RISK ANALYSIS
MBA 3.5 (Fall 17)
1
5th semester
GROUP MEMBERS
1.
Alvina Hussain
2.
Benish Ali
3.
Misbah Qayyum
4.
Aimon Pervaiz
5.
Asad Ali
2
CONTENTS
1.
Economic Risk vs Uncertainty
2.
Various types of risk
3.
Expected Profit of a Project
4.
Absolute vs Relative Risk
5.
Measure of expected value
6.
Managerial Applications
3
Alvina Hussain
4
DEFINITION

Event: Occurrence of something .

Outcome: Result or consequence of event.

Probability: The likelihood of an outcome .

Value at Risk: Amount of loss if a negative event
happens.
5
IMPORTANCE OF RISK ANALYSIS

Risk Analysis helps you understand risk, so that
you can manage it, and minimize disruption to
your events.

Risk Analysis also helps you control risk in a
effective way.

Risk Analysis helps you identify and manage
potential problems that could affect your activity.
6
DEFINITION OF RISK
The possibility that something bad or unpleasant
(such as an injury or a loss) will happen.
OR
Risk is made up of two things: the probability of
something going wrong, and the negative
consequences that will happen if it does.
7
UNCERTAINTY & RISK UNCERTAINTY:

Uncertainty:
This is a situation wherein the possible outcomes
or probability of the outcomes is unknown.
It can be described as the chance of occurrence of
some event where the probability is not known.
8
CONTINUED

Risk Uncertainty:
This is a situation wherein all possible outcomes
and the probability of occurrence are known ,
where the outcome of a event, or each set of
possible outcomes, can be predicted on the basis of
statistical probability.
9
RISK VS. UNCERTAINTY

Risk

Must make a decision for which the outcome is not
known.

Can list all possible outcomes & assign probabilities
to the outcomes

Uncertainty

Cannot list all possible outcomes

Cannot assign probabilities to the outcomes
10
ECONOMIC RISK VS UNCERTAINTY

Economic Risk is the significant change in the
economic structure or growth rate that produce a
major change in the expected return of an
investment.
Uncertainty exists because the outcomes of managerial
decisions cannot be predicted.
11
POSITIONING UNCERTAINTY & RISK
Uncertainty
Probabilities and
outcomes ( unknown)
Risk and
Uncertainty
Some knowledge of
Probabilities and
outcomes
Risk
Probabilities and
outcomes (known)
12
Misbah Qayyum
13
RISK CATEGORIES / TYPES OF RISKS
1.
Known Unknown
2.
Unknown Unknowns

Known Unknown: These are the risks whose occurrence
is predictable or foreseeable. Either their probability of
occurrence (or) their likely effect is known.

Unknown Unknowns: These are events whose
probabilities of occurrence and effect are not foreseeable
by even the most experienced people.
14
TYPES OF RISK
MARKET RISK
FINANCIAL RISK
CREDIT RISK
LIQUIDITY RISK
RISK
OPERATIONAL RISK
LEGAL AND
REGULATORY RISK
BUSINESS RISK
STRATEGIC RISK
15
TYPES OF RISK
Market Risk – the chance that a portfolio of
investments can lose money because of overall
swings in financial markets
Credit Risk – the chance that another party will
fail to abide by its contractual obligations
16
TYPES OF RISK
Liquidity Risk – comprises both funding liquidity risk
and asset liquidity risk, although these two
dimension of liquidity risk are closely related.

Funding liquidity risk relates to a firm’s ability to
raise the necessary cash to roles over its debt.

Asset liquidity risk, often simply called liquidity risk,
is the risk that an institution will not be able to
execute a transaction at the prevailing market price.
17
TYPES OF RISK

Operational Risk – operational risk refers to
potential losses resulting from inadequate
system, management failure, faulty controls,
fraud, and human error.

Legal and Regulatory Risk – Legal and
regulatory risk arises for a whole variety of
reasons and is closely related to reputation risk
18
TYPES OF RISK
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
Strategic Risk: Strategic risk refers to the risk of
significant investments for which there is high uncertainty
about success and profitability.
If the venture is not successful, then the firm’s reputation
among investors will be damaged.
19
RISK AND REWARD/RETURNS

Greater the risk greater the return.

A risk without return is a suicide.

Risk can be minimized but cannot be eliminated.

