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Risk factors and measurement:

Risk, Uncertainty and Sensitivity Analysis
Prof. Dr. Kalika Bahadur Adhikari
Risk, Uncertainty and Sensitivity Analysis

• Risk and uncertainty are two classes of imperfect knowledge. Risk represents less
imperfection or more perfection in knowledge than uncertainty.
• Under risk, the occurrence of future event can be predicted fairly accurately by
specifying the level of probability.
• When the risk situation prevails it can be said, for instance that the chances of a
hailstone at the time harvesting 5:95 or 20:80 . An a priori risk prevails when
sufficient advance information is available about the occurrence of an event.
• For instance, probability of head or tail occurring is unbiased at coin tossing. On
the other hand, statistical risk can only be predicted on the basis of occurrence of
several observations in the past.
• Mortality rate of insurance companies provides good examples of statistical
risk.
Uncertainty
• While from the economic point of view, uncertainty is undoubtedly the most
important. The occurrence of the event can not be quantified with the
help of probability.
• Thus the future occurrence of an event can not be predicted. A farmer often
finds himself confronted him with such a situation where the knowledge is
incomplete, yet the decision has to be taken. It becomes therefore essential to
formulate some estimates, however, of the most likely event.
• If the future is so uncertain that a farmer does not commit any of his
resources to a production plan, such a decision itself is farmer’s reaction
to the imperfect knowledge situation he is faced with .
• For instance, when a farmer cannot envisage prices except perhaps in
term of some wide ranges rather than one or two figures, it is situation of
uncertainty.
Types of Risk and Uncertainty
1. Economic uncertainty
2. Technological Uncertainty
3. Institutional Uncertainty
4. Biological Uncertainty
5. Personal Uncertainty
1. Economic uncertainty
• Price expected before sowing or at the time of planning
may not be same at the time of implementation and at the
time of harvesting.
• The price may fall far below the expectation or may rise
far above the expectation. For instance, the price of raw
rice is expected to be at least Rs. 2000/qtl fall less than Rs.
1200/qtl.
2. Technological Uncertainty
• The continuous advancement in technology through innovation process is
making the old technology less efficient.
• The technological improvement necessarily implies that the same level
input can now produce larger quantities of the produce.
• Graphically, it can be depicted by an upward shift of the production
function or down ward shift in the isoquant curve.
• The upward shift in the production function signifies that more output can
now be produced at each level of input after technological progress.
• The upward shift of isoquant in the other hand represents that, now it is
possible to produce the level of output by using the less amounts X1 and X2.
3. Institutional Uncertainty
• Institutions like government, banks, etc. may also cause
uncertainties for an individual farmer. For instance, crop tax,
support price, subsidies, etc. may be enforced or withdrawn
without taking an individual farmer into confidence.
• This type of uncertainties may also result in unavailability
resources in appropriate quantities and at the appropriate time
and place..
4. Biological Uncertainty
• Agriculture is being the biological in nature,
this type of risk and uncertainties are quite
common and important
• Heavy rainfall, drought, floods, and
hailstones, etc. are directly or indirectly affect
the production of agricultural commodities by
increasing the incidence of diseases or insects.
5. Personal Uncertainty
• Human being, being the biological in nature may
suffer from several ecological, physical or health
disorder causing the serious problem in planning.
• Similarly, the farm plan may not be executed because
of the mishap in the farmers’ household or in the
permanent labor force.
Safe Guarding against Risk and
Uncertainties
1. Discounting the returns
2. Crop or livestock insurance
3. Forward contract farming
4. Selection of enterprises with low variability of risk
5. Maintenance resources in reserves
6. Flexibility: Time, cost and product
7. Liquidity (crop)and asset management
8. Adjustment to certain available inputs
9. Diversification
Sensitivity Analysis
• Sensitivity analysis is the quantitative process of seeing what change
in the value of dependent variable is consequent on a chosen change
in the value of one or more of the variables that determines it.
• In economic analysis it generally involves considering the effect on
NPV of plausible variations in some of the assumptions made.
• An alternative approach, sometimes used, is to calculate what degree
of variation in the particular variable would, by itself, reduce the
project NPV to zero.
• In addition to its value as information for project assessment,
sensitivity analysis can help to guide project design.
Some ways are:
a. Improving understanding of the nature and workings of the
project, by seeing more clearly how change in one thing affect
others;
b. Increasing expected NPV, by allowing the testing of variations in
the design of the project;
c. Reducing the risk by suggesting areas where particular
precautions should be taken; and
d. Indicating areas needing more investigation to improve
knowledge of the values likely to be taken by significant
variables.
Some Standard Tests
• The price(s) of the main output(s);
• The price(s) of the main inputs(s);
• The volume of demand;
• The level of capacity attained during the build- up period
and to be sustained in the long- run;
• The costs of investment, either as a whole or of specific
items;
• The duration of the investment period; and
• The discount rate.
Government and Risk
• In sometime argued that public sector decision- makers should not be
too preoccupied with avoiding the risk of economic or financial failure
by projects which are otherwise acceptable.
• Guiding economic and social development can not be made risk free
process. Individual and private agencies may be unable to take big
chances, because the failure of one activity could threaten the position
of the whole unit
• Whatever the merit of this pooling argument, it is clear that
government must accept some risk in development. Simply considering
the question carefully can help planners to design projects that are
valuable but less risky than other alternatives.
Government and Risk contd…
• A project that is both better (high NPV) and less risky (however
measured) than an alternative will, of course preferred. Difficulty
arises where a trade- off has to be made between the level of
expected return and level of riskiness.
• It is inevitable that undesired inconsistencies regarding risk- taking
and risk– aversion will appear in the project choices. The rules might
specify the size of projects that should be subject to risk analysis.
• They must also specify that projects should be rejected if the
probability of negative NPV is estimated to be greater than say 20%,
with a different cut- off point (10%) for large projects.
Summary
Despite the frequent application of valuation studies in developing
countries, only a few studies have incorporated risk and uncertainty.
Researchers are using the option value of quantifying the cost
and benefits of the projects. In the light of the following
suggestions are made to enhance the valuation of benefits and costs
under risk and uncertain situations.
• Option price should be considered as the theoretically correct the measure
of project benefits and costs under risk and uncertain situation, and
whenever data availability permits, the analyst should estimate the option
price rather than expected surplus of the project.
• Sensitivity analysis should be carried out as supplementary measure in the
selection of projects under risk and uncertainty.
THANKS