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 today’s 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.

5. 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 Subjective definition.

6. Probability (1)

7. Probability (2) Probability Distribution:  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 Σ 1  Expected Value  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: decision fork 1. Make a choice (or a series of choice) among alternative courses of action (decision fork); chance fork 2. The choice leads to some consequences that depend on come unpredictable event as well as on the choice itself (chance fork).

9. 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

10. Example: Shell Oil corporation EventProbabilityOutcome No oil.60- 90,000$ 10,000 barrels.15+ 100,000$ 20,000 barrels.15+ 300,000$ 30,000 barrels.10+ 500,000$

11. 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! EventPrProfit ($) No Default 0.54,100 Default0.5-60$

12. 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.

13. 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; Standard Deviation:  Statistical Measure = Standard Deviation:  Larger S.D. = Greater likelihood that the profitability would depart greatly from the expected value! = Larger amount of risk!

14. Adjusting the Valuation Model for Risk  Adjusting the Expected Cash Flows for the country risk: With u = risk probability; 0<u<1.  Adjusting the Discount Rate: With k = risk premium

15. 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.

16. 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).