Risk Analysis

Risk : A situation when the outcome

of a decision is uncertain but the
probability of each possible outcome
is known.
Uncertainty: The situation when there
is more than one possible outcome of
a decision, but the probability of
occurrence of each possible outcome
is unknown or even cannot be
estimated.

Decision Making
For decision making, 3 important
terms
Strategy: One of several alternative
courses of action or plans that can be
implemented to achieve the desired
goals.
State of Nature: conditions that prevail
in future and have significant effect on
strategy.
Outcome: Results of implementation of
strategy.

Probability of Risk
Probability is the number that indicates
the likelihood that an event would occur.
Frequency concept of Probability
Example: 3/4th probability
0.3 times
50%
Subjective concept of Probability
When past data is not available:
Based on human judgments

Expected Value
Average value of the possible payoffs of
aninvestmentdecision, taking
intoaccountthe likelihood of
eachpayoff.
Expected value is the best prediction of
avariable'svalue, and is computed by
multiplying each outcome by
theprobabilityof its occurrence and
thenaveragingthem.
Mathematically it is described as the
probability-weighted average

Expected Value
Cash flows(Rs.
Lakhs) Xi

Probability Pi

Expected Value PiXi

30

0.1

40

0.2

50

0.4

20

60

0.2

12

70

0.1

Expected Value = 3+8+20+12+7 = Rs. 50

lakhs
Decision Making
Higher the expected Value Better the
project

Risk Management
Risk managementis the
identification, assessment, and
prioritization ofrisksfollowed by
coordinated and economical
application of resources to minimize,
monitor, and control the probability
and/or impact of unfortunate
events. ISO 31000

Principles of risk management

Createvalue resources expended to
mitigate risk should be less than the
consequence of inaction - the gain should
exceed the pain
be an integral part of organizational
processes
be part of decision making process
be systematic and structured
be based on the best available information

be tailorable
take human factors into account
be transparent and inclusive
be dynamic, iterative and responsive
to change
be capable of continual improvement
and enhancement
be continually or periodically reassessed

Risk Management through

Insurance
Insurance is a risk transfer
mechanism by which an individual or
organisation can exchange its
uncertainty for certainty.
The individual agrees to pay a fixed
premium and in return, the insurance
company agrees to meet any loss
that falls within the terms of the
policy.

 Insurance planningshould be
based on the Large Loss Principle,
which means, insure low frequency
but high severity risks.
Risk Premium: The maximum price
that an individual is willing to forego
or pay for insurance is called risk
premium.

 Ex. House worth Rs. 20,00,000/- with

0.01 probability of catching fire is
ready to pay a premium of
= 0.01*20,00,000
Premium = 20,000/-

Risk Management through

Diversification
Dont put all your eggs in One
basket
Investing at a time in more than one
different projects.
Mutual funds is an example of
diversification.

Hedging
Making an investment to reduce the risk of
adverse price movements in an asset.
Normally, a hedge consists of taking an
offsetting position in a related security,
such as a futures contract.
Hedging is a two-step process.
A gain or loss in the cash position due to
changes in price levels will be countered by
changes in the value of a futures position.

Decision Tree Analysis

Adecision treeis a decision support tool
that uses a tree-likegraphor modelof
decisions and their possible consequences,
includingchance event outcomes, resource
costs, andutility.
It is one way to display an algorithm.
Decision trees are commonly used
inoperations research, specifically
indecision analysis, to help identify a
strategy most likely to reach a goal.

Example Decision
Tree
Decision
1
n
o
i
node Decis
De c
isio

n2

Chance
node

Event
1
Event 2
Event 3

 An oil exploration company has 100 million

available in cash.
It can invest the money in a bank at 10% yielding
a return of 150 million over five years (ignore
compound interest).
Alternatively it can invest in an oil exploration
project, of which there are currently two
available.
If it invests in Project A there is a 0.5 chance of
the project being a success yielding 200 million,
and a 0.5 chance of the project failing leading to
a loss of 50 million.(over the five year period)
If it invests in Project B there is a 0.6 chance of

We can now work out the likely expected

values:
Invest in bank: 1.0 x 150m
= 150m
Project A
0.5 x 200 = 100m
0.5 x -50 = 25m
= 125m
Project B
0.6 x 300 = 180m
0.4 x -20 = -8m
= 172m

Case 1
Jenny Lind is a writer of novels.
A movie company and a TV network both
want exclusive rights to one of her more
popular works.
If she signs with the network, she will
receive a single lump sum, but if she signs
with the movie company, the amount she
will receive depends on the market
response to her movie.
What should she do?

 Movie company Payouts

Small business $2,00,000
Medium business - $1,000,000
Large business - $3,000,000

TV Network Payout
Flat rate - $900,000

Probabilities
P(Small business) = 0.3
P(Medium business) = 0.6
P(Large business) = 0.1

States of Nature
Small
business

Medium
business

Large
business

Prior
Probabilities

0.3

0.6

0.1

Sign with Movie

Company

$200,000

$1,000,000

$3,000,000

Sign with TV
Network

$900,000

$900,000

$900,000

Decisions

Jenny Lind Decision Tree Solved

ER
.3
960,000
Sign with Movie Co.
.6
ER
960,000

.1

Small Box Office

Medium Box Office
Large Box Office
Small Box Office

ER
.3
900,000
Sign with TV Network
.6
.1

Medium Box Office

Large Box Office

$200,000
$1,000,000
$3,000,000
$900,000
$900,000
$900,000

Class Exercise: A Glass

Factory
A
A glass
glass factory
factory specializing
specializing in
in crystal
crystal is
is
experiencing
experiencing aa substantial
substantial backlog,
backlog, and
and the
the firm's
firm's
management
management is
is considering
considering three
three courses
courses of
of
action:
action:
A)
A) Arrange
Arrange for
for subcontracting
subcontracting
B)
B) Construct
Construct new
new facilities
facilities
C)
C) Do
Do nothing
nothing (no
(no change)
change)
The
The correct
correct choice
choice depends
depends largely
largely upon
upon demand,
demand,
which
which may
may be
be low,
low, medium,
medium, or
or high.
high. By
By
consensus,
consensus, management
management estimates
estimates the
the respective
respective
demand
demand probabilities
probabilities as
as 0.1,
0.1, 0.5,
0.5, and
and 0.4.
0.4.
Given
Given the
the payoffs
payoffs on
on the
the next
next page,
page, manually
manually
create and solve this problem using a decision

A Glass Factory: The Payoff

Table
The
The management
management estimates
estimates the
the profits
profits
when
when choosing
choosing from
from the
the three
three
alternatives
alternatives (A,
(A, B,
B, and
and C)
C) under
under the
the
differing
differing probable
probable levels
levels of
of demand.
demand.
These
These profits,
profits, in
in thousands
thousands of
of dollars
dollars
are
in
are presented
presented0.1
in the
the table
table
below: 0.4
0.5 below:

A
B
C

Low
10
-120
20

Medium
50
25
40

High
90
200
60

Thank You!