Syllabus Meaning of Risk. Types of Risks of a Business Enterprise, Risk Analysis in Capital Budgeting, Managing Capital Budgeting Risks, Sensitivity Analysis, Scenario Analysis, Simulation, Standard Deviation and Co. ficient of Variation, Risk-Adjusted Discount Rate Method, Certainty Equivalent Co-efficient Method, Decision Tree Analysis and Probability Distribution Method, Measuring andINTRODUCTION Day to day activities and investment comes along with risk. Risk is the a loss of value. Risk can be foreseen or unpredictable too. Risk element ig brought j h Calusin, circumstances influenced by many external and internal factors, Now.a-daye os by tutu increased exposure to risk, as there is an innumerable financial and trading activity ha IN See over the globe. Exposure refers to degree of sensitivity whereas risk is degree of vans all the predictions made. lity from tal Risk combines two factors — Probabilities and impact. Two factors that deci lecide the tisk of the event is skins a) Whatare the possibilities of the occurrence of the event? b) What is the effect of the event on the risk bearer? Meaning of Risk ‘The word risk has been derived from Latin word ‘resecare where ‘re’ means ‘against’ and 'secare' means ‘to cut’. It means to cut against or the part that is cut off or lost. Thus risk is losing something or suffering loss due to future uncertainties. According to the Dictionary meaning risk is existence of volatility in the occurrence of an expected incident. "Higher the unpredictability greater is the risk. According to this definition risk may or may not involve money. | Risk implies future uncertainty about deviation from expected earings or expected outcome, Risk measures the uncertainty that an investor is willing to take to realize a gain from an investment. Risks are of different types and originate from different situations. We have liquidity risk, sovereign risk, insurance risk, business risk, default risk, etc. Various risks originate due to the uncertainty arising out of various factors that influence an investment or a situation. In finance, risk is the probability that actual results will differ from expected results. In the Capital Asset Pricing Model (CAPM), risk is defined as the volatility of returns. The concept of “risk and return” is that riskier assets should have higher expected returns to compensate investors for the higher volatility and increased risk.Risk Meaning, Types. Risk Analysis In Capital Budgeting 3 Definition of Risk Emmett J. Vaughan,” Risk is a condition in which there is a possibilty of an adverse deviation from a desired outcome that is expected or hoped so far.” Merkhofer “risk allows for a mariiber of possible outcomes, not all of which are bea e Ballard "Risk = Frequency x Consequences! Irving Fisher," tisk may be defined as combinations of hazards measured iby poatiy* Blomiist Helined risk as “the Possible loss of something of value". Friedman lefined risk as “aol inits latent form". event com| 1ed with ate magnitude of ‘he loses oe that wil Carol Fox, a veteran risk professional with over 20 years’ experience, is director of the Strategic and enterprise risk practice at the Risk and Insurance Management Society Risk. She Sees the role's evolution from "Do we have insurance to cover the fraud?" to one of an internal advisor and consultant who plays an active part in detecting and preventing fraud, In the past, when fraud or a security incident occurred within an organization, the initial Fesponse from risk professionals was "How could that have happened?” Typically, they stuck to their traditional approach of reducing and managing a predetermined set of risk exposures and mitigating known risks. Today risk management is exclusively tied to business performance and is a top-down approach aligned centrally with business objectives. “Strategic decision-making, analysis and leading to the root cause of fraud are what risk Managers do now," Fox says.> Risk Management ang Derivatives 7 YES or NO? The Evolution of Ri wo OC RELY | cnwe | “ ) > When fraud occurs, it is the risk manager who has to analyze the occurrence whether it is policy, systemic or by electronic means. Which systems are affected? What loss did the organization incur in terms of monetary and reputation risk? ‘Additionally, the drive toward emerging technologies such as mobile, social media and cloud computing has resulted in multiple channels of delivering products and services, thereby increasing the potential risk. "As such, the risk manager now is driving organizational behavior and looking at issues ‘outside their control," says Kenneth Newman, VP at Central Pacific Bank and a risk specialist with over a decade's experience. ies Most disaster risk assessment today is static, focusing only on understanding current risks. A paradigm shift is needed toward dynamic risk assessments, which reveal the drivers of risk and the effectiveness of policies focused on reducing risk. (i) Global disaster risk is changing extremely fast, due to combined dynamics of hazard, exposure, and vulnerability. society, and individuals—but (ii) The drivers of disaster risk are in the control of policy makers, effective risk accurate assessment and continuous reevaluation of risk is required to enable reduction and prevent drastic increases in future losses.Risk Meaning, Types. Risk Analysis In Capital Budgeting 5 NATURE. OF RISK Ee ie Risk is the potential that a chosen action or activity including the choice of inaction will lead to a loss of an undesirable outcome. Risk exists because of the inability of the decision maker to make perfect forecasts. Forecasts cannot be made with perfection or certainty since the future events on which they depend are uncertain. An investment is not risky if, we can specify a unique sequence of cash flows for it. But whole trouble is that cash flows cannot be forecasted accurately and altemative sequences of cash flows can occur depending on the future events. Example: A firm is considering a proposal to commit its funds in a machine, which will help to produce a new product. The demand for this product may be very sensitive to the general economic conditions. It may be very high under favorable economic conditions and very low under unfavorable economic conditions. Thus, the investment would be profitable in the former situation and unprofitable in the latter case. But, it is quite difficult to predict the future state of economic conditions, uncertainty about the cash flows associated with the investment derives. A large number of events influence forecasts. These events can be grouped in different ways. However, no particular grouping of events will be useful for all purposes. The considerations categories into three types such as: i) General economic conditions This category includes events which influence general level of business activity. The level of business activity might be affected by such events as internal and external economic and political situations, monetary and fiscal policies, social conditions etc. ii) Industry factors This category of events may affect all companies in an industry. For example, companies in an industry would be affected by the industrial relations in the industry, by innovations, by change in material cost etc. iii) Company factors This category of events may affect only a company. The change in management, strike in the company, a natural disaster such as flood or fire may affect directly a particular company. _ 1. New technology. 2. Uncommon systems or methods. 3. Uncertain funding.qi Risk Management ang Unusual financing arrangements. 4. 5. Controversial functions are provided by the project. 6. _ Unrealistic completion dates and/or budgets. 7. Changing customer ownership/control. 8. Unusual contracting arrangements. 9. Project scope is not clearly defined. 10. Project need and alternatives have not been rigorously evaluated. 11. Large number of approvals are required. 12. Conflict among project participants, 13. Relationship between parent organization's role and the project is not clear, ae e oe siicice eee In today’s world, managing corporate risks is a — task. The last few decades have seen a substantial increase in the average rate as well as the volatility, of inflation. The increased uncertainty about inflation has been followed by greater volatility in interest fates, exchange rates and commodity prices. Global competition has intensified in the wake of reduced tariff baniers, The entire process of identifying, evaluating, controling and reviewing risks to make sure that the organization is exposed to only those risks that it needs to take to achieve its primary Objectives is known as risk management, Risk management is a proactive process not reactive. in different markets or sectors there are different types of risks and so the risk management Procedures and techniques vary in their application ways but the target is same; putting the risks under control and accomplishing the mission as expected. Risk cannot be eliminated. However, it can be: (i) Transferred to another party, who is willing to take risk, say by buying an insurance policy or entering into a forward contract. (ii) Reduced, by having good internal controls. (ili) Avoided, by not entering into risky businesses. (wy) Retained, to either avoid the cost of trying to reduce risk or in anticipation of higher profits by taking on more risk. (¥) Shared, by following a middle path between retaining and transferring risk.Risk Meaning, Types. Risk Analysis In Capital Budgeting 7 There are various tools available to the management to manage risks. Some of them being, derivative products like Forwards, Futures, Options and Swaps. The others involve having better internal controls in place, due diligence exercises, compliance with rules and regulations, etc. In coping with the challenge of risk management, the following interrelated guidelines should be considered: () Understanding the firm's strategic exposure. (i) Employing a mix of real and financial tools. (iii) Proactively managing uncertainty. (v). Aligning risk management with corporate strategy. (¥)__Leaming when it is worth reducing risk. Managing risk is considered important; it comes next only to minimizing borrowing costs and maintaining/improving the firm's credit. Firms often reduce some exposures, leaving others unhedged, the principal emphasis being on hedging transaction exposures. 1. Future Potential Event: Risk relates to the potential occurrence of future events, not a past event that has already occurred, although the past may be used to better understand and predict the future. Example, a ski resort is exposed to future changes in weather, specifically ‘snowfall and temperature. Past changes in weather do not pose a risk as these events have already occurred. 2. Uncertainty: The potential future event may or may not have uncertainty over whether it will occur or not. For example, over the next ten years, one of the organization's buildings may or may not catch fire whereas it is almost certain that we will be sick over that same period. In the latter case, where the occurrence of the event is certain, or almost certain, there must be uncertainty over the level of consequence that will result from the event occurring in order for it to be considered a risk. Although sickness may be almost certain, the severity of the sickness is not. Therefore, in order to be a risk, there must be a degree of uncertainty over the occurrence of a specific outcome-consequence. Uncertainty is sometimes referred to as ‘likelihood’, ‘chance’, ‘probability’ or ‘frequency’. 3. Impact: To be considered a risk, the future events must have a potential impact on the organization or person. This potential impact will include a negative aspect (threat) but may» PN Oa Risk Management ang Deas . also include a positive impact (opportunity). Impact is also sometimes refereg om ‘consequence’, ‘effect’ or ‘severity’. There are a range of potential consequences and these may differ between types Of isk, consequence may be financial, such as 2 monetary loss, Cte (qualitative, os as damaged reputation. Consequence is the degree of deviation away from the Organization's or person's expected state. The expected state is usually referred to as ‘objectives’, This deviation represents the consequence, which may be positive or negative. Exampk le: Tho lack of future snowfalls will have a negative consequence on the ski resort as le¥s skiers Will take to the slopes and revenue will fall. Itis therefore considered a risk. Exposure: If the potential future event would, or could, have a consequence on the organization or person, that organization or person is said to be ‘exposed’ to that risk, The implies that in order to be an ‘exposure’, the likelihood and the consequence of the risk Must be greater than zero. Where a risk has @ potential consequence but has no chance of occurring, there is no exposure. Equally, where the potential event is likely but the consequence is zero, there is also no exposure. Risks that create no exposure to one entity may cause an exposure to another entity. Example: Weather risk in the locality of a ski resort in Australia causes a risk exposure to that resort but not to a resort in Canada. That's the reason exposure is termed as degree of sensitivity. Intangible: On the one hand risk is intangible in that it is not directly visible. It is like the wind which, although unseen, can result in very visible effects. Likewise, risk, although unseen, can have very visible consequences. On the other hand, the sources of risk such as exposed chemicals, often referred to as ‘hazards’, are usually very visible. ae eer REASONS FOR RISK IN is (2S Eco ial Investment method and timing may be wrong. Quantity of investment decided is wrong. Instruments chosen for investment are wrong, Interest rate risk, Exchange rate risk. Translation risk in international trades. Terms and conditions of lending. Creditworthiness of the issuer._ Risk Meaning, Types. Risk Analysis In Capital Budgeting g, _Length/duration of investment. 