Statistical Techniques for Risk Analysis

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Statistical Techniques for Risk Analysis

Statistical techniques are analytical tools for handling risky investments. These techniques, drawing from the fields of mathematics, logic, economics and psychology, enable the decision-maker to make decisions under risk or uncertainty.

The concept of probability is fundamental to the use of the risk analysis techniques. Hoe is probability defined? How are probabilities estimated? How are they used in the risk analysis techniques? How do statistical techniques help in resolving the complex problem of analyzing risk in capital budgeting? We attempt to answer these questions in our posts.

Probability defined

The most crucial information
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The simulation analysis is an extension of scenario analysis. In simulation analysis a computer generates a very large number of scenarios according to the profitability distributions of the variables. The analysis involves the following steps:

* First, you should identify variables that influence cash inflows and outflows. For example, when a firm introduces a new product in the market these variables are initial investment, market size, market growth, market share, price, variable costs, fixed costs, product life cycle, and terminal variable. * Second, specify the formulae that relative variables. For example, revenue depends on by sales volume and price; sales volume is given by market size, market share, and market growth. Similarly, operating expenses depend on production, sales and variable and fixed costs. * Third, indicate the profitability distribution for each variable. