Risk and Uncertainty

Kings College

King's College, MBA - 2015

Risk Analysis
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Motivation
To make effective investment decisions,
one must understand risk.
Decision makers sometimes know with
certainty the outcomes associated with
each possible course of action.

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Motivation Contd..
Example:
A firm with Rs.100,000 in cash
Decision to make:
(1) Invest in a 30-day Treasury bill yielding 6%
interest
(2) Prepay a 10% bank loan
Which course of action to take?

Choose (1) => Rs.493 interest income after 30 days

Choose (2) => Rs.822 interest expense savings after 30 days
Choose (2) provides Rs.329 additional 1-month return
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Definition of Risk and Uncertainty

- Risk/Uncertainty: Both concepts deal with
the probability of loss or the chance of
adverse outcomes
- Risk: All possible outcomes of managerial
decisions and their probabilities are not
completely known
- Uncertainty: The possible outcomes and
their probabilities are uncertain
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General Risk Categories

Business Risk the chance of loss associated with a given
managerial decision; typically a by-product of the unpredictable
variation in product demand and cost conditions
Market Risk the chance that a portfolio of investments can lose
money because of overall swings in financial markets
Inflation Risk the danger that a general increase in the price
level will undermine the real economic value of corporate
agreements
Interest-rate Risk another type of market risk that can affect
the value of corporate investments and obligations
Credit Risk the chance that another party will fail to abide by its
contractual obligations
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General Risk Categories Contd..

Liquidity Risk the difficulty of selling corporate
assets or investments that have only a few willing
buyers or are otherwise not easily transferable at
favorable prices under typical market conditions
Derivative Risk the chance that volatile financial
derivatives such as commodity futures and index
options could create losses by increasing rather
than decreasing price volatility
Currency Risk the chance of loss due to changes in
the domestic currency value of foreign profits
Other Risks Operational Risk, Systemic Risk etc.

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Probability
- Probability: likelihood of particular outcome
occurring, denoted by p. The number p is always
between zero and one.

- Frequency: estimate of probability, p=n/N, where

n is number of times a particular outcome
occurred during N trials.

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Investment Decision Under Risk and

Uncertainty
Probability Distribution

Discrete probability
distribution: deals with events
whose states of nature are
discrete. The event is the state
of the economy. The states of
nature are recession, normal, and
boom.

Event
State of Economy

P (probabilty)

Recession

0.2

Normal

0.6

Boom

0.2

Continuous probability
distribution: deals with events
whose states of nature are
continuous values. The event is
profits, and the states of nature
are various profit levels.
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Payoff Matrix Method

A table that shows outcomes associated with each possible state of nature.

State of Economy

Project A

Project B

Probability of State of Economy

Recession

$4,000

$0

0.2

Normal

$5,000

$5,000

0.6

Boom

$6,000

$12,000

0.2

Project A more desirable in a recession.

Project B more desirable in a boom.
In a normal economy, the projects offer the same profit potential.
Decision to Make:
A firm must choose only one of the two investment projects (choose Project A
or Project B).
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Expected Value
The payoffs of all events:
x1, x2, , xN
The probability of each event: p1, p2, , pN
Expected value of x:
N

EV ( x) x1 p1 x 2 p 2 ... x N p N xi pi
i 1

EV(x) is a weighted-average payoff, where the weights are

defined by the probability distribution.
Use the payoff matrix in the previous slide, together with the
probability of each state of the economy.

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Expected profit of
Project A and B under
different economic
states of nature
EV ( A) $4,000 0.2 $5,000 0.6 $6,000 0.2 $5,000

EV ( B ) $0 0.2 $5,000 0.6 $12,000 0.2 $5,400

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Variance and Standard Deviation

Variance and Standard Deviation:
The payoffs of all events:

measuring risk

x1, x2, , xN

The probability of each event: p1, p2, , pN

Expected value of x:

EV ( x) x1 p1 x 2 p 2 ... x N p N xi pi
i 1

Variance:

2 p N ( EV ) 2 p
2 p ( EV ) 2 p ... (
2

EV
)
(

EV
)

xi
xN
x1

1 x2
2
N
i
i 1

Standard deviation: square root of variance

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For project A, what are the variance and standard deviation?

EV(A) = $5,000

Variance ( 2) = ($4,000-5,000)2 (.2) + ($5,000-$5,000)2 (.6) + ($6,000-$5,000)2 (.2)

( 2) = ($1,000)2 (.2) + ($0)2 (.6) + ($1,000)2 (.2)

( 2) = $400,000 (units are in terms of squared dollars)
A = $632.46
For project B, what are the variance and standard deviation? EV(B) = $5,400
Variance ( 2) = ($0-5,400)2 (.2) + ($5,000-$5,400)2 (.6) + ($12,000-$5,400)2 (.2)
( 2) = 5,832,000 + 96,000 + 8,712,000 (units are in terms of squared dollars)
( 2) = 14,640,000 (units are in terms of squared dollars)
B = $3,826.23
Project B has a larger standard deviation; therefore it is the riskier project

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Risk Measurement

Absolute Risk:

- Overall dispersion of possible payoffs

- Measurement: variance, standard deviation
- The smaller variance or standard deviation, the
lower the absolute risk.

- Relative Risk

- Variation in possible returns compared with the

expected payoff amount

CV

- Measurement: coefficient of Variation (CV),

EV
- The lower the CV, the lower the relative risk.
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Project A
EV(A) = $5,000
A = $632.46
Project B
EV(B) = $5,400
B = $3,826.23
Coefficient of variation
A
CVA = E V ( A ) = 0.1265

CV

EV

B
CVB = E V ( B ) = 0.7086
Coefficient of variation measures the relative risk; the variation
in possible returns compared with the expected payoff amount.
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Risk Attitudes
Risk Aversion
characterizes decision makers who seek to avoid or minimize risk.
Risk Neutrality
characterizes decision makers who focus on expected returns and
disregard the dispersion of returns.
Risk Seeking (Taking)
characterizes decision makers who prefer risk.

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Risk Attitudes
Scenario:
A decision maker has two choices, a sure thing
and a risky
option, and both may/may not yield the
same expected value.
Risk-averse behavior:
Decision maker takes the sure thing
Risk-neutral behavior:
Decision maker is indifferent between the two choices
Risk-loving (or seeking) behavior:
Decision maker takes the risky option

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Utility Theory and Risk Analysis

Typically, consumers and investors display
risk-averse behavior, especially when
substantial sums of money are involved. Risk
aversion is the general assumption behind
decision models in managerial economics.

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Risk Attitudes
(MU)
(MU)

(MU)

Risk averter: diminishing

MU
Risk neutral: constant
MU
Risk lover: increasing MU
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Examples of utility functions

Let w = income (or profit) or more generally wealth, w > 0

U ( w )

U ( w ) ln w
U ( w )w

U ( w ) 3 w 1 0

1
M U ( w ) w
2
M U ( w )

1
2

1
2

1
w

M U ( w )2 w
M U ( w )3

Which utility function is consistent with risk-seeking behavior?

Which utility function is consistent with risk neutrality?
Which utility function is consistent with risk aversion?
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Example:
Suppose that Anitas utility function is given by U ( w ) w
where w represents total wealth.
(a)Is Anita risk averse, risk loving, or risk neutral?

1
M U w
2

1
2

1
2 w

1
2

MU diminishes with increases in w.

Anita is risk averse.
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