Risk can be managed to keep it at lower side.
20
Risk Analysis
•
•
Intended Purpose Identification
Risk Estimation
Risk
Assessment
Risk Evaluation
•
Risk Acceptability Decision
Risk
Management
Risk Control
•
•
•
•
Options analysis
Implementation
Residual Risk Evaluation
Overall Risk Acceptance
Post-production Information
•
•
•
•
Post-production experience
Systemic Procedures
Identification of new Hazards
Change Control & Feedback Loop
21
Benish Ali
22
RISK ANALYSIS
Systematic use of available information to identify
hazards and estimate risk.
23
Five Steps of Risk Analysis
24
Step 1—Identify Risks
Step 2— Risk Analysis/Assess event to determine levels of risk
Step 3—Identify Methods to Manage Risks
Step 4—Implement Methods
Step 5—Manage and Evaluate
2
Assess Risks
3
Identify
Methods to
Manage Risks
1
Identify Risks
5
Manage &
Evaluate
4
Implement
Methods
25
IDENTIFY
Step 1: Identify the existing and possible threats
that you might face. Look for and identify
threats by consulting with members of the
organization
26
RISK ANALYSIS
It has four elements:

Risk Assessment

Risk Communication

Risk Perception

Risk Management
27
RISK ANALYSIS
Step 2: Decide who might be harmed and how -
consider everyone at the event. Once you've
identified the threats you're facing, you need
to work out both the likelihood of these
threats being realized, and their possible
impact.
28
IDENTIFY METHODS TO MANAGE RISKS
Step 3: Evaluate the risks arising from threats,
and decide whether the existing
precautions are adequate, or if more should
be done. If something needs to be done,
take steps to eliminate or control the risks.
29

Using existing assets - this may involve reusing
existing equipment, improving existing methods
and systems, changing people's responsibilities,
improving accountability and internal controls,
and so on.
You can also manage risks by adding or changing
things.
30

Investing in new resources –
Risk Analysis will help you decide whether you
need to bring in additional resources to counter
the risk.
31
IMPLEMENT METHODS
Step 4: Record the findings and state how they can be
controlled to prevent harm. Most importantly,
organizational members and advisor must be
informed about the outcome of the risk
assessment, as they will be the ones who will
need to take action.
32
MANAGE & EVALUATE RISK
It is a process to identify, assess, reduce, accept,
and control risks in a systematic, comprehensive
and cost effective manner
33
Step 5: Risk evaluation allows you to determine the
significance of risks to the event and decide to
accept the specific risk or take action to prevent
or minimize it.
34
THE RISK MANAGEMENT PROCESS
Step 1. Risk Identification
Step 2. Assess the Risks
Step 3. Control the Risks
Step 4. Monitor / Review Control Measures
35
KEY POINTS

Risk Analysis is a proven way of identifying
and assessing factors that could negatively
affect the success of a program.

It allows you to examine the risks that you or
your organization face, and decide whether or
not to move forward with a decision.
36
KEY POINTS

You can do a Risk Analysis by identify threats,
and by then estimating the likelihood of those
threats being realized.

Once you've identified the risks you face, you can
start looking at ways to manage them effectively.
This may include using existing assets, or
investing in new resources.
37
Aimon Pervaiz
38
MEASURING RISK
PROBABILITY DISTRIBUTIONS

Probability


Chance that an event will occur
Probability Distribution

List of all possible events and the probability that
each will occur
n
E ( )      i  Pi
i 1

Expected Value or Expected Profit
39
EXAMPLE (PROBABILITY)
A dice is thrown

Probability of 1 = 1/6 or 0.167

Utility Function=Level of satisfaction
40
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  x2 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.
41
EXPECTED VALUE

Expected value (or mean) of a probability
distribution is:
Where Xi is the ith outcome of a decision,
pi is the probability of the ith outcome, and
n is the total number of possible outcomes
42
EXPECTED VALUE

Does not give actual value of the random outcome

Indicates “average” value of the outcomes if the
risky decision were to be repeated a large number
of times
43
RISK MEASUREMENT

Absolute Risk:
- 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
- Measurement: coefficient of Variation (CV),
- The lower the CV, the lower the relative risk.
44
MEASURING RISK
PROBABILITY DISTRIBUTIONS
An Absolute Measure of Risk:
The Standard Deviation

n
2
(
X

X
)
 Pi
 i
i 1
Standard deviation is the square root of the variance
• The higher the standard deviation, the greater the
risk
45
VARIANCE

