- 1. RISK AND UNCERTAINTY BY SYED MUHAMMAD IJAZ, FCA DATED AUGUST
03, 2007
2. RISK DEFINED
- Risk refers to the set of unique outcomes for a given event
which can be assigned probabilities
- Risk exists when the decision maker is in a position to assign
probabilities to various outcomes i.e. a probability distribution
is known to him. This happens when he has some historical data on
the basis of which he assigns probability to other projects of the
same nature
3. UNCERTAINTY DEFINED
- Uncertainty refers to the outcomes of given event which are too
unsure to be assigned probabilities
- uncertainty exists when the decision maker has no historical
data from which to develop a probability distribution and must make
intelligent guesses in order to develop a subjective probability
distribution
4. RISK AND REWARD/RETURNS
- Greater the risk greater the return
- A risk without return is a suicide
- Risk can be minimized but cannot be eliminated
- Risk can be managed to keep it at lower side
5. TYPOLOGY OF RISKS RISKS MARKET RISK CREDIT RISK LIQUIDITY
RISK OPERATIONAL RISK Legal and regulatory Risk Business Risk
Strategic Risk Reputation Risk Financial Risk 6. SUBDIVISION OF
RISK FinancialRisk Market Risk Credit Risk Equity price risk
Interest-rate risk Foreign exchange risk Commodityprice risk
Transaction risk Portfolio concentration Issue risk Issuer risk
Counterparty risk Trading risk Gap risk General Market risk
Specific risk 7. LIQUIDITY RISK FUNDING LIQUIDITY RISK ASSET
LIQUIDITY RISK 8. MARKET RISK
- Is the risk that changes in financial market prices and rates
will reduce the monetary value (e.g. Rs., US $, UK ) of a security
or a portfolio.
- There are four major types of market risk
-
- Interest Rate Risk : The simplest form of interest rate risk is
the risk that the value of a fixed income security will fall as a
result of an increase in market interest rates.
-
- Equity Price Risk : The risk associated with volatility in
stock prices. The general market risk of equity refers to
sensitivity of an instrument or portfolio valueto a change in the
level of board stock market indices.
9. Market Risk-Continued
-
- Foreign Exchange Risk : Foreign exchange risk arises from open
or imperfectly hedged positions in a particular currency. These
positions may arise as a natural consequence of business operation,
rather than from anyconscious desire to take a trading position in
a currency.
-
- Commodity Price Risk : The price risk of commodities differs
considerably from interest-rate and foreign exchange risk, since
most commodities are traded in market in which the concentration of
supply in the hand of a few suppliers can magnify price
volatility
10. Risk-Continued
-
- Credit Risk : Credit risk is the risk that a change in the
credit quality of counterparty will affect the value of security or
a portfolio
-
- Liquidity Risk : Liquidity risk comprises both funding
liquidity risk and asset liquidity risk, although these two
dimension of liquidity risk are closely related. Funding liquidity
risk relates to a firms ability to raise the necessary cash to
roles over its debt; to meet the cash , margin and collateral
requirements of counterparties: and (in the case of fund) to
satisfy capital withdrawals. Asset liquidity risk, often simply
called liquidity risk, is the risk that an institution will not be
able to execute a transaction at the prevailing market price
because there is, temporarily, no appetite for the deal on the
other side of the market
11. Risk-Continued
-
- Operational Risk ; operational risk refers to potential losses
resulting from inadequate system, management failure, faulty
controls, fraud, and human error
-
- Legal and Regulatory Risk : Legal and regulatory risk arises
for a whole variety of reasons and is closely related to reputation
risk
-
- Business Risk : Business risk refers to the classic risk of the
world of business, such as uncertainty about the demand for
products, the price that can be charged for those products, or cost
of producing and delivering products
12. Risk-Continued
-
- Strategic Risk : Strategic risk refers to the risk of
significant investments for which there is high uncertainty about
success and profitability. If the venture is not successful, then
the firm will usually suffer a major write-off, and its reputation
among investors will be damaged
-
- Reputation Risk : Reputation risk is taking on a new dimension
after the accounting scandals that defrauded the shareholders,
bondholders, and employees of many major corporations during the
boom in the equity markets in the late 1990s
13. SENSIVITY ANALYSIS
- It provides informationas to how sensitive the estimated
project parameters, namely, the expected cash flow, the discount
rate and the project life are to estimation errors
- The sensitive analyses provides different cash flow estimates
under three assumptions: (i) the worst (i.e. the most pessimistic),
(ii) the expected (i.e. the most likely), and (iii) the best (i.e.
the most optimistic) outcomes associated with the project
- But it has a limitation in that it does not disclose the
chances of the occurrence of these variations. To remedy this
shortcoming of sensitive analysis so as to provide a more accurate
forecast, what is needed is that the probability of the variations
occurring should also be given. Probability assignment to expected
cash flow, therefore, would provided a more precise measure of
variability of cash flow
- The quantification of variability of returns involves two
steps. First, depending on the chance of occurrence of a particular
cash flow estimate, probabilities are assigned
- The assignment of probabilities can be objective or
subjective
- The second step is to estimate the expected return on the
project. The returns are expressed in terms of expected monetary
values. The expected value of a project is a weighted average
return , where the weight are the probabilities assigned to the
various expected events, i.e. the expected monetary values of
estimated cash flows multiplied by the probabilities.