40. Natural disaster. 41. Uncertainty in funding. 42, Technology: both outdated and updated pose risk. RISK AND RETURN TRADE OFF Risk / Return Tradeoff ~ High Risk High Potential Return Standard Deviation (or Risk) Higher the risk greater the possibility of Return and lower the risk , smaller the return. In any investment decision an investor has to face this trade off to achieve good return on his investment. This is known as Risk Retum Trade-off. Understanding the RisicReturn trade-off with exemple Ashutosh had been pleading with his father for over a month to revise his pocket money. Finally, his father decided to use this as an opportunity to teach him an important investing lesson. He called Ashutosh and told him that he was ready to reconsider his pocket money. He gave him 2 options to choose from: Option A: | will increase your pocket money by 20% if you score above 90% in your upcoming exams. However, if you score below 90%, you pocket money will be reduced by 15%. Option B: Your pocket money will be increased by 5% effective immediately and will not depend on how you score in your exams. While it took some time for Ashutosh to figure out which option was suitable for him, he did learn an important investing lesson that day — there is always a risk-return tradeoff in investments. Higher the expected returns (note the word expected) form an investment option, the higher areWw Risk M 0 isk Management ang Petra the risks associated wit it (more like Option Ain this case). While investment options wit tt We risks will also have lower expected returns. But what exactly is Risk? Investments generally entail diferent types of risk driven by various factors. However ay on boils down to one simple definition of risk - the chance that the actual return on your imvestnes will vary from the expected return. For example, say you purchase mutual fund units Worth , 10,000 today and plan to withdraw your money in 3 years. Historically, mutual fund Units hay yielded 12% annual retum and hence you expect your investment to grow to approx. & 14,059 in 3 years time. Your risk here is the chance that your units will be worth less than % 14,050 (downside tisk) in 3 years from today or the chance that your units will be worth more. This is called arg upside risk. To put this in perspective, lets consider two investment options — shares of a Company (lets call this option A) & a bank fixed deposit (lets call this option B). Option A Option B ‘Type of investment ‘Shares Bank FD Expected return (%) 15% ™% Return range with 95% chance 9%-21% | 6% -8% As you can see, while A has higher expected return, there is also a higher degree of uncertainty over actual returns (your actual returns could vary between 9% and 21% with a 95% chance). In B, you are more or less assured of earning close to the expected return (7%). Food for thought: What do you think is the risk associated with buying a lottery ticket of 7 100? It's actually very low. Surprised! Well, in a lottery, since chances of winning are extremely low, you are almost “certain” to lose = 100. Since degree of uncertainty over final outcome is so low, the risk in this context is almost nil. To come back to our original point, investment A is a riskier investment option and hence offers a relatively higher expected retum (to compensate for the associated risk) while investment Bis a less risky investment option and hence offers a relatively lower expected return. The same is true for all kinds of investments. This understanding of risk-return tradeoff is very important in making correct investment decisions. It helps you pick the right investment option bearing in mind how much risk are you willing to take. It also helps weed out fraudulent investment proposals.1 "Risk Meaning, Types. Risk Analysis In Capital Budgeting Ss ~~ TYPESI/CLASSIFICATION OF- RISK. Following are the two broad types of risk: §) Systematic Risk eee — —_ ‘Systematic risk is uncontrollable by an organization and macro in nature. ‘Systematic risk is due to the influence of external factors on an organization. Such factors are normally uncontrollable from an organization's point of view. It is macro in nature as it affects a large number of organizations operating under a similar stream or same domain. It cannot be planned bythe organization. Components of Systematic Risk (Market risk: Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or securities. That is, it arises due to rise or fall in the trading price of listed shares or securities in the stock market. Market prices of shares move up or down consistently for time periods. A general rise in the share prices is referred to as a bullish trend whereas a general fall in share prices is referred to as a bearish trend. In other words the share market alternates between the bullish phase and the bearish phase. The alternating movements can be easily seen in the movement of share price indices such as the BSE Sensitive Index, BSE National Index, NSE Index etc. in the interest rates from time (i) Interest Rate Risks: Interest-rate risk arises due to variabil to time. It particularly affects debt securities as they carry the fixed rate of interest. The fluctuations in the interest rates are caused by the changes in the government monetary policy and the changes that occur in the interest rates of treasury bills and the government bonds. (iif) Purchasing power risk: Purchasing power risk is also known as inflation risk. It is so, since it emanates from the fact that it affects a purchasing power adversely. People have more money in their hands and they demand more consumable as well as durable goods. Purchasing power risk is the uncertainty of the purchasing power of the amounts to be received in future due to both inflation and deflation. There is possibility of prices of desired goods and services going up due to inflation, during the holding period of the investment, as a consequence of which the investor loses the real purchasing power. The element of purchasing power risk is inherent in all investments and is uncontrollable. Itis not desirable to invest in securities during an inflationary period.Risk Management a — ——————Fimlomal factors pravaiing wing = of internal factors pre\ 9 ano Unsystematic risk is due to the influence f ou : a Such factors are normally controllable from an organization's point of view. It is a micro in naty as it affects only a particular organization. It can be planned, so that necessary actions can 5 taken by the organization to reduce the effect of the risk. Types of Unsystematic risk () Business risk: Business risk refers to the possibility that a company will have lower anticipated profits or that it will experience a loss rather than a profit. Business Tisk ig influenced by numerous factors, including sales volume, per-unit price, input cost, competition and overall economic climate and government regulations. A company with a higher business risk should choose a capital structure that has a lower debt ratio to ensure that it can meet its financial obligations at alll times. The variation that occurs in the expecteg operating income indicates the business risk. The term business risk refers to the possibility of inadequate profits or even losses due to uncertainties e.g., changes in tastes, preferences of consumers, strikes, increased competition, change in government policy, obsolesce etc. Every business organization contains various risk elements while doing the business. Business risks implies uncertainty in profits or danger of loss and the events that could pose a risk due to some unforeseen events in future, which causes business to fail. Business risks can be classified into two types: a) Internal risk: Internal risk arises from the events taking place within the organization. Intemal risks arise from factors which can be controlled such as human factors like talent management and strikes. Technological factors like emerging technologies in the market. Physical factors like failure of machines, fire or theft happening in the organisation. Operational factors like access to credit, cost cutting, advertisement. b) External risk: External risks arise from the events taking place outside the organization External risks arise from factors which cannot be controlled such as economic factors (market risks, pricing pressure), natural factors (floods, earthquakes), political factors (compliance and regulations of govemment (i) Financial Risk: Financial risk also refers to the possibility of a corporation or government defaulting on its bonds, which would cause those bondholders to lose money. The probability of loss is inherent in financing methods which may impair the ability to provide adequal? retum._— | “isk Meaning, Types. Risk Analysis In Capital Budgeting 13 Financial risk refers to the possibility that a bond issuer will default, by failing to repay principal and interest in a timely manner. Bonds issued by corporations are more likely to be defaulted on, since companies often go bankrupt. Municipalities occasionally default as well, although it is much less common. It is also called default risk or credit risk. | ginancial risk can be divided into: a Credit Risk: Credit risk refers to the risk that a borrower will default on any type of debt by failing to make required payments. The risk is primarily that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial and can arise in a number of circumstances. For example: ‘Aconsumer may fail to make a payment due on a mortgage loan, credit card, line of credit or other loan. ‘Accompany is unable to repay asset-secured fixed or floating charge debt. 3, Abusiness or consumer does not pay a trade invoice when due. 4. Abusiness does not pay an employee's earned wages when due. A business or government bond issuer does not make a payment on a coupon or principal payment when due. 6. Aninsolvent insurance company does not pay a policy obligation. 7. Aninsolvent bank won't return funds to a depositor. 8. Agovemment grants bankruptcy protection to an insolvent consumer or business. To reduce the lenders credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance or seek security or guarantees of third parties. In general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay on the debt. b) Currency Risk: It is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged. Currency risk involves losses from adverse movements in foreign exchange rates, both short-term and long-term. It affects any company that sells abroad or buys from abroad in foreign currency or that has foreign subsidiaries. Indirectly, it also affects any company that has foreign competition in its domestic markets. a) Country Risk: Country risk arises from an adverse change in the financial conditions of a country in which a business operates. There are three aspects of country risk.} Risk Management and Deva 14 () Political Risk: This is the risk of deteriorating financial condidons from the Consequences of a change of government or political regime, or fem continuing) uncertainty about What government might do. The risk is greatest in countries with political instability, because change in goverment could be sudden and the actions of the incoming gove unpredictable and drastic, e.g., the imposition of exchange controls, banks etc. n Mment Nationalization Of the (i) Economic Risk: This is the risk that economic conditions within a country will have hy financial consequences, particularly for inflation, interest rates and foreign-exchange @ government were to decide, e.g., to increase spending by borrowing heavily, business opportunities would arise for suppliers and contractors to the government, but the financiay consequences of a larger government spending deficit (excess of expenditure ver income that must be financed by government borrowing) might be much higher interest rates for commercial and private borrowers. farmtul Fates. If (iii) Liquidity Risk: This refers to the Possibility that the market for a security, such as a bond or Stock, might be illiquid, so that holders of the security could have difficulty in selling their holding easily, should they wish to do so, at a fair price. © OFALKENGES OF FISK To BUSINESS Building a business takes work and risks. But some risks are more dangerous than others. Here are a few risks that every business owner should keep in mind. Satisfaction. While success is the ultimate goal, business risk may goals you set. Running a business takes hard work, which can reap the rewards of customers, revenue and y stop you from achieving the When it comes to risk management, there are steps you can take, however. Here are seven types of business risk you may want to address in your company. 