6-1

Chapter 6(8): Foundations

of Risk Analysis
The essence of risk: A firms expectation about
future profit may not be according to desire. There
may be variation of actual profit (return) from
expected profit (return). In fact, the best that a firm
can reasonably be expected to do is to make some
estimate of the range of possible future costs and
benefits and the relative chances of earning a high or
low profit on the investment. The essence of risk
deals with two states of expectations:
6-2
The essence of risk:
Certainty: Certainty refers to expectations which are
single valued i.e. prospective profits are
represented in terms of a single outcome and not in
terms of a range of alternative possible outcomes.
For example, a firm decides to invest in three-
month treasury bills. By investing in these short-
term treasury bills, the firm can calculate the exact
return that will be received at the end of three
months.
6-3
The essence of risk:
Uncertainty/Risk: The future unknown,
unexpected or undesired event/situation is
termed as uncertainty and the
mathematical/statistical/numerical
expression of chance of occurring that
unknown event is called risk. Sometimes
uncertainty and risk are used as synonym. It
describes an investment whose profit is not
known in advance with absolute certainty.
6-4
The essence of risk:
But for which an array of alternative outcomes
and their probabilities are known. A risky
investment is one for which the distribution
of profits is known that may be estimated on
the basis of either objective or purely
subjective probabilities.
6-5
Alternative investment criteria
1. The maximum return criterion (MRC): To
choose the investment out of all alternatives
that provides the rate of return with perfect
certainty is known as maximum return
criterion. For example, if returns from
investment X is 10% and from investment Y is
12%, then clearly maximum return criterion
prefers investment Y.
6-6
Alternative investment criteria
2. Maximum expected return criterion
(MERC): Expected return is sum of
multiplicative results of possible rate of
return and associated probability of earning
that and the investment offers the highest
expected return choosing that investment is
known as maximum expected return
criterion.
6-7
Alternative investment criteria
The MERC can be applied to uncertain investments
since each investment can be characterized by
single measure of probability and therefore all
investment proposals can be ranked according to
this criterion. For example:
E(Rx) = 0.80X0.30 + 0.20X0.10 = 0.26= 26%
E(Ry) = 0.25X(-0.08) +0.50X0.16+0.25X0.24=12%
E(Rz) = 0.20X0.12+0.30X0.06+0.10X0.09+0.40X(-
0.05)=3.10%
Investment X is chosen according to MERC.

6-8
Alternative investment criteria
3. Maximum expected utility criterion (MEUC):
Utility is the level of satisfaction can be
enjoyed by converting money in term of
goods or services. Generally level of utility
for increasing the conversion of money in
terms of level of goods or services is
decreasing that is called diminishing
marginal utility. This utility theory/concept
recognizes that it is the pleasure or
satisfaction
6-9
Alternative investment criteria
that can be obtained from money, not money
itself, which is more important. The sum of
multiplicative results of utility against
money and respective probability is called
expected utility. According to maximum
expected utility criterion the
investment/asset involves the highest
MEUC is to be chosen.
6-10
Alternative investment criteria
Investment A Investment B
Prob. Profit Utility Prob. Profit Utility
0.50 1000 1.00 0.50 0 0.00
0.50 3000 2.50 0.50 4000 3.00
E(P) 2000 Same 2000
E(U) 1.75 Prefers A 1.50
6-11
Alternative attitudes toward risk
It is convenient for the purpose of the analysis to
distinguish among major categories of investors
such as:
i. Risk averters individuals with concave utility
function/curve (dislike risk). The utility function
is concave if U'(X) 0 and U'' (X) 0.
ii. Risk lovers individuals with convex utility
function/curve (prefer risk). The utility function
is convex if U'(X) 0 and U'' (X) 0.
6-12
Alternative attitudes toward risk
iii. Risk neutral individuals with linear utility
function/curve (indifferent to risk). Linear
utility function U(X), where U(X) = a+bx
(where b >0) hence U'(X) = b> 0 and U'' (X)
= 0.

Problems: 8.2, 8.3, 8.6, 8.10 (a, b & c).