Risk And Uncertainty Lecture 2

1. RISK AND UNCERTAINTY BY SYED MUHAMMAD IJAZ, FCA DATED AUGUST 03, 2007

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

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

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

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.

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

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

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

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

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.

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

n=number of terms

i=first term

P=Probability

CF=cash flow

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.

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;

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.

From a Risk Mitigation

Strategy:

Transfer

Mitigate

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.

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.

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.

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

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.

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.

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

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Risk And Uncertainty Lecture 2

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