1. Economic Risk: The economy is constantly changing as the markets fluctuate. Some Positive changes are good for the economy, which lead to booming purchase environments, while negative events can reduce sales. It's important to watch changes and trends to Potentially identify and plan for an economic downturn. To counteract economic risk, save as much money as possible to maintain a steady cash flow. Also, operate with a lean budget with low overhead through all economic cycles as part of your business plan.Risk Meaning, Types. Risk Analysis In Capital Budgeting 15 2. Compliance Risk: Business owners face an abundance of laws and regulations to comply with. For example, recent data protection and payment processing compliance could impact how you handle certain aspects of your operation. Staying well versed in applicable laws from federal agencies like the Occupational Safety and Health Administration (OSHA) or the Environmental Protection Agency (EPA) as well as state and local agencies can help minimize compliance risks. Non-compliance may result in significant fines and penalties. Remain vigilant in tracking compliance by joining an industry organization, regularly reviewing government agency information and seeking assistance from consultants who specialize in compliance. 3. Security and Fraud Risk: As more customers use online and mobile channels to share personal data, there are also greater opportunities for hacking. News stories about data breaches, identity theft and payment fraud illustrate how this type of risk is growing for businesses. Not only does this risk impact trust and reputation, but a company is also financially liable for any data breaches or fraud. To achieve effective enterprise risk management, focus on security solutions, fraud detection tools and employee and customer education about how to detect any potential issues. Financial Risk: This business risk may involve credit extended to customers or your own company’s debt load. Interest rate fluctuations can also be a threat. Making adjustments to your business plan will help you avoid harming cash flow or creating an unexpected loss. Keep debt to a minimum and create a plan that will start lowering that debt load as soon as possible. If you rely on all your income from one or two clients, your financial risk could be significant if one or both no longer use your services. Start marketing your services to diversify your base so the loss of one won't devastate your bottom line. Reputation Risk: There has always been the risk that an unhappy customer, product failure, Negative press or lawsuit can adversely impact a company's brand reputation. However, social media has amplified the speed and scope of reputation risk. Just one negative tweet or bad review can decrease your customer following and cause revenue to plummet. To prepare for this risk, leverage reputation management strategies to regularly monitor what others are saying about the company online and offline. Be ready to respond to those comments and help address any concerns immediately. Keep quality top of mind to avoid lawsuits and product failures that can also damage your company's reputation.i 16 Risk Management and Dervatia: 6. Operational Risk: This business risk can happen internally, externally or involve , } 1 combination of factors. Something could unexpectedly happen that causes you to jog, business continuity. That unexpected event could be a natural disaster or fire that damages or destroys you | physical business. Or, it might involve a server outage caused by technical problems, People, or power cut. Many operational risks are also people-related. An employee might make Mistakes that cost time and money. Whether its a people or process failure, these operational risks can adversely impact you, business in terms of money, time and reputation. Address each of these potential operational risks through training and a business continuity plan. Both tactics Provide a way to think about what could go wrong and establish a backup system or proactive measures to ensure operations | aren't affected. _ MEANING AND_DEFI Meaning Risk management can be defined in many ways. For example, Anderson and Terp (2006) | maintain that basically, risk management can be defined as a process that should seek to eliminate, reduce and control risks, enhance benefits, and avoid detriments from speculative exposures. The objective of risk management is to maximize the potential of success and | minimize the probability of future losses. Risk that becomes problematic can negatively affect | cost, time and quality and system performance. _ the development of derivatives markets’. : Risk management is the process to manage the potential risks by identifying, analyzing and addressing them. The process can help to reduce the negative impact and emerging copportunitis: The outcome may help to mitigate the likelihood of risk occurring and the negative impact whenit happens aisk Meaning, Types. Risk Analysis In Capital Budgeting 7 Risk management involves identifying, measuring, monitoring and controlling risks. The process is to ensure that the individual clearly understands risk management and fulfils the business strategy and objectives. Probability is the likelihood of an event occurring, and severity is the extent and cost of the resulting loss. The extent of a risk can be expressed as follows: Risk = Probability x Severity In broad terms, risks may be broken down into two categories: Pure Risk - Risks where the possible outcomes are either a loss or no loss. It includes things like fire loss, a building being burglarized, having an employee involved in a motor vehicle | accident, ete Speculative Risk - Risks where the possible outcomes are either a loss, profit, or status quo. It includes things like stock market investments and business decisions such as new product lines, new locations, etc. . ca ‘There are many reasons to manage risk. Some of them include: a. Saving resources: people, income, property, assets, time. b. Protecting public image. c. Protecting people from harm. d. Preventing/reducing legal liability. e. Protecting the environment. | PURPOSE OF RISK MANAGEMENT = Haba hss Se IDENTIFY ASSESS J ANALYZE “ee ; _— MANAGEMENT => a Ri REDUCE tT CONTROLRisk Management and Derivatives The purpose of Risk Management is 4. Identify: Identify the probabilty and impact of positive events (opportunites) n business m to decrease the probability and impact of adverse events (threats) to business Objectives, 2. Assess: Assess whether the company is achieving strategic and corporate objectives along with meeting statutory and legal obligations. 3. Analyse: Analyse opportunities associated with risk to suggest the management to be pro. active. 4. Control: Control the loss of capital invested in the business along with maximum Utilization of resources. 5. Reduce: Reduce the financial and other negative consequences of losses and claims, 6. Transfer: Transfer the risk from the risk averse people to the risk bearers at a cost, These risk bearers are the hedgers. USES OF RISK MANAGEMENT Risk Management practices are widely used in public and the private sectors, Covering a wide range of activities or operations. These include: a) Finance and Investment. b) Insurance. ©) Health Care. d) Public Institutions. e) Governments. Risk Management is important due to the following reasons: a) Increase probability of positive event. b) Reduce the occurrence of negative event. c) A project manager's work should not focus on dealing with problems; it should focus on preventing them._—_—_ psk Meaning, Types. Risk Analysis In Capital Budgeting 9 g) Performing risk management helps prevent many problems and helps make other problems less likely. e) Enhances regulatory compliance requirements. f) Assists in audit preparation. 9 Reducing risk creates greater confidence in the activities - encourages people to participate. h) Gives managers the confidence to make decisions about how to manage risk to an acceptable level. i) Creates effective planning and preparation with appropriate and adequate resource allocation j) Enables contingency plans to deal with the consequences. OBJECTIVES OF RISK MANAGEMENT ‘A primary objective of risk management is to identify and to manage individual and management risk. Other important objectives are: (i) To concentrate on initial investment and underwriting Investment decisions are supported by appropriately documented research and analysis and made in accordance with company and client guidelines and objectives, Appropriate recommendations and approvals are obtained to authorize investment decisions (ii) To focus on credit monitoring Investment agreement terms and covenants are monitored for adherence and reported on an on-going basis. Changes to investment terms, if any, are approved in accordance with documented limits. Credit risk and investment quality is timely monitored, appropriately categorized and rated. Periodic reviews, including collateral security reviews, are performed timely, appropriately documented and results are reported. Remedial action or restructuring plans for loans identified as especially mentioned or Watch List are appropriate, timely developed, authorized and reported to the Quarterly Loan Review Committee. To manage the investment portfolio monitoring Investment positions and transactions are monitored against company policies and limits and client investment guidelines and objectives. Exceptions of noncompliance are properly reported, escalated to senior management and the resolution is properly authorized. Third-party investments acquired are allocated to investment accounts on a reasonable and fair basis,(iv) To ensure trading transactions Trading transactions for publics are accurate, complete and property authorized, (v) Valuation and Pricing Public's portfolios are accurately valued using independent sources on a timely ba Teported to senior management. Discrepancies are researched and resolved timely, p, valuation of private investments is appropriate and documented. SiS ang Tivates, (vi) Performance Monitoring Performance measurement, ranking and attribution analysis is regularly Performed, TeVieweg reported and approved. , (vii) Policies, Procedures, Authorities and Responsibilities Policies, procedures, authorities and responsibilities are clearly defined and communicated, Employees have the necessary knowledge, information and tools to manage relevant tisks = ‘support the achievement of the business unit's objectives. | viii) Management Information Management information is sufficient and timely. Performance is monitored against large and indicators. Follow-up procedures are established and performed. Risk plays a very important role in business for the following benefits 1. Effective use of resources. 2. — Promoting continuous improvement. 3. Fewer shocks and failures. 4. — Strategic business planning 5. Raised awareness of significant risks. 6. Quick grasp of new opportunities. 7. Enhancing communication. 8. Reassuring stakeholders. 9. Focus on internal audit programme. 10. Recognition of responsibility and accountability.isk Meaning, Types. Risk Analysis In Capital Budgeting a Risk management is a proactive, continuous process that identifies, measures and manages those risks, 42. Enables decision making as to whether a risk is acceptable or requires further action. 43, Toavoid, reduce or prevent risk from imposing negative consequences. 14, Projects and programs achieve better results. 45, Process leads to effective decision making. 46, Provides valuable decision making information. 47, Assists in clearly defined insurance needs. 48. Enhances regulatory compliance requirements. 49. Assists in audit preparation, 20. Reducing risk creates greater confidence in your activities - encourages people to participate. Risk is inevitable in the organisation. The organisation should undertake study on the risk faced by the business. After the data-gathering phase that sets the foundation for risk management, professionals must move into setting the scope, purpose, context and limitations of risk assessment itself. Whether managing the risks associated with a task, a process or an entire facility, the purpose and scope of the assessment must remain top of mind. Having a clear understanding of the specific goals and objectives will help guide the assessment, establish roles and responsibilities for stakeholders, and bring focus to the process. The purpose and scope of the risk assessment must be aligned with the organization's risk management process that takes into consideration both internal and external factors that affect safety and business performance. Within that framework, one then identifies the objectives and decisions that need to be made as an output of the risk assessment. This informs the selection of specific risk assessment tools and techniques and the resources (e.g. time, people, data) required to complete the assessment. Note that it is equally as important to identify aspects that are out of scope as it is to define what is within the scope of a risk assessment. Doing so helps focus the assessment on the objectives and minimizes wasted effort. Once the purpose and scope are established, they must be clearly communicated and well understood by those involved in carrying it out to ensure the assessment proceeds efficiently and effectively. In addition, it is also important for the scope to be reviewed when conducting the risk assessment and revised as necessary as the process moves forward.