Risk Analysis

1
Lecture 4

• Risk Analysis

2
Invest or not Invest in Developing Countries?

• YES!
• Growing economies
• Increasing investment opportunities
• High revenues.
• NO!
• Default risk
• Volatility and Instability.

3
Which Problems in Investment Decision?

• Too complex to measure
• Many variables (both qualitative and
  quantitative)
• Not common pattern across countries.
• Few and unreliable data
• Unstable patterns and unpredictable change
• UNSURE OUTCOME!
• RISK!

4
Country Risk Analysis Definition

• Businessmen and bankers must make their choices
  based on their analysis, taking into
  consideration how todays choices are likely to
  affect their companies/investment in the future.
  This implies a certain amount of risk.
• Probability of occurrence of negative events that
  will change the profitability of a given
  investment.
• All the additional risks induced by doing
  business abroad, as opposed to domestic
  transitions.

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Risk Probability

• RISK is a hazard or chance of loss
• The bigger the chance of loss, the more risky a
  particular course of action is
• Chance of loss probability of loss
• PROBABILITY measure of the degree of belief that
  an event will occur
• Frequency definition P(A)r/R
• Subjective definition.

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Probability (1)
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Probability (2)

• The Probability Distribution
• ? Invest or not in Sovereign bonds in Argentina
• Possible consequences/events
• The country would default Pr(A) 0.4
• The country would not default Pr(B) 0.6
• 
  S 1
• Expected Value of the Profit/Outcome
• To each possible event corresponds a loss/gain
• The country would default -600,000
• The country would NOT default 1,000,000
• EV 0.6(1,000,000) 0.4(-600,000) 360,000
• EV Pr(B)(Vb) Pr(A)(Va)
• How can we make a decision?

8
The Decision Tree

• A situation involving decision making under
  condition of risk has the following
  characteristics
• Make a choice (or a series of choice) among
  alternative courses of action (decision fork)
• The choice leads to some consequences that depend
  on come unpredictable event as well as on the
  choice itself (chance fork).

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Example Shell Oil corporation

• DECISION do we drill a well in Zambia?
• To make the decision, the firm collects info
  about
• Cost of drilling
• Price of oil
• Geologists report about the likelihood af
  striking oil

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Example Shell Oil corporation
Event Probability Outcome
No oil .60 - 90,000
10,000 barrels .15 100,000
20,000 barrels .15 300,000
30,000 barrels .10 500,000
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The Attitudes Toward Risk (1)

• Invest in
• Russian bonds
• OR invest in US bond
• sure profit 2,000
• Which investment do you prefer?
• It depends on your attitude to risk!

Event Pr Profit ()
No Default 0.5 4,100
Default 0.5 -60
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The Attitudes Toward Risk (2)

• Although one can expect that utility increases
  with monetary gain, the shape of the utility
  function can vary greatly, depending on the
  preferences of the decision maker
• CONCAVE risk averters
• CONVEX risk lover
• LINEAR risk neutral.

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Measure of Risk

• Risk is not easy to measure
• BUT the riskiness of a decision is directly
  related to the dispersion of the prossible
  profits resulting from the decision
• Statistical Measure Standard Deviation
• Larger S.D. Greater likelihood that the
  profitability would depart greatly from the
  expected value! Larger amount of risk!

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Adjusting the Valuation Model for Risk

• Adjusting the Expected Cash Flows for the country
  risk
• With u risk probability 0ltult1.
• Adjusting the Discount Rate
• With k risk premium

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For Tomorrow!

• http//www.trading-safely.com/
• Choose a country
• Ignore the sector option!
• Print and bring to the lesson all the material
  about the country available in the web-page.

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References

• Bouchet, Clark and Groslambert (2003) Country
  Risk Assessment, Wiley finance (chapter 2).
• Mansfield, E. (1993) Managerial Economics.
  Theory, Application, and Cases Norton (Chapter
  13).