10. Risk and Uncertainty Flashcards

1
Q

What is sensitivity analysis?

A

Seeing how much the estimates used to make the original decision can change before the decision becomes incorrect

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2
Q

What is the equation for sensitivity?

A

Project NPV / PV of variable

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3
Q

When calculating the sensitivity of selling prices, what does care need to be taken over?

A

Reducing the sales price by tax charges

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4
Q

How do you calculate sensitivity for cost of capital?

A

(IRR - Existing Cost of Capital) / Existing Cost of Capital

How much does can the cost of capital change before NPV is zero?

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5
Q

How do organisations measure the likelihood of risks?

A

By probabilities

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6
Q

How do organisations measure the impact of risks?

A

Estimating monetary amounts or using a scale of 1 to 100

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7
Q

What is Value at Risk?

A

A measure that quantifies the maximum loss that is acceptable to a company over a period of time, given normal market movements and a given level of probability

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8
Q

What is the formula for value at risk?

A

Confidence interval value x standard deviation

Where the confidence interval value is the Z score at Confidence % - 0.5

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9
Q

Given a 1 period Value at Risk, how would you calculate the X period Value at Risk?

A

Value at risk * Sqrt(X)

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10
Q

What is the expected value? E(V)

A

The weighted average payoff: Sum (Probability x Payoff)

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11
Q

What risk preference investor would use E(V) to base their decisions on?

A

Risk neutral

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12
Q

What are the 3 key limitations of E(V)?

A
  1. Not relevant in one offs as they represent a long run average
  2. Ignores the spread of possible returns
  3. Relies on the accuracy of probabilities
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13
Q

What is the equation for the value of perfect information?

A

VOPI = EV (with perfect information) - EV (without)

Where EV (with perfect information) comes from the expected values as if we know what the outcome scenario will be

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14
Q

What is the equation of the coefficient of variation?

A

SD / E(V)

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15
Q

What do we use the coefficient of variation for?

A

To compare relative risks of projects

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16
Q

What is a decision tree?

A

A pictorial method of showing a sequence of interrelated decisions and their expected outcomes

17
Q

From what direction do you draw / read decision trees?

A

From the left / from the right

18
Q

What is the EV at a decision point?

A

The of lower of all cost or higher of all return options to the right

19
Q

What is maximax?

A

Maximising the maximum achievable profit - selecting the option with the best outcome possible

20
Q

Who favours maximax criteria?

A

Risk seekers

21
Q

What is maximin?

A

Maximising the minimum achievable profit - selecting the option with the best worst possible outcome

22
Q

Who favours maximin criteria?

A

Risk averse investors

23
Q

What is minimax regret?

A

Minimising the maximum regret of making the wrong decision

24
Q

What is the payback period approach to assessing risk?

A

Projects with faster paybacks are less risky

25
What is the risk adjusted discount rate approach to assessing risk?
Adding a premium to the cost of capital when appraising higher risk projects - setting a higher hurdle rate
26
What is the certainty equivalent approach to assessing risk?
Multiplying each years cash flow by a 'certainty equivalent factor' to give a 'risk free' cash flow, before discounting to find an NPV
27
What are simulation techniques?
Statistical techniques, often using computers and random numbers, for simulating potential outcomes are useful in situations where they are multiple uncertain variables
28
What is stress testing?
Simulation designed to determine the ability of a project to deal with worse case situations