= z RiskManagementang Dane oo.) - When conducting a risk assessment, safety profe: lals must work with Stakeh, ol establish criteria for the consequence of the risks present and whether those are in tine i. Goals and objectives ofthe assessment. Having an organization specif set ocitrig ‘om fh against is a powerful tool for evaluating operational risk and making effective Tisk-baseq pee ns, “An organization must carefully consider appropriate risk criteria to Serve its specific n and attain desired results,” says Georgi Popov, Ph.D., QEP, SMS, ARM, CMC, eed : aa - * Professor int safety sciences program at the University of Central Missouri and Member Of ASSP, Ris IS) Assessment Committee. “The basis for developing risk criteria consists of determining and defining the key elemen to be used including consequences, likelihood, risk levels, risk acceptability, risk treatments combined tisk,” says Popov. “Safety professionals should select a method that allows stakeholders to consistently and effectively assess, measure and achieve acceptable risk levels" Delving further into each element, safety professionals and stakeholders ShOUId ask th following questions when examining risk criteria: () Consequences: What consequences could this risk have on worker Safety and health, the environment, business interruption, Teputation and legal and regulatory, requirements? (ii) Likelihood: How probable is this risk to cause one of the identified consequences? (iii) Risk levels: How are we Measuring and comparing risks in order to score and prioritize them? (@¥) Risk acceptability: Whatis the acceptable level of risk based on our culture and objectives, as well as industry, legal and regulatory requirements? (v) Risk treatment: What measures are required to achieve acceptable risk? (vi) Combined risks: How will we account for ‘combinations of risks? Risk 9 _ By answering these questions and working from the organization's established risk criteria, risks can then be scored and prioritized. Risk Scoring has traditionally been based on a two-factor calculation involving the likelihood of occurrence and the severity of the consequences. In recent years, other factors such as failure detectability, frequency and control effectiveness have entered the equation.Risk Meaning, Types. Risk Analysis In Capital Budgeting 23 Tools such as a risk assessment matrix, failure mode and effects analysis and risk heat maps can help safety professionals further examine the potential likelinood and consequences associated with the identified risks and hazards. Risk scoring can be divided into one of three categories: () Qualitative Risk Assessment - based on subjective definitions with descriptive words for risk factor levels (i) Semi-Quantitative Risk Assessment - using qualitative data with numerical values used to develop a risk score (iil) Quantitative Risk Assessment - using organizational data to assign a numerical value to predict the probability of an incident Which method you select depends on the availability of data and resources, as well as the complexity and level of detail with which the assessment will be carried out. It should be noted that conducting a truly quantitative assessment can be challenging because the statistical data needed to complete a quantitative analysis is often difficult to obtain. As noted, the data you gather by establishing risk criteria and risk scoring will provide valuable insight into the current level of risk that employees are facing in a facility or when performing a particular task or process. An organization's level of risk tolerance depends on several factors including its objectives, culture, regulatory requirements and available technology, and it is crucial that stakeholders understand and agree on what is an acceptable risk level. _ ADVANTAGES OF RISK MANAGEMENT IN BUSINESS es 1. _ Identification of Risk involved in the business. 2. Categorizing the risk based on its priority of adverse effect to the business. 3. Prepares the company to manage the adverse effects. 4. Determine the likelihood of occurring of the event and come out with solutions for the same. 5. Impact of risk is predetermined and action plan for proceeding further induces lots of preparedness in business.nt Risk Management ang Orig, DISADVANTAGES OF RISK MANAGEMENT IN BUSINESs, 4. Risk is involved in every activity. When the probability of occurrence is less it jg oe move on instead of restraining the investment plans. to 2. Risk Assessment quality is subjective and lacks consistency. 3. Useful resources can be, more profitably used rather than spending on assessing : : : if managing unlikely risk. PROCESS OF RISK MANAGEMENT a The process of risk management involves the following steps: 1, Establish the Context The purpose of this stage of planning enables to understand the environment in which the respective organization operates, that means to thoroughly understand the external environment and the intemal culture of the organization. The analysis is undertaken through: establishing the strategic, organizational and risk management context of the organization and identifying the constraints and opportunities of the operating environment. The establishment of the context, ‘and culture is undertaken through a number of environmental analyses that include, e.g., a review of the regulatory requirements, codes and standards, industry guidelines as well as the relevant corporate documents and the previous year's risk management and business plans. Methods to assess the environmental analysis are SWOT (Strength, Weaknesses, Opportunities and Threats) and PEST (Political, Economic, Societal and Technological) frameworks. By establishing the context, the organization defines the parameters to be taken into account when managing risk, and sets the scope and risk criteria for the remaining process. This process needs to be considered in greater detail and particularly how it relates to the scope of the particular risk management process. Standards Australia and Standards New Zealand (2004) provides a five-step process to assist with establishing the context within which risk should be identified: a) The external context: |s the external environment in which the organization seeks to achieve its objectives. b) The internal context: The internal environment in which the organization seeks to achieve its objectives.isk Meaning, Types. Risk Analysis In Capital Budgeting 25 ) The risk management context: Defines the objectives, strategies, scope and parameters of the activities of the organization or those parts of the organization where the risk management process is being applied or should be established. d) Develop risk evaluation criteria: The organization should develop criteria that should be used to evaluate the significance of risk and define acceptable levels of risk for a specific activity or event and decide what is unacceptable. @) Define the structure of risk analysis: |solate the categories of risk which are managed. The structure will provide greater depth and accuracy in identifying significant risks. 2. Risk Identification SSS = Risk identification is the basic step of risk management. This step reveals and determines the potential risks which are highly occurring and other events which occur very frequently. Risk is investigated by looking at the activity of organizations in all directions and attempting to introduce the new exposure which will arise in the future from changing the internal and external environment. Correct risk identification ensures risk management effectiveness. Using the information gained from the context, particularly as categorized by the SWOT and PEST frameworks, the next step is to identify the risks that are likely to affect the achievement of the goals of the organization, activity or initiative. It should be underlined that a risk can be an opportunity or strength that has not been realized. Key questions that may assist your identification of risks include: a) For us to achieve our goals, when, where, why and how are risks likely to occur? b) What are the risks associated with achieving each of our priorities? c) What are the risks of not achieving these priorities? d) Who might be involved (for example, suppliers, contractors, stakeholders)? The appropriate risk identification method will depend on the application area (i.e. nature of activities and the hazard groups), the nature of the project, the project phase, resources available, regulatory requirements and client requirements as to objectives, desired outcome and the required level of detail. The use of the following tools and techniques may further assist the identification of risks: a) Examples of possible risk sources, b) Checklist of possible business risks and fraud risks, ©) Typical risks in stages of the procurement process,- Risk Management and Dative, d) Scenario planning as a risk assessment tool, e) Process mapping and f) Documentation, relevant audit reports, program evaluations and / or research reports, The identification of the sources of the risk is. the most critical stage in the risk 8sessmen, process, The sources are needed to be managed for pro-active risk management. The better he understanding of the sources, the better the outcomes of the risk assessment process, and the more meaningful and effective will be the management of risks. Key questions to ask at this stage of the risk assessment process to identify the impact o the risk are: a) Whyis this event a risk? b) What happens if the risk eventuates? c) How can it impact on achieving the objectives/outcomes? Risk identification of a particular system, facility or activity may yield a very large number of | potential accidental events and it may not always be feasible to subject each one to detailed quantitative analysis. In practice, risk identification is a screening process where events with low or trivial risk are dropped from further consideration. | However, the justification for the events not studied in detail should be given. Quantification is then concentrated on the events which will give rise to higher levels of risk. Fundamental methods such as Hazard and Operability (HAZOP) studies, fault trees, event tree logic diagrams and Failure Mode and Effect Analysis (FMEA) are tools which can be used to identify the risks and assess the criticality of possible outcomes. S.Riskanalysié Risk analysis is concerned with assessing the potential impact of exposure and likelihood of the particular outcome actually occurring. The impact of exposure should be considered under the elements of time, quality, benefit and resource. This step determines the probabilly and consequences of a negative impact and then estimates the level of risk by combining the probability and consequences (Standards Australia and Standards New Zealand, 2004). Risk analysis involves the consideration of the source of risk, the consequence and likelihood to estimate the inherent or unprotected risk without controls in place. It also involves identification of the controls, an estimation of their effectiveness and the resultant level of risk with controls in place (the protected, residual or controlled risk). Qualitative, semi-quantitaive and oyRisk Meaning, Types. Risk Analysis In Capital Budgeting a7 quantitative techniques are all acceptable analysis techniques depending on the risk, the purpose ofthe analysis and the information and data available, Often qualitative or semi-quantitative techniques can be used for screening risks whereas higher risks are being subjected to more expensive quantitative techniques as required. Risks can be estimated qualitatively and semi-quantitatively using tools such as hazard matrices, risk graphs, risk matrices or monographs but noting that the risk matrix is the most common. Applying the risk matrix, it is required to define for each risk its profile using likelihood and consequences criteria. Replica of Risk Matrix Using the consequence criteria provided in the risk matrix, one has to determine the consequences of the event occurring with current controls in place. To determine the likelihood of the risk occurring, one can apply the likelihood criteria again contained in the risk matrix. As before, the assessment is undertaken with reference to the effectiveness of the current control activities. To determine the level of each risk, one can again refer to the risk matrix. The risk level is identified by intersecting the likelinood and consequence levels on the risk matrix. Complex risks may involve a more sophisticated methodology. For example, a different approach may be required for assessing the risks associated with a significantly large procurement. 