14. STANDARD DEVIATION
- Standard deviation is an absolute measure which can be applied
when the projects involve the same outlay
- In statistical terms, standard deviation is defined as the
square root of the Mean of squared deviations, where deviation is
the difference between an outcome and the expected mean value of
all outcomes
15. STANDARD DEVIATION-CONTINUED
- CF i=cash flow first term
- P i=Probability of first term
- CF =mean of given cash flow
- If the two projects have the same expected value (mean), then
one which has the greaterwill be said to have the higher degree of
uncertainty or risk.
16. PRECISE MEASURES OF RISK: COEFFICIENT OF VARIATION
- If the projects to be compared involve different outlay, the
coefficient of variation is the correct choice, being a relative
measure.
- The standard deviation can be misleading in uncertainty of
alternative projects, if they differ in size. The coefficient of
variation (V) is a correct technique in such cases. Its calculated
as follow;
17. COEFFICIENT OF VARIATION CONTINUED
- Coefficient of variation is a better measure of the uncertainty
cash flow returns than the standard deviation. This because the
coefficient of variation adjust for the size of cash flow, whereas
the standard deviation doesnt .
- The higher the correlation with economy the riskier is the
project.
18. THE RISK MANAGEMENT METHODOLOGY Identify Risk Exposure
Measure and Estimate Risk Exposure Find instrument and Facilities
to shift or Trade Risk Assess Effects of Exposure Assess Costs and
Benefits of Instruments
Evaluate Performance 19. RISK EVALUATION APPROACHES-RISK
ADJUSTED DISCOUNT RATE APPROACH
- Under this method, the amount of risk inherent in a project is
incorporated in the discount rate employed in the present value
calculations. The relatively risky projects would have relatively
high discount rate and relatively safe projects would have
relatively low discount rate.
- The rate of discount or what we refer to as the cost of capital
(k) is the minimum acceptable required rate of return.
- If the project earns less than the rates earned in the economy
for that risk, the shareholders will be earning less than the
prevailing rate for that risk level and the value of the companys
shares will fall.
20. ADJUSTED DISCOUNT RATE APPROACH-CONTINUED
- A well-accepted economic premise is that the required rate of
return should increase as risk rises.
- Therefore, the greater the riskiness of the project, the
greater should be the discount rate and vice versa.
21. RISK EVALUATION APPROACHES-ACCEPT-REJECT DECISION
- The risk-adjusted discount rate approach can be used with both
the NPV and the IRR. If the NPV method is used to evaluate capital
expenditure decisions, the NPV would be calculated using the
risk-adjusted rate.
- If the NPV is positive, the proposal would qualify for
acceptance. A negative NPV would signify that the project should be
rejected.
22. RISK EVALUATION APPROACHES-CERTAINTY-EQUIVALENT APPROACH
- The certainty-equivalent approach, as an alternative to the
risk-adjusted rate method, to incorporate risk in evaluating
investment projects, overcomes some of the weaknesses of the latter
method.
- The riskiness of the project is taken into consideration by
adjusting the expected cash flows and not to discount rate.
- The certainty equivalent coefficient represents the
relationship between certain (riskless) cash flows and risky
(uncertain) cash flows. Thus, the coefficient is equal to
23. DECISION-TREES APPROACH
- It takes into accounts the impact of all probabilistic
estimates of potential outcomes.
- The DT approach is especially useful for situations in which
decisions at one point in time also affect the decisions of the
firm at some later date.
- A decision tree is a pictorial representation in tree form
which indicates the magnitude, probability and inter-relationship
of all possible outcomes.
- The decision tree shows the sequential cash flows and the NPV
of the proposed project under different circumstances.
24. SENSIVITY ANALYSIS 25. 26. These cash flows are exposed to
risk thats why risk adjusted rate is used to mitigate the risk This
cash flow is certain and no risk is involved thats why normal cost
of capital is used for its PV RAD- RISK ADJUSTED DISCOUNT RATE
APPROACH
- A firm is considering a proposal to buy a machine for
Rs.30,000/-. The expected cash flow after taxes from the machine
for a period of 3 consecutive years are Rs. 20,000/- each. After
the expiry of the useful life of the machine, the seller has
guarenteed its purchase at Rs. 2,000/-. The firms cost of capital
is 10% and risk adjusted discount rate is 18%. Should the company
accept the proposal of purchasing machine.
27. CERTAINTY EQUIVALENT APPROACH
- A company is considering the proposal of buying one of the two
machines to manufacture a new product. Each of these machines
require an investment of Rs. 50,000/- and its expected to provide
benefits over the period of 4 years. After the expiry of useful
life the sellers of the both machines have guaranteed to buy back
the machines at Rs. 5000/-. The management of the company uses
certainty equivalent approach. RAD is 16% and Risk free rate is
10%. CFAT and CE are as under
28. Risk adjusted cash flow is a better measure than RAD Since
this inflow is certain therefore CE for this event is 1 29.
DECISION TREE 30. 31. CONCLUDED