Variance is a measure of absolute risk

Measures dispersion of the outcomes about the mean or
expected outcome
Variance (X) 
=

n
2
(
X

X
)
 Pi
 i
i 1
• The higher the variance, the greater the risk associated
with a probability distribution
46
PROBABILITY DISTRIBUTIONS WITH
DIFFERENT VARIANCES
15-47
MEASURING RISK
PROBABILITY DISTRIBUTIONS
Calculation of Expected Profit
Project
A
B
State of Probability Outcome Expected
()
Economy
(P)
Value
Boom
0.25
$600
$150
Normal
0.50
500
250
Recession
0.25
400
100
$500
Expected profit from Project A
Boom
0.25
$800
$200
Normal
0.50
500
250
Recession
0.25
200
50
$500
Expected profit from Project B
48
AN ABSOLUTE MEASURE OF RISK:
THE STANDARD DEVIATION
  (600  500) 2 (0.25)  (500  500) 2 (0.50)  (400  500) 2 (0.25)
  5, 000  $70.71
49
COEFFICIENT OF VARIATION

When expected values of outcomes differ
substantially, managers should measure riskiness
of a decision relative to its expected value using the
coefficient of variation

A measure of relative risk
50
A Relative Measure of Risk:
The Coefficient of Variation

v

Project A
70.71
vA 
 0.14
500
Project B
212.13
vB 
 0.42
500
51
DECISION-MAKING UNDER RISK

Possible Criteria to consider:
- Maximize expected value
- Minimize variance or standard deviation
- Minimize coefficient of variation
52
MAXIMIZING EXPECTED VALUE
Event (State of Economy)
P
Profit
Project A
Project B
Recession
0.2
$4,000
$0
Normal
0.6
$5,000
$5,000
Boom
0.2
$6,000
$12,000
EV(A)=$5,000 EV(B)=$5,400
Thinking:
Which project will you choose based on this criterion?
What is ignored using this criterion?
53
MINIMIZING VARIANCE/STANDARD DEVIATION
Event (State of Economy)
P
Profit
Project A
Project B
Recession
0.2
$4,000
$0
Normal
0.6
$5,000
$5,000
Boom
0.2
$6,000
$12,000
 =A $632.46
 =B $3,826.23
Thinking:
Which project will you choose based on this criterion?
What is ignored using this criterion?
54
MINIMIZING COEFFICIENT OF VARIATION
A
B
Expected value
$5,000
$5,400
Standard deviation
$632.46
$3,826.23
Coefficient of Variation
0.2265
0.7086
Think:
Which project will you choose based on this criterion?
What is ignored?
55
Asad Ali
56
MANAGERIAL RESPONSIBILITIES

Risk managers advise organizations on any
potential risks to the profitability or existence of
the company.

They identify and assess threats, put plans in
place for if things go wrong and decide how to
avoid, reduce or transfer risks.
57
MANAGERIAL RESPONSIBILITIES

Risk managers are responsible for managing the
risk to the organization, its employees,
customers, reputation, assets and interests of
stakeholders.

They may work in a variety of sectors and may
specialize in a number of areas including
operational risk, technology risk, and market and
credit risk.
58
MANAGER’S ATTITUDE TOWARD RISK

Risk averse

If faced with two risky decisions with equal expected
profits, the less risky decision is chosen.

They are characterizes decision makers who seek to avoid
or minimize risk.

Risk loving

Expected profits are equal & the more risky decision is
chosen. They characterizes decision makers who prefer
risk.
59
MANAGER’S ATTITUDE TOWARD RISK

Risk neutral

Indifferent between risky decisions that have equal
expected profit.

They characterizes decision makers who focus on
expected returns.
60
RISK ATTITUDE
Scenario:
A decision maker has two choices, a sure thing
and a risky option, and both 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
61
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.
62
UTILITY THEORY



Risk Averse

Must be compensated for taking on risk

Diminishing marginal utility of money
Risk Neutral

Are indifferent to risk

Constant marginal utility of money
Risk Seeking

Prefer to take on risk

Increasing marginal utility of money
63
MANAGER’S ATTITUDE TOWARD RISK
Can relate to marginal utility of profit

Diminishing MUprofit


Increasing MUprofit


Risk averse
Risk loving
Constant MUprofit

Risk neutral
64
MANAGER’S ATTITUDE TOWARD RISK
15-65
MANAGER’S ATTITUDE TOWARD RISK
15-66
MANAGER’S ATTITUDE TOWARD RISK
15-67
WHICH RULE IS BEST?

For a repeated decision, with identical probabilities
each time

Expected value rule is most reliable to maximizing
(expected) profit

Average return of a given risky course of action repeated
many times approaches the expected value of that action
15-68
WHICH RULE IS BEST?


For a one-time decision under risk

No repetitions to “average out” a bad outcome

No best rule to follow
Rules should be used to help analyze & guide
decision making process

As much art as science
69
70