4. Risk evaluation _ Before determining the probability, it is essential to consider risk tolerance. The organizations will consider “risk appetite” along with the amount of risk they are willing to take and decide upon acceptable or unacceptable risk. The acceptable level of risk depends upon the degree of voluntaries. Risk evaluation is important for making sense in specific situations and Provides adequate material for decision making. This step is about deciding whether risks are acceptable or need treatment. Once the risks have been analysed they can be compared against the previously documented and approved tolerable risk criteria. When using risk matrices this tolerable risk is generally documented with the risk matrix. Should the protected risk be greater than the tolerable tisk then the specific risk needs additional control measures or improvements in the effectiveness Of the existing controls.Risk M: 28 lanagement and Doria ‘| The decision of whether a risk is acceptable or not acceptable is taken by the — ] manager. A isk may be considered acceptable if for example: nt = The risk is sufficiently low that treatment is not considered cost effective, -Atreatment is not available, e.g. a project terminated by a change of government, - Asufficient opportunity exists that outweighs the perceived level of threat, If the manager determines the-level of risk to be acceptable, the risk may be accepted no further treatment beyond the current controls. Acceptable risks should be monitoreg an periodically reviewed to ensure they remain acceptable. The level of acceptability can be organizational criteria or safety goals set by the authorities. 5. Risk treatment Risk treatment involves selecting and implementing one or more options for treating tisk, ‘Standards Australia and Standards New Zealand (2004) offer the following Options for risk treatment: avoid risk, change the likelihood of occurrence, change the consequences, share tisk and retain risk (residual risk may be retained if it is at an acceptable level), An unacceptable risk requires treatment. The objective of this stage ofthe risk assessment Process is to develop cost effective options for treating the risks. Treatment options which are not necessarily mutually exclusive or appropriate in all circumstances are driven by outcomes that include: a) Avoiding the risk. b) Reducing or mitigating the risk. c) Transferring or sharing the risk. 4) Retaining or accepting the risk. e) Avoiding the risk. f) Not undertaking the activity that is likely to trigger the risk. Factors to consider for this risk treatment ‘strategy include: 1. Can the likelihood of the risk occurring be reduced? (through preventative maintenance, 0 quality assurance and management, change in business systems and processes), Of 2. Can the consequences of the event be reduced? (through contingency planning, minimizn exposure to sources of risk or separation/relocation of an activity and resources).Risk Meaning, Types. Risk Analysis In Capital Budgeting 29 Transferring the risk totally or in part - This strategy may be achievable through moving the responsibility to another party or sharing the risk through a contract, insurance, or partnership/ joint venture. However, one should be aware that a new risk arises in that the party to whom the risk is transferred may not adequately manage the risk! Retaining the risk and managing it - Resource requirements feature heavily in this strategy. The next step is to determine the target level of risk resulting from the successful implementation of the preferred treatments and current control activities. The intention of a risk treatment is to reduce the expected level of an unacceptable risk. Using the risk matrix one can determine the consequence and likelihood of the risk and identify the expected target risk level. Monitoring and review is an essential and integral step in the risk eae process. Risk needs to be monitored to ensure the changing environment does not alter risk priorities and to ensure the risk management process is effective both in design and in operation. The organization should review at least on an annual basis. The process of risk management illustrates cyclical nature of the process. It should be an integral of management. It includes: 1. It is important to understand that the concept of risk is dynamic and needs periodic and formal review. 2. The currency of identified risks needs to be regularly monitored. New risks and their impact on the organization may to be taken into account. 3. This step requires the description of how the outcomes of the treatment will be measured. Milestones or benchmarks for success and waming signs for failure need to be identified. 4, The review period is determined by the operating environment (including legislation), but as a general rule a comprehensive review every five years is an accepted industry norm. This is on the basis that all plant changes are subject to an appropriate change process including risk assessment. 5. The review needs to validate that the risk management process and the documentation is still valid. The review also needs to consider the current regulatory environment and industry practices which may have changed significantly in the intervening period. 6. The organization, competencies and effectiveness of the safety management system should also be covered. The plant management systems should have captured these changes and the review should be seen as a ‘back stop’.\ y Risk Management and Derivaty ey 30 7. The assumptions made in the previous risk assessment (hazards, likelihood consequence), the effectiveness of controls and the associated management system as as people need to be monitored on an on-going basis to ensure risk are infact controteg the underlying criteria. 8. For an efficient risk control the analysis of risk interactions is necessary This ensures thy the influences of one risk to another is identified and assessed. Usual method for thy purpose is a cross impact analysis, Petri nets or simulation tools. A framework needs tobe in place that enables responsible oficers fo report onthe flying aspects of risk and its impact on organizations’ operations: a) What are the key risks? b) _Howare they being managed? ©) Are the treatment strategies effective? — If not, what else must be undertaken? d) 7. Communication and reporting Clear communication is essential for the risk management process, i.e. clear communication of the objectives, the risk management process and its elements, as well as the findings and Are there any new risks and what are the implications for the organization? required actions as a result of the output. Risk management is an integral element of organizations management. However, for it successful adoption it is important that in its initial stages, the reporting on risk management i visible through the framework. The requirements on the reporting have to be fixed in a qualified an documented procedure. Documentation is essential to demonstrate that the process has been systematic, th methods and scope identified, the process conducted correctly and that it is fully auditable Documentation provides a rational basis for management consideration, approval an implementation including an appropriate management system. A documented output from the above sections (risk identification, analysis, evaluation ar controls) is a risk register for the site, plant, equipment or activity under consideration. Th document is essential for the on-going safe management of the plant and as a basis { communication throughout the client organization and for the ‘on-going monitor and revi Processes. It can also be used with other supporting documents to demonstrate regulate compliance.-_ © isk Meaning, Types. Risk Analysis In Capital Budgeting nun -ROLE OF RISK MANAGEMENT IN BUSINESS In order to achieve its objectives, the organization has to take risks. It is the same in the case of individuals who are looking to earn a good return in the financial market. They need to take some risk to enjoy good returns on their investments. Hence, the organizations or individuals who take risk on investments should not only manage the crises that come up but should also actively manage the potential opportunities that offer them with a competitive advantage. Risk taking and risk management are the very essence of an organization's growth and survival. Every decision ‘one makes should take into account the risk factor involved in the process. Itis best to use formal risk analyzing techniques to ascertain the risk and this helps greatly in taking wise decisions. Effective risk management — or as the Danish professionals say risikostyring — helps in improving the performance of an organization against the set objectives by contributing to: a) b) °) d) °) 9 9) hy Fewer unwelcome surprises and sudden shocks. Resources will be used more efficiently. Less wastage. Less fraud. Improving the service delivery. Lowering the time management spent in fire-fighting. Better management of maintenance and contingent activities. Cost of capital will be reduced. Better and improved innovation. Any change initiatives will be implemented effectively. Focusing more on doing the right things internally. Focusing more on shaping effective strategies externally. The above-mentioned benefits of risk management are applicable to organizations in both Public and private sectors. The private sector companies resort to management of risk to mainly focus on the investment made by shareholders and for preserving the share value. On the other side, the organizations in public sector conduct the process to perform cost management effectively in line with the government policies and legislationRisk Management and = 2 MENT/ANALY: TECHNIQUES OF RISK MANAGEMENT/A| of methods used for determining the level of risk of our business, The There are three kinds methods can be: 1. Qualitative Methods ee This is the kind of risk analysis method most often used for decision making in business Projects; entrepreneurs base themselves on their judgment, experience and intuition for decision making. These methods can be used when the level of risk is low and does not warrant the time and resources necessary for making a full analysis. These methods are also used when the numerical data available are not adequate for a more quantitative analysis that would serve as the basis for a subsequent and more detailed analysis of the entrepreneur's global risk. The qualitative methods include: a) Brainstorming. b) Questionnaire and structured interviews. c) Evaluation for multidisciplinary groups. d) Judgment of specialists and experts (Delphi Technique). Word classifications are used, such as high, medium or low, or more detailed descriptions of likelihood and consequences. These classifications are shown in relation to an appropriate Scale for calculating the level of risk. We need to give careful attention to the scale used in order to avoid misunderstandings or misinterpretations of the results of the calculation.Risk Meaning, Types. Risk Analysis In Capital Budgeting 33 Quantitative Methods Quantitative methods are considered to be those that enable us to assign values of occurrence to the various risks identified, that is, to calculate the level of risk of the project. Quantitative methods include: () Analysis of likelihood. (i) Analysis of consequences. (ii) Computer simulation. The development of these measurements can be effected by means of different mechanisms, among which we note particularly the Monte Carlo Method, which is characterized by: a) Abroad vision in order to show a range of possible scenarios. b) Simplicity in putting it into practice. c) Suitable for performing computer simulations. GENERAL RISK MANAGEMENT GUIDELINES - ee as 4. All human activity involving technical devices or complex processes entails some element of risk. 2. Hazards can be controlled; they are not a cause for panic. Problems should be kept in perspective. 3. Judgments should be based upon knowledge, experience and mission requirements. 4. Encouraging all participants in an operation to adopt risk management principles both reduces risk and makes the task of reducing it easier. 5. Good analysis tilts the odds in favour of safe and successful operation. 6. Hazard analysis and risk assessment do not replace good judgment: they improve it. 7. _ Establishing clear objectives and parameters in risk management works better than using a cookbook approach. 8. Noone best solution may exist. Normally, there are a variety of alternatives, each of which may produce a different degree of risk reduction. 9. Tactis essential. It is more productive to show a mission planner how he can better manage risk than to condemn his approach as unworkable, risky, unsafe or unsound.a Risk Management and Der; Nati, 10. Seldom can Complete safety be achieved. 