Please explain and show all work Question 2: Risk and Financial Analysis There i
ID: 2719459 • Letter: P
Question
Please explain and show all work
Question 2: Risk and Financial Analysis
There is always uncertainty when we forecast or estimate future revenues and costs. The totality of the uncertainty can roughly be captured as:
UTot = U{UE1, UE2, UI1, UI2, UI3, UIS}
Where:
UTot Constructed estimate of the total uncertainty related to a decision based on typical financial analysis approaches
UE1 Unknown factors not considered in our financial models
UE2 Factors that are known but not incorporated into our financial models
UI1 Factors that are known and incorporated into our financial models that have a known degree of uncertainty surrounding them
UI2 Factors that are known and incorporated into our financial models for which we fail to recognize the full nature of their uncertainty
UI3 Factors that are known and incorporated into our financial models that have little or no uncertainty, but we erroneously assume to have a significant degree of surrounding them
UIS Uncertainty related to the structure of the financial models that we use in out analysis
How will these differing "sources" of uncertainty impact our decision-making ability?
How might we deal with the different forms of uncertainty?
Explanation / Answer
· Uncertainty and risk are not the same thing. Whereas uncertainty deals with possible outcomes that are unknown, risk is a certain type of uncertainty that involves the real possibility of loss. Risks can be more comprehensively accounted for than uncertainty.
· Decision-making under conditions of risk should seek to identify, quantify, and absorb risk whenever possible.
· The quantity of risk is equal to the sum of the probabilities of a risky outcome (or various outcomes) multiplied by the anticipated loss as a result of the outcome.
· A firm's ability to absorb, transfer, and manage risk will often define management's risk appetite; once risks are identified and quantified, decisions may be made as to what extent risky outcomes may be tolerated.
Different forms of uncertainty
Sense-making
• Uncertainty about meaning/ambiguity
• Uncertainty about what might happen (the science)
• Uncertainty about how much impacts matter (values)
• Uncertainty about related decisions
Analysis
• Uncertainty because of physical randomness
• Uncertainty because of lack of knowledge
• Uncertainty about the evolution of future beliefs and values
• Uncertainty about the accuracy of calculations
Induction
• Uncertainty about the appropriateness of descriptive model (how well we have explained the world)
• Uncertainty about the appropriateness of normative model (principles of modelling beliefs and values)
• Uncertainty about depth to which to conduct an analysis