Chapter 11

Introduction to Risk Analysis

Why do individuals, companies, and

stockholders take risks?

Terminology

Risk - possibility of an undesired outcome

Probability - expected relative frequency of an
event

Terminology

Risk and uncertainty

Risk - probabilities of outcomes is known -- casino

Uncertainty - outcomes not known with certainty
reality

Probability distributions

discrete - number of probability occurrences is finite

continuous - infinite number of occurrence
- range of outcomes

Terminology

Subjective versus objective probability

Subjective - someones opinion

Objective - can be measured

Terminology

Variation versus event risk

Event risk - probability of a certain , such as

bankruptcy
Variation risk- probability of a range of outcomes
around an event

typically measured by standard deviation

Terminology

Diversifiable versus nondiversifiable risk

Diversifiable risk -- risk that can be reduced or

eliminated by combining one investment with
another

Must have a correlation less than +1

Nondiversifiable risk -- risk that remains after

combining large numbers of projects

Probability Rules

Mutually exclusive events

Independent events

add the probabilities of the events

build a table of possible combinations of events
multiply the probabilities to get table values

Dependent events

build a table where the probabilities of outcomes for

the second event are dependent on the first event

Stages of Risk Measurement

Stage 1 -- Descriptive and Subjective

listing of things that might go wrong

good for identifying the important variables

Stage 2 -- Sensitivity analysis

look at possible outcomes over a range of values for

a critical variable (such as sales)
do not attempt to assign probabilities
example -- breakeven analysis

Stages of Risk Measurement

Stage 3 -- Event probability

assign probabilities to the various outcomes

one in ten chance of bankruptcy

Stage 4 -- Summary measures of probability

distributions

Measures of central tendency

Measures of dispersion

Summary Measures: Central

Tendency

Expected value: possibilities time probabilities

Median: Center outcome; probability of
outcome above median equals probability of
outcome below median.
Mode: Most common outcome
Geometric mean (Pi = probability of outcome i):
[(1+ return1)^P1][(1+ return2)^P2] . . . .

Summary Measures: Dispersion

Variance

Standard deviation

Multiply squared distances from the expected value

by the probability, then sum
Square root of the variance
Same unit of measure as the original problem

Coefficient of variation

standard deviation/ expected value

adjust for the scale of the project

Summary Measures: Dispersion

Semivariance

computed like variance, but considers only outcomes

below the expected value
used when the distribution is not normal (skewed)

Quartile range

There is a 25% probability of a value greater than X

and a 25% probability of a value less than Y

Summary Measures

Normal distributions and standard deviations

using a z-table you can find the area under the

normal curve (probability of a range of outcomes)

Utility Theory

Assumptions

Completeness -- you can judge your preference in all

situations
Rational -- consistent in judgements order of
presentation does not matter
Transitivity -- if A is preferred over B and B is
preferred over C then A is preferred over C

Utility Theory

Types of utility functions

Increasing -- risk seeker or lover -- will pay to take

the riskier project -- casinos and lottery tickets
Constant -- risk neutral -- is indifferent to risk -- will
accept the same expected return for risky as well as
safe projects
Decreasing -- risk averse -- prefer safety to risk and
must be compensated for accepting additional risk

Utility Theory

Problems with utility functions in reality

Hard to measure
Whose utility should we measure?
Once measured then the decision can be made by the
analyst

Utility theory is important to arbitrage pricing

theory

equal expected utilities should have equal prices

Risk Perspectives
Single

investment perspective

Proposing manager -- Chapter 12

Company

perspective

Senior management and board -- Chapter 13

Shareholder

Shareholder -- Chapter 14

Contingent

claims

Option writer, debt-holder -- Chapter 15

Overall

perspective

economy

Everybody