Lecture 4
Risk Analysis
Invest or not Invest in Developing
Countries?

YES!




Growing economies;
Increasing investment opportunities;
High revenues.
NO!


Default risk;
Volatility and Instability.
Which Problems in Investment
Decision?

Too complex to measure:




Many variables (both qualitative and
quantitative);
Not common pattern across countries.
Few and unreliable data;
Unstable patterns and unpredictable
change;
= UNSURE OUTCOME!
= RISK!
Country Risk Analysis: Definition



Businessmen and bankers must make
their choices based on their analysis,
taking into consideration how today’s
choices are likely to affect their
companies/investment in the future. This
implies a certain amount of risk.
Probability of occurrence of negative
events that will change the profitability of
a given investment.
All the additional risks induced by doing
business abroad, as opposed to domestic
transitions.
Risk & Probability




RISK is a hazard or chance of loss;
The bigger the chance of loss, the more
risky a particular course of action is;
Chance of loss = probability of loss;
PROBABILITY: measure of the degree of
belief that an event will occur:


Frequency definition: P(A)=r/R
Subjective definition.
Probability (1)
Probability (2)

The Probability Distribution:


? Invest or not in Sovereign bonds in Argentina:
Possible consequences/events:



The country would default :
The country would not default:
Pr(A) = 0.4
Pr(B) = 0.6
Σ
1
Expected Value of the Profit/Outcome:

To each possible event corresponds a loss/gain:
The country would default = -600,000$
 The country would NOT default = + 1,000,000$
EV = 0.6*(1,000,000) + 0.4*(-600,000) = 360,000
EV = Pr(B)*(Vb) + Pr(A)*(Va)


How can we make a decision?
The Decision Tree

A situation involving decision
making under condition of risk has
the following characteristics:
1.
2.
Make a choice (or a series of choice)
among alternative courses of action
(decision fork);
The choice leads to some
consequences that depend on some
unpredictable events as well as on the
choice itself (chance fork).
Example: Shell Oil corporation


DECISION: do we drill a well in
Zambia?
To make the decision, the firm
collects info about:
-
Cost of drilling;
Price of oil;
Geologists’ report about the likelihood
af striking oil.
Example: Shell Oil corporation
Event
Probability
Outcome
No oil
.60
- 90,000$
10,000 barrels
.15
+ 100,000$
20,000 barrels
.15
+ 300,000$
30,000 barrels
.10
+ 500,000$
The Attitudes Toward Risk (1)



Invest in
Russian bonds:
Event
Pr
Profit
($)
No
Default
0.5
4,100
Default
0.5
-60$
OR invest in US bond:
sure profit = 2,000$
Which investment do you prefer?

It depends on your attitude to risk!
The Attitudes Toward Risk (2)

Although one can expect that utility
increases with monetary gain, the
shape of the utility function can
vary greatly, depending on the
preferences of the decision maker:



CONCAVE: risk averters;
CONVEX: risk lover;
LINEAR: risk neutral.
Measures of Risk



Risk is not easy to measure;
BUT the riskiness of a decision is directly related
to the dispersion of the possible profits resulting
from the decision;
Statistical Measure = Standard Deviation:

N
 
i 1

 E ( ) Pi
2
i
Larger S.D. = Greater likelihood that the
profitability would depart greatly from the
expected value! = Larger amount of risk!
Adjusting the Valuation Model for Risk

Adjusting the Expected Cash Flows for the
country risk:
n
ut CFt
NPV  
t
(
1

i
)
t 0
With u = risk probability; 0<u<1.

Adjusting the Discount Rate:
n
CFt
NPV  
t
(
1

i

k
)
t 0
With k = risk premium
For Next Lesson!
http://www.trading-safely.com/



Choose a country;
Ignore the sector option!
Print and bring to the lesson all the
material about the country available in
the web-page.
References


Bouchet, Clark and Groslambert
(2003): “Country Risk Assessment”,
Wiley finance (chapter 2).
Mansfield, E. (1993): “Managerial
Economics. Theory, Application, and
Cases” Norton (Chapter 13).