
When a project is considered in the context of corporate risk it is important to
consider the correlation between the project’s cash flows and those of the firm
as a whole. In practice this is often done subjectively:
• if the project is in the same line of business as the firm’s other projects, then
there will be high positive correlation and high stand-alone risk will also
involve high corporate risk.
• On the other hand, if the project is in a different line of business then the
correlation may be low and the firm’s corporate risk may not be much
affected.
9. c. Market risk
Market risk is the most relevant type of risk as far as shareholders are
concerned. It is also possible to measure this type of risk using an objective,
though not necessarily accurate, method. This involves using one of the
most important models in financial analysis, the capital asset pricing model
(CAPM). The CAPM describes the risk–return relationship for securities,
assuming that these securities are held in well-diversified portfolios.