11. There are No “safety problems” in planning or design, only management Problems that may Cause accidents, if left unresolved. RISK MANAGEMENT RESPONSIBILITIES Managers @) Are responsible for effective Management of risk b) Select from risk reduction options recommended by staff. ©) Accept or reject risk based upon the benefit fo be derived, d) Train and motivate Personnel to use risk management techniques. ©) Elevate decisions to a higher level when it is appropriate, Staff @) Assess risks and develop risk reduction allematives, 5) Integrate risk controls into plans and orders, ©) Identify unnecessary tisk controls, Supervisors @) Apply the risk management process >) Consistently apply effective risk management Concepts and methods to operations and tasks, c) Elevate risk issues beyond their control or authority to superiors for resolution. Individuals @) Understand, accept and implement risk management Processes, b) Maintain a constant awareness of the Changing risks associated with the operation or task. Cc) Make supervisors immediately aware of any unrealistic ri procedures. isk reduction measures or high-risk SERMPIELES QF RISK Risk management enables leaders to distinguish between and among alternative actions, assess capabilities and prioritize activities and associated resources by understanding risk and its impact on their decisions. Risk management should enhance an organization's overall decisionisk Meaning, Types. Risk Analysis In Capital Budgeting 35 making process and maximize its ability to achieve its objectives. Risk management is used to shape and control risk, but cannot eliminate all risk. The key, principles for effective risk management include: Unity of Effort 2. Transparency © 3. Adaptability ‘A description of each principle follows: 4. Unity of Effort Risk management efforts should be coordinated and integrated among all partners, with shared or overlapping risk management responsibilities, to include Federal, state, local, tribal, and and territorial governments, as well as the private sector, non-governmental organizations, international partners. 2. Transparency Transparency is vitally important in risk management due to the extent to which the decisions involved affect a broad range of stakeholders. Transparency is important for the analysis that contributes to the decision making. It includes the assumptions that supported that analysis, the uncertainty involved with it, and the communications that follow the decision. Risk management should not be a “black box” exercise where analysis is hidden. Those impacted by a risk management approach should be able to validate the integrity of the approach. This principle does not countermand the times when there is need for security of sensitive or classified it does suggest that the processes and methodologies used for homeland information; however, ion is not. In turn, transparency will security risk management may be shared even if the informati foster honest and realistic dialogue about opportunities and limitations. 3. Adaptability The principle of adaptability includes desi amic and responsive to change. A changing world, filled with adaptive asures that are igning risk management actions, strategies, and processes to remain dyn: adversaries, increased interdependencies, and new technologies, necessitates me: equally adaptable.Risk Management and Derivatives 36 4. Practicality / The principle of practicality pertains to the acknowledgement that tisk management cing | eliminate all uncertainty nor is it reasonable to expect to identify all risks a their likelihoog an consequences. The limitations of managing risk arise from the dynamic nature of threats, vulnerabilities and consequences, as well as the uncertainty that is generally associateg assessing risks. Risk management is an effective and important management practice that shou ' 'ead to better-supported decisions and more effective programs and operations. 5. Customization The principle of customization emphasizes that risk management programs shou tallored to match the needs and culture of the organization, while being balanced with the g; decision environment they support. Id be PECitic | ESSENTIALS OF RISK MANAGEMENT oe Risk management has a firm commitmer 1. int from the accountable officer or Statutory body | board. 2. The risk management framework is integrated with other agency goverance Processes such | as strategic planning, operational planning and executive management functions, | 3. Effective risk management is based on a ‘strong organizational culture and awareness of tisk | at all levels of the agency, which involves encouraging a risk-informed workforce and Culture, 4. Risk management is supported by a program of education, training and development for staff | that is devoted to risk management at key levels in the agency. 5. The risk Management process designates cle: 'esponsibilities, duties and actions, ar Ownership of risk accountabilities, | 1. Risk Assessment Risk assessment is the Process of summarizing a scientific analysis of a particular risk What are the probability and the severity of the adverse outcome?isk Meaning, Types. Risk Analysis In Capital Budgeting v7 2. Risk Management Risk management is the process of identifying and implementing measures which can be applied to reduce risk to an acceptable level and documenting the final import decision. 3, Risk Communication Risk communication is the process by which the results of risk assessment and risk management are communicated to decision-makers and the public. Adequate risk communication is essential in explaining official policies to stakeholders, who are often aware of the risks but not the benefits of importations. Risk communication must also be a two-way process, with the concems of stakeholders being heard by officials and addressed adequately. _» RISK ANALYSIS Maes Risk is the potential that a chosen action or activity including the choice of inaction will lead toa loss an undesirable outcome. The concept implies that a choice having an influence on the outcome exists or existed. Risk analysis refers to the uncertainty of forecasted future cash flows streams, variance of portfolio/stock returns, statistical analysis to determine the probability of a project's success or failure and possible future economic states. Risk analysts often work in tandem with forecasting professionals to minimize future negative unforeseen effects. Example: Commercial banks need to properly hedge foreign exchange exposure of oversees loans while large department stores must factor in the possibility of reduced revenues due to a global recession. Risk analysis allows professionals to identify and mitigate risks, but not avoid them completely. Proper risk analysis often includes mathematical and statistical software programs. RISK ANALYSIS IN CAPITAL BUDGETING Risk analysis in capital budgeting bears a substantial degree of importance in the field of corporate finance. Risk arises in project evaluation because the firm cannot predict the occurrence of possible future events with certainty and hence, cannot make any correct forecast about the cash flows. The uncertain economic conditions are the sources of uncertainty in the cash flows. For example, a company wants to produce and market a new product to their prospective- i Risk Management and Dervatvg, Customers. The demand is affected by the general economic conditions. Demand may be Very high if the country experiences higher economic growth. Every business decision involves risk. Risk arises cs @ the ear Conditions Under which a firm has to operate its activities. Because of the inability oi to an accurate| Cash flows of future operations the firms face the risks of operations. The capital budgeting Proposals are not based on perfect forecast of costs and revenues because the assumptions bout the future behaviour of costs and revenue may change. | SIGNIFICANCE OF RISK ANALYSIS IN CAPITAL BUDGETING The significance of risk analysis in capital budgeting considers the following methods: §) Risk Management: Risk management focuses on factors such as pricing strategy fixe and variable costs sequential investment insurance financial leverage long term arrangements derivatives strategic alliance and improvement of information. ji Sensitivity Analysis: This is also known as a “what if analysis” Because of the uncertainty of the future if an entrepreneur wants to know about the feasibility of a project in Variable quantities for example investments or sales Change from the anticipated value, Sensitivity analysis can be a useful method, This is calculated in terms of NPV or net present value, iil) Scenario Analysis: In the case of scenario analysis, the focus is on the deviation of a ‘umber of interconnected variables. It is different from sensitivity analysis which usually Concentrates on the change in one Particular variable at a specific Point of time. WW) Selection of Project under risk: This involves requirement risk adjusted discount rate method. Procedures such as Payback period judgmental evaluation and certainty equivalent Y) Practical Risk Analysis: The techniques involved include the acceptable overall certainty index margin of Safety in cost fi igures conservative revenue estimation flexible investment yardsticks and judgment on three point estimates, vi) ing terms, vii) Hillier Model: in Particular situations, the anticipated NPV and the standard deviation of NPV can be incurred with the help of analytical derivation. This was first realized by FS.pisk Meaning, Types. Risk Analysis in Capital Budgeting 39 Hillier. There are situations where correlation between cash flows is either complete or nonexistent. vill) Simulation Analysis: Simulation analysis is utilized for formulating the probability analysis for a criterion of merit with the help of random blending of variable values that carry a relationship with the selected criterion. ix) Decision Tree Analysis: The principal steps of decision tree analysis are the definition of the decision tree and the assessment of the alternatives. x) Corporate Risk Analysis: Corporate risk analysis focuses on the analysis of risk that may influence the project in terms of the entire cash flow of the firm. The corporate risk of a project refers to its share of the total risk of a company. comprehensive list of risks and often opportunities as well, organized by risk category (financial, operational, strategic, compliance) and sub-category (market, credit, liquidity, etc.) for business units, corporate functions and capital projects. A wide net is cast to understand the universe of tisks making up the enterprise's risk profile. While each risk captured may be important to management at the function and business unit level, the list requires prioritization to focus senior management and board attention on key risks. This prioritization is accomplished by performing the risk assessment. Assessing risks consists of assigning values to each risk and opportunity using the defined criteria. This may be accomplished in two stages where an initial screening of the risks is performed using qualitative techniques followed by a more quantitative analysis of the most important risks. Risks do not exist in isolation. Enterprises have come to recognize the importance of managing risk interactions. Even seemingly insignificant risks on their own have the potential, as they interact with other events and conditions, to cause great damage or create significant opportunity. Therefore, enterprises are gravitating toward an integrated or holistic view of risks using techniques such as risk interaction matrices, bow-tie diagrams, and aggregated probability distributions.tes Risk MansgementandDeriag,. COMMON RISK ANALYSIS IN PRACTICE The most common risk analysis in practices are: 1. Conservative Estimation of Revenues 2. Safety Margin in Cost Figures 3. Flexible Investment Yardsticks 4. Acceptable Overall Certainty index 5. Judgement on Three-Point Estimates _ : 1. Conservative Estimation of Revenues The revenues expected from a project are conservatively estimated to ensure that the Viability of the projects is not easily threatened by unfavorable circumstances. The capital budgeting systems often have built in devices for conservative estimation. 2. Safety Margin in Cost Figures A good financial manager should know the different levels of sales that can be good or harmful to @ business. Margin of safety is a managerial accounting tool that helps financial managers know how much sales can decrease before a company hits its break even Point, Making business decisions regarding sales without using this tool can put your business in the red. Subtract variable expenses from total sales and divide the resulting figure by total sales to get the contribution margin ratio. Contribution margin refers to the difference between sales and variable expenses. 3. Flexible Investment Yardsticks Flexible Plan Investments is a leading provider of investment risk Management services. The organization should consider the flexible investment yardsticks, The Cut-off point on an investment varies according to the judgement of management about the riskiness of the Project. 