P2 - 10. Risk and Uncertainty Flashcards
What is sensitivity analysis used for?
Seeing how much the estimates used to make the original decision can change before the decision becomes incorrect
What is the calculation for sensitivity %?
NPV / PV of variable x 100%
What is a more sophisticated method of assessing risk likelihood and impact?
Looking at a range of probabilities and of outcomes, analysing distributions and using confidence limits
What 4 things might you get from a detailed assessment of risk likelihood and impact?
- Likelihood and magnitude of best result
- Average or expected result
- Likelihood of making a loss
- Likelihood and magnitude of worst result
What is the Value at Risk?
The maximum loss that is acceptable to a company over a period of time, given normal market movements and a given level of probability
What is the formula for Value at Risk?
Confidence interval value x standard deviation
What is the expected value?
The weighted average of outcomes, found by the sum of each payoff x each probability
What type of investor will generally use maximum EV to make their decision?
Risk neutral
What are the 3 main limitations of using EV?
- Not relevant in one offs (represent long run average)
- Ignores spread of possible returns (risk)
- Relies of accuracy of probabilities
What is the value of perfect information?
How much we would pay someone to have the perfect information about future economic state
EV(with perfect info) - EV (Without)
What does standard deviation measure?
Volatility - how widely values range from the average - measure of risk
What is the equation of the Coefficient of Variation?
SD / EV
What is the Coefficient of Variation used for?
Comparing the relative risks of projects
What is a decision tree?
A pictorial method of showing a sequence of interrelated decisions and their expected outcomes
When are decision trees useful?
In expected value decision making, where there is a long sequence of decisions
What is maximax decision making?
Maximising the maximum achievable profit - selecting the scenario with the best possible outcome
What type of investor will use maximax decision criteria?
Risk seekers
What is maximin decision making?
Maximising the minimum achievable profit - selecting the scenario with the highest worst possible outcome
What type of investor will use maximin decision criteria?
Risk averse
What is minimax regret decision making?
Minimising the maximum regret of making the wrong decision, so minimising the maximum opportunity loss
How can you account for risk when doing NPV calculations?
- Adjusting the discount factor for risk - adding an estimated % or by identifying true business risk (Hurdle rate)
- Applying certainty equivalents to each cash flow
What are simulation techniques?
Statistical techniques for simulating potential outcomes where there are multiple uncertain variables, using random number generators to model real life situations
What is stress testing?
An analysis designed to determine the ability of a project to deal with worse case situations, varying inputs to a simulation and assessing the impact on the project’s outcome
