Risk Analysis

Risk AnalysisRisk : 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 MakingFor decision making, 3 important termsStrategy: 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 RiskProbability is the number that indicates the likelihood that an event would occur.Frequency concept of ProbabilityExample:3/4th probability0.3 times50%Subjective concept of ProbabilityWhen past data is not available: Based on human judgments

Expected ValueAverage 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 values of all possible outcomesExpected ValueCash flows(Rs. Lakhs) XiProbability PiExpected Value PiXi300.13400.28500.420600.212700.17Decision MakingHigher the expected Value Better the projectExpected Value = 3+8+20+12+7 = Rs. 50 lakhsRisk ManagementRisk 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 31000Principles of risk managementCreatevalue resources expended to mitigate risk should be less than the consequence of inaction - the gain should exceed the painbe an integral part of organizational processesbe part of decision making processbe systematic and structuredbe based on the best available information

be tailorabletake human factors into accountbe transparent and inclusivebe dynamic, iterative and responsive to changebe capable of continual improvement and enhancementbe continually or periodically re-assessed

Risk Management through InsuranceInsurance 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*20,00,000Premium = 20,000/-

Risk Management through DiversificationDont put all your eggs in One basket

Investing at a time in more than one different projects.

Mutual funds is an example of diversification.HedgingMaking 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 AnalysisAdecision 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 TreeDecision nodeChance nodeDecision 1Decision 2

Event 1Event 2Event 316An 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 the project being a success yielding 300 million and a 0.4 chance of the project failing leading to a loss of 20 million. (over the five year period)We can now work out the likely expected values:Invest in bank: 1.0 x 150m= 150mProject A0.5 x 200 = 100m0.5 x -50 = 25m= 125mProject B0.6 x 300 = 180m0.4 x -20 = -8m= 172mCase 1Jenny 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 - $3,000,000TV Network Payout Flat rate - $900,000Probabilities P(Small business) = 0.3 P(Medium business) = 0.6 P(Large business) = 0.1

DecisionsStates of NatureSmall businessMedium businessLarge businessPriorProbabilities0.30.60.1Sign with Movie Company$200,000$1,000,000$3,000,000Sign with TV Network$900,000$900,000$900,000Jenny Lind Decision Tree - SolvedSmall Box OfficeMedium Box OfficeLarge Box OfficeSmall Box OfficeMedium Box OfficeLarge Box OfficeSign with Movie Co.Sign with TV Network$200,000$1,000,000$3,000,000$900,000$900,000$900,000.3.6.1.3.6.1ER900,000ER960,000ER960,00022Class Exercise: A Glass FactoryA glass factory specializing in crystal is experiencing a substantial backlog, and the firm's management is considering three courses of action:A) Arrange for subcontractingB) Construct new facilitiesC) Do nothing (no change)

The correct choice depends largely upon demand, which may be low, medium, or high. By consensus, management estimates the respective demand probabilities as 0.1, 0.5, and 0.4.

Given the payoffs on the next page, manually create and solve this problem using a decision tree. 2320A Glass Factory: The Payoff Table

The management estimates the profits when choosing from the three alternatives (A, B, and C) under the differing probable levels of demand. These profits, in thousands of dollars are presented in the table below: 2421Thank You!