4. Acceptable Overall Certainty Index Certainty is perfect knowledge that has total Security from error, or the mental state of being without doubt. Objectively defined, Certainity is total Continuity and validity of all foundational inquiry, to the highest degree of precision. Something is certain only if no skepticism can occu. Some companies calculate what may be called the Overall certainity index, based on a few crucial factors affecting the success of the project.Ee ak Meaning, Types: Risk Analysis In Capital Budgeting at g, sudgement on Three-Point Estimates The three-point estimation technique is used in management and information systems. applications for the construction of an approximate probability distribution representing the outcome of future events, based on very limited information. While the distribution used for the approximation might be a normal distribution, this is not always so and, for example a triangular distribution might be used, depending on the application. In three-point estimation, three figures are produced initially for every distribution that is required, based on prior experience or best-quesses: a= the best-case estimate m= the most likely estimate b=the worst-case estimate. NIQUES FOR RISK ANALYSIS ity Assignment ‘The concept of probability is fundamental to the use of the risk analysis techniques. It may be defined as the likelihood of occurrence of an event. If an event is certain to occur the probability of its occurrence is one but if an event is certain not to occur, the probability of its occurrence is zero. Thus, probability of all events to occur lies between zero and one. The classical view of probability holds that one can talk about probability in a very large number of times under independent identical conditions. Thus, the probability estimate, which is based on a large number of observations is known as an objective probability. But this is of little use in analyzing investment decisions because these decisions are non-repetitive in nature and hardly made under independent identical conditions over time. The another view of probability holds that it makes a great deal of sense to talk about the probability of a single event without reference to the repeatability long run frequency concept. Therefore, it is perfectly valid to talk about the probability of sales growth will reach to 4%, the probability of rain tomorrow or fifteen days hence. Such probability assignments that reflect the state of belief of a person rather than the objective evidence of a large number of trials are called personal or subjective probabilities. 2. Expected Net Present Value Once the probability assignments have been made to the future cash flows, the next step is to find out the expected net present value. It can be found out by multiplying the monetary values Of the possible events by their probabilities. The following equation describes the expected net Present value:42 Risk Management ang Deriy, my Formula: R = ENCF, =y——t C ENPV = 3, (1+k} 1 Where, ENPV is the Expected Net Present Value ENCF, Expected Net Cash Flows is Period + and k is the discount rate, The expecteg rn Cash Flow can be calculated as follows: 4 ; ENCR, = NCF, x Py Whare, NCFy is Net Cash Flow for Jth event in period + and Py. probability of net Cah Foy for Jth even in period t. 3. Standard Deviation Standard deviation is defined as t he Square root of the mean of the Squares of deviations from the mean. The concept of standard deviation was intr important and widely used measures of st earlier methods. Toduced by Karl Pearson's in 1893, it is the Mog, ludying dispersion. It Overcom 'es the defects from the ‘Standard deviation is “the ‘Square root various values from their arithmetic mean, The formula is as follows: Calculating Standard deviation on individual Series under: direct method: 1. Find out the mean of the Series, 2. Find out the deviation of each value from the mean 3. Square the deviations and add up the Squares of the deviations 4. Ap ply the following formula to ascertain the Standard deviation os fee NCalculating Standard deviation in individual Series under Short-cut method: 4, Assume anyone of the values in the Series as an average. 2. Find out the deviation of each value from the assumed average. ‘Add up the deviation from the mean. 4, Square the deviations. 5. Add up the Squares of deviation. 6. Apply the following formula ee Calculating Standard deviation in continuous Series under step deviation method: 4, Find out the mid-value of each group. Multiply the Square of deviation by its frequency. Add up the Products. 2, Assume one of the mid-values as an average. 3. Find out the deviation of each mid-value from the assumed average in terms of class interval. 4, Multiply the deviation by its frequency. 5. Add up the Products. 6. Square the deviation. re 8. 9 Apply the following formula dat N oF 4. Co-efficient of Variation Variance (5?) is a measure of the dispersion of a set of data points around their mean value. |n other words, variance is a mathematical expectation of the average squared deviations from the mean. It is computed by finding the probability-weighted average of squared deviations from the expected value. Variance measures the variability from an average (volatility). Volatility is a4 Risk Managementand, Dea a“ measure of risk, so this statistic can help determine the risk of an investor might take gp hy purchasing a specific security. The Coefficient of variation is a relative measure of standard deviation. It is obtaingg 4 1d expressing it is a percentage. The fol dividing the Standard deviation by the mean an\ . formula is used _ Standard deviation 199 ~ Mean 5. Probability Distribution Approach ; / / ability is for incorporating risk in evaluating capital budgeting proposal over time provides valuable information about the. the probability distribution of possible returns Which, The concept of prob: The probability distribution of cash flows expected value of retum and the dispersion of iy helps in taking accept-reject decision of the investment decision. ‘The application of this theory in analyzing the risk in capital budgeting depends upon the behaviour of the cash flows, being (i) independent or (i) dependent. The assumption that cash tows are independent overtime signifies that future cash flows are not affected by the cash flow in the preceding or following years. When the cash flows in one period depend upon the cash flows in previous periods they are referred to as dependent cash flows. zara Bg | Sensitivity analysis helps a business estimate what will happen to the project if the assumptions and estimates turn out to be unreliable. Sensitivity analysis involves changing the assumptions or estimates in a calculation to see the impact on the project's finances. Sensitivity analysis determines how much an output is expected to change due to changes in a variable or parameter. Sensitivity analysis helps find the optimal levels for inputs. Sensitivity analysis is a statistical tool based on seeing how inputs and parameters affect outputs. Generally each input is changed one at atime to see how it affects output. | While evaluating any capital budgeting project, there is a need to forecast cash flows. The forecasting of cash flows depends on sales forecast and costs. The Sales revenue is a function sales volume and unit selling price. Sales volume will depend on the market size and the firms market share. The NPV and IRR of a project are determined by analyzing the after-tax cash fovs arrived at by combining various variables of project cash flows, project life and discount rate. The behavior of all these variables is very much uncertain. The sensitivity analysis helps in identifying how sensitive are the various estimated variables of the project. It shows how sensitive 54 —_» esi Types. Risk Analysis In Capita Budgeting “s IRR for a given change i . gs NPV OF 9° in particular var i the re als 6 variables. fariables, The more sensitive the NPV, ra : ~ ———— analysis is an analysis that finds out how sensitive an output is to any change in ning wile keeping other inputs constant, ‘This isan analysis of how each of the input variables in a capital budgeting decision such as count rate, cash flows growth rate, tax rate, etc. affects the net present value, IRR or any other cuiput while keeping other variables constant, | 4, Identity the variables which can influence the project's NPV or IRR. 2, Define the underlying relationship between the variables. 3, Analyze the impact of the change in each of the variables on the project's NPV. The Project's NPV or IRR can be computed under following three assumptions in sensitivity analysis. 4. Pessimistic (i.e. the worst), 2. Expected (i.e: the most likely) 3. Optimistic (ie. the best) ‘The sensitivity analysis has the following advantages: i) Itcompels the decision maker to identify the variables affecting the cash flow forecasts which helps in understanding the investment project in totality. ji) Itidentifies the critical variables for which special actions can be taken. li) tquides the decision maker to concentrate on relevant variables for the project. Disadvantages of Sensitivity Analysis The sensitivity analysis suffers from following limitations: | ) The Tange of values suggested by the technique may not be consistent. The terms imistic’ and ‘pessimistic’ could mean different things to different people.a Risk Management and Derivajng, li) It fails to focus on the interrelationship between variables. The study of variability of ong facta, ata time, keeping other variables constant may not make sense. For example, sales Volume may be related to price and cost. One cannot study the effect of change in price keeping quantity constant. SCENARIO ANALYSIS. . | Scenario analysis commonly focuses on estimating what a portflo's value would decrease | to if an unfavorable event, or the "worst-case scenario", were realized. Scenario analysis, involves computing different reinvestment rates for expected returns that are reinvested during the investment horizon. Scenario analysis can also be used to illuminate "wild cards." For example, analysis of the Possibility of the earth being struck by a large celestial object a mete or Suggests that whilst the probability is low, the damage inflicted is so high that the event is much more important threatening than the low probability in any one year alone would suggest. However, this Possibility is usually disregarded by organizations using scenario analysis to develop a strategic plan since it has such over reaching repercussions. Scenario analysis is no substitute for complete and factual exposure of survey error in economic studies. In traditional prediction, given the data used to model the problem, with a reasoned specification and technique, an analyst can state, within a certain Percentage of statistical error, the likelihood of a coefficient being within a certain numerical bound, Scenario analysis evaluates the expected value of a proposed investment or business | activity. The statistical mean is the highest probability event expected in a certain situation. By creating various scenarios that may occur and combining them with the probability that they will occur, an analyst can better determine the value of an investment or business venture and the Probability that the expected value calculated will actually occur. Meaning of Scenario 0 Analysis . Scenario Analysis is the process of estimating the expected value of a Portfolio after a given period of time, assuming specific ic changes in the values of the Portfolio's securities or key factors that would affect security values Such as changes in the interest rate.sek meanings TYPOS: Riek Ane Slameenoe als Ri IMPORTANCE OF SCENARIO. ANALYSIS _ scenario analysis helps companies and investors to measure the expected value of an tment. BY combining this information with probability, analysts can make highly accurate on about the likelihood of realizing the expected value, Comparing the probability myn of an event is equivalent to calculating the risk of an investment and important for the sane reasonit allows you to make better decisions about business and financial investments, There are many different approaches to scenario analysis, but one common method is to determine the high/low spread and standard deviation from daily or monthly returns, then compute the value of the portfolio if each security generated returns two or three basis Points above and pelow this average. This method means the investor or company can ha\ 5 met : ve reasonable certainity that the value of a portfolio will remain within expected Parameters over a given period of time. Scenario analysis allows analysts to plan for their “worst-case scenario.” Being able to quantify the potential costs of a possible outcome is vital in risk management and forming business strategy. Scenario planning can be highly detailed and customized to accommodate any number of variables, such as the flattening of the yield curve or Narrowing spreads. One advantage of scenario analysis is that it is simple to use and very flexible. It can address almost any present or future risk, and can anticipate the impact of future business decisions. However, its major drawback is that it can only consider the impact of risks that are anticipated outputs are entirely limited to paths suggested by the user, and so if you overlook a tisk, it will not be calculated. itis also important to remember that if scenario analysis is based on Probability, there is still potential that the low and high extreme values could occur. This is why scenario analysis is often run alongside risk analysis to determine whether these potential risks are within acceptable tolerance levels. ‘When dealing with complex scenarios over multiple time periods and involving many possible outcomes such as the impact on 1,000 clients of 100 different interest rate permutations scenario analysis can be extremely cumbersome, generating large and complex tables. In such instances, duration analysis can Provide more user-friendly