Week 3 - Risk And Sensitivity Analysis Flashcards
Define Risk
Is the uncertainty where the probability is known
Define uncertainty
Is where the probability is not known
What is the formula for the expected value? + Xg example
The sum of all possible outcomes in terms of probability x consequence (expected outcome aka cash)
How do I answer a question on risk/probability? (4)
• List the possible outcomes that arise from the question
• Multiply the probabilities for each of the different outcomes
• Ensure that the sum of all probabilities total 1.0
• Include any assumptions I have made that can impact my answer e.g. assuming a certain value of something, or certain number of possible outcomes based on logic or commonality
Example of risk/probability in an investment auestion
• The question will ask for the expected value (NPV) and the range of values after the probabilities and possible outcomes have been considered
How do you manage an investment decision with a cash flow that is risky or volatile? (2)
• Manage the decision by increasing the required discount rate or hurdle rate
• This will allow for probabilities to be assigned to cash flows helping to see where the risks are and what they are having on the outcome or decision further indicating the hurdle rate
What is the relationship between risk and returns of investments? (2)
• Where risk increases investors expect greater returns
• Where these risks cannot be measured or understood then investors tend to assume worst case
What is the relationship between risk and returns of investments? (2)
• Where risk increases investors expect greater returns
• Where these risks cannot be measured or understood then investors tend to assume worst case
Example of list the probability of an investment (can be related to a question)
What do you use when you cannot assign a probability?
You use sensitivity & scenario analysis
Which two things must we know when dealing with risk?
• The expected outcome or value
• The range of values and their probabilities
Define expected value (2)
Expected value if the average value
Formula: Sum of all probabilities x all outcomes
Example of how to structure the report section of a exam question (2)
• Outline what the expected NPV of the scheme/project is
• Outline the ranges of both the NPV and probabilities (pair the NPV and probability of the different outcomes together e.g, NPV of £80,000 with a probability of 0.42
What role does sensitivity have in an investment decision?
Sensitivity may be taken into account where the NPV is quite close to Zero which can be used to explain to the investor the degree of sensitivity the project scheme can tolerate before it is no longer viable
What is the formula for sensitivity?
NPV / Initial investment = %
