P2 - 10. Risk and Uncertainty

Question 1

What is sensitivity analysis used for?

Answer 1

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

Question 2

What is the calculation for sensitivity %?

Answer 2

NPV / PV of variable x 100%

Question 3

What is a more sophisticated method of assessing risk likelihood and impact?

Answer 3

Looking at a range of probabilities and of outcomes, analysing distributions and using confidence limits

Question 4

What 4 things might you get from a detailed assessment of risk likelihood and impact?

Answer 4

1. Likelihood and magnitude of best result
2. Average or expected result
3. Likelihood of making a loss
4. Likelihood and magnitude of worst result

Question 5

What is the Value at Risk?

Answer 5

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

Question 6

What is the formula for Value at Risk?

Answer 6

Confidence interval value x standard deviation

Question 7

What is the expected value?

Answer 7

The weighted average of outcomes, found by the sum of each payoff x each probability

Question 8

What type of investor will generally use maximum EV to make their decision?

Answer 8

Risk neutral

Question 9

What are the 3 main limitations of using EV?

Answer 9

1. Not relevant in one offs (represent long run average)
2. Ignores spread of possible returns (risk)
3. Relies of accuracy of probabilities

Question 10

What is the value of perfect information?

Answer 10

How much we would pay someone to have the perfect information about future economic state
EV(with perfect info) - EV (Without)

Question 11

What does standard deviation measure?

Answer 11

Volatility - how widely values range from the average - measure of risk

Question 12

What is the equation of the Coefficient of Variation?

Answer 12

SD / EV

Question 13

What is the Coefficient of Variation used for?

Answer 13

Comparing the relative risks of projects

Question 14

What is a decision tree?

Answer 14

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

Question 15

When are decision trees useful?

Answer 15

In expected value decision making, where there is a long sequence of decisions

Question 16

What is maximax decision making?

Answer 16

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

Question 17

What type of investor will use maximax decision criteria?

Answer 17

Risk seekers

Question 18

What is maximin decision making?

Answer 18

Maximising the minimum achievable profit - selecting the scenario with the highest worst possible outcome

Question 19

What type of investor will use maximin decision criteria?

Answer 19

Risk averse

Question 20

What is minimax regret decision making?

Answer 20

Minimising the maximum regret of making the wrong decision, so minimising the maximum opportunity loss

Question 21

How can you account for risk when doing NPV calculations?

Answer 21

1. Adjusting the discount factor for risk - adding an estimated % or by identifying true business risk (Hurdle rate)
2. Applying certainty equivalents to each cash flow

Question 22

What are simulation techniques?

Answer 22

Statistical techniques for simulating potential outcomes where there are multiple uncertain variables, using random number generators to model real life situations

Question 23

What is stress testing?

Answer 23

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