analysis. MULATION ANALYSIS IN CAPITAL BUDGETIN' A simulation is the imitation of the operation of a real-world process or system. The behaviour of a system is studied by generating an artificial history of the system through La - of random numbers. These numbers are used in the context of a simulation model, which is the : fe bjects of mathematical, logical and symbolic representation of the relationships between the object interest of the system,48 Risk Management and Derivatives Risk analysis using Monte Carlo simulation is a useful tool to extend the depth of capitay budgeting and enhancing the investment decision. The deterministic approach has the advantage of simplicity and easy to applied but it has inability to deal with uncertainties, excluding inaccuracies of input data. Overlooking significant interrelationship among the projected variables can distort the results of risk analysis and lead to misleading conclusions. The analyst should take due care to identify the major correlated variables and to adequately provide for the impact of such Correlations in the Simulation. Risk analysis also must amplify the predictive ability of sound models of reality. The accuracy of its predictions therefore can only be as good as the predictive Capacity of the mode} employed. Meaning of $ ulation Analysis Simulation analysis is the use of a mati hematical model to re-create a situation, often repeatedly, So that the likelihood of various outcomes can be more accurately estimated, Definition of Simulation Analysis Simulation may be defined as a technique that imitates the operation of a teal system as it evolves overtime. This is normally done by developing a simulation simulation model usually takes. the form of a set of assumptions about the operation of the System, expressed as mathematically or logical relations between objects of interest in the system, = world model. A A simulation of a system or an organization is the operation of a model or simulator which is. @ representation of the system or organism. The model is amendable to manipulation which would be impossible , too expensive or unpractical to operation of the model can be studied and for it, prope actual system can be inferred. - Shubik Perform on the entity it portrats, The ties concerning the behaviour of the Simulation is the process of designing a model of a Teal system and conducting experiments with this model for the purpose of understanding the behaviour (within the limits imposed by a criterion or set of criteria) for the operation of the system. - Shannon Simulation is a numerical technique for conducting experiments on a digital computer, which involves certain types of mathematical and logical relationships necessary to describe the behaviour and structure of a complex real ~ World system over extended periods of time. - Naylor et al—_ i} NS Types. Risk Analysis In Capital Budgeting — ‘i Risk Meaning, OF SIMULATION ANALYSIS” Step-1: Problem Definition The initial step involves defining the goals of the study and determining what needs to be solved. The problem is further defined through objective observations of the process to be studied. Care should be taken to determine if simulation is the appropriate tool for the problem under investigation. Step-2: Project Planning The tasks for completing the project are broken down into work packages with a responsible parties assigned to each package. Milestones are indicated for tracking progress. This schedule is necessary to determine if sufficient time and resources are available for completion. Step-3: System Definition This step involves identifying the system components to be modeled and the performance measures to be analyzed. Often the system is very complex, thus defining the system requires an experienced simulator who can find the appropriate level of detail and flexibility. Step-4: Model Formulation Understanding how the actual system behaves and determining the basic requirements of the model are necessary in developing the right model. Creating a flow chart of how the system operates facilitates the understanding of what variables are involved and how these variables interact. Step-5: Input Data Collection and Analysis After formulating the model, the type of data to collect is determined. New data is collected andior existing data is gathered. Data is fitted to theoretical distributions. For example the arrival rate of a specific part to the manufacturing plant may follow a normal distribution curve. Step-6: Model Translation ls The model is translated into programming language. Choices range from general purpose nguages such as Fortran or simulation programs such as Arena. Step-7: Verification and Validation Verification i: — set is the process of ensuring that the model behaves as intended, usually by Model FS ' rough animation. Verification is necessary but not sufficient for validation that is a @ verified but not valid. Validation ensures that no significant difference exists ee2 Risk Management and Derivatives between the model and the real system and that the model reflects reality. Validation can be achieved through statistical analysis. Additionally, face validity may be obtained by having the model reviewed and supported by an expert. Step-8: Experimentation and Analysis Experimentation involves developing the alternative model(s), executing the simulation runs and statistically comparing the alternative(s) system performance with that of the real system. Step-9: Documentation and Implementation Documentation consists of the written report and/or presentation. The results and implications of the study are discussed. The best course of action is identified, recommended and justified. ‘Some ofthe applications in real world are given below: 1. Aircraft scheduling 2. Assembly line scheduling 3. _ Bank Teller scheduling 4. Bus scheduling 5. Telephone traffic routine 6. Brand selection 7. Advertising allocation 8. Locating warehouses 9. Job shop scheduling 10. Library operations design scbaieerateania VANTAGES OF SIMULATION ‘Advantages of Simulation are as follows: It is a valuable method of breaking down a complicated system into sub-systems and then study each of these sub-systems individually or jointly with others. i) It can be used to analyze large and complex real world systems that cannot be solved by ii) conventional quantitative techniques models.Risk Meaning, Typ vi isk Analysis In Capital Budgeting 51 Itis useful in solving problems where all values of the variables are not known or Partly kr in advance and there is no easy way to find these values. "Known ‘Simulation may be the only method available when it is difficult to observe the actual reality, Simulation can be used to foresee unknown bottlenecks in Problems where it is difficult to predict or identify bottlenecks. It can be used to study the interactive effect of individual components or variables in order to determine which ones are important. Simulation is flexible and straightforward technique. It is easier to apply than pure analytical methods, vii) Usually data for further analysis can be generated from a simulation model. Agood simulation model can be very expensive. 2. Development of simulation models can be time consuming. 3. . Simulation is not precise and it does not yield an answer but provide a set of system in different conditions. 4. Itdoes not yield optimal solution because it is trail and error approach. 5. Each solution model is unique hence its solution and inferences cannot be transferable to other problem. 6. Solution method of simulation model are not as efficient as other quantitative method. tllustration - 1 Over 100 days period, the dally demand of a certain commodity shows the following frequency distribution pattern. DailyDemand 0 4 2 8 4 8 No.ofdays10 2040 20 6 4 eee and values. i the demi Using the given data, stimulate ten day sequence of the de 44 and77. The two digits random numbers are 67, 84, 01, 77, 90, 14, 15, 74, 44 an> 52 Risk Management and Derivaty, Solution: We will make probability distribution table and assign random numbers. Daily Probability = No. of days Cumulative Prob. | Random No. Assignment Demand Total No. of days ° 10/100 = 0.10 0.10 00-09 1 20/100 =0.20 0.30 10-29 2 40/100 =0.40 0.70 30-69 3 20/100 =0.20 0.90 70-89 | 4 6100 = = 0.06 0.96 90-95 | 5 400 = 0.04 1.00 96-99 | Day Number Generated random demand Generated demand, 1 67 2 | 2 84 3 3 a1 0 4 7 3 5 20 4 6 14 1 7 15 1 8 74 3 9 44 2 10 7 3 Total 2 Average daily demand = 22/10 = 2.2 Answer Mlustration - 2 Bright Bakery keeps stock of a popular brand of cake. Previous experience indicates the daily demand as given here. Daily Demand 0 10 2 30 40 50 Probability 0.01 0.02 0.15 0.50 0.12 0.02 Consider the following sequence of random numbers.a “ Meaning, TYP@S- isk Analysis In Capital 1 53 Budgeting Risk i 56,77, 15, 14, 68, : —_ imulate the demand for the next 10 days. Find out the soe situation a to make 30 cakes every day . Also estimate the daily average lec R.No. 48, 78, 19, 51, Using this sequence, ifthe owner of the bakery ind for the cakes on the basis of stimulate data. demat Solution: ding to the given distribution of demand, the random number coding for various demand Accor levels is shown in table below: Random Number Coding Demand Probability Cum. Prob. Random Number Interval 0 0.01 0.01 00 10 0.20 0.21 01-20 2» 0.15 0.36 21-35 vn 0.50 0.86 36-85, 0 0.12 0.98 26-97 2 0.02 1.00 98-99 The simulation demand for the cakes for the next 10 days is given below. Also given is the stock situation for various days in accordance with the bakery decision of making 30 cakes per day. Determination of Demand and Stock Levels 4 a = 2 78 20 : ° 19 10 oo ‘ 51 30 a 5 = x : 6 7 x ” : 15 10 ‘0 : 14 40 60 9 « . : 10 - , ° 220 Expected demand = 220/10 = 20 units per day—_ Risk Management and Derivatiy, STANDARD DEVIATION | deviation is defined as the Square root of the mean pf the Squares of deviations Standard from the mean. The concept of standard deviation was introduced by Karl Pearson's in 1893. Itis the mos, important and widely used measures of studying dispersion. It overcomes the defects from the earlier methods. Standard deviation is “the square root of the arithmetic mean of the square deviations of various values from their arithmetic mean. Standard deviation is the absolute measures of dispersion of a distribution. The greater standard deviation indicates more variations and less uniformity. The smaller standard deviation indicates less variations and more consistency of a series. The formula is as follows: ‘alculating Standard deviation on individual Series under direct method: 1. Find out the mean of the Series. 2. _ Find out the deviation of each value from the mean. 3. Square the deviations and add up the Squares of the deviations 4. — Apply the following formula to ascertain the Standard deviation AF Calculating Standard deviation in individual Series under Short-cut method: 1. Assume any one of the values in the Series as an average. Find out the deviation of each value from the assumed average. ‘Add up the deviation from the mean. ‘Square the deviations. . ‘ Add up the Squares of deviation. ea Sw Apply the following formulaCalculating Standard deviation in continuous Series under step deviation method: 4. Find out the mid-value of each group. Assume one of the mid-values as an average. 3. _ Find out the deviation of each mid-value from the assumed average in terms of class interval. 4, Multiply the deviation by its frequency. 5, Add up the Products. 6. Square the deviation. 7. Multiply the Square of deviation by its frequency. 8. Add up the.Products. 9. Apply the following formula The advantages of Standard deviation are as follows: 1. Standard deviation is rigidly defined and its value is always a definite figure. 2. Ittakes into account every value in the series. Thus it is based On all the observations of the data. 3. Itis suitable for mathamatical treatment, 4. tis less affected by flactuations of ‘Sampling. The following are the demerits of the Standard deviation: 1. As compared to other measures it is difficult to compute. 2. Itgives more weight to values Which differ greatly from the mean (ie, extreme values) and less weight to values which are nearer to the mean. Suppose the mean of the series is 20, Suppose 40 and 19 are 2 values in the series. The deviation of these values from the mean are 20 and —1. The Squares of the deviations are 400 and 1. Thus the standard deviation Gives, more weight to extreme values. This is the reason why it is not much useful in most @conomic studies.Risk Management and Derivative, Variance is defined as the mean of the Squares of deviation from the mean. It is also calleg mean Square deviation. In order to calculate variance, we must first find out the mean of the series. The deviation of each size from mean is found out. The deviations are Squared and addeq up. The Sum of the Squares of deviations must be divided by the total number of items. The result is the variance. xe N Variance = IMlustration - 1 Calculate the Standard deviation of the following data Age (in years): 23, 27, 28, 29, 30,31, 33, 35, 36, 38 Solution: Calculation of Standard Deviation ‘Age in years d=31 EA 23 8 64 27 4 16 28 3 9 29 -2 4 30 a1 1 31 0 0 33 +2 4 35 +4 16 36 +5 2 38 +7 49 =x = 310 Xd? = 188 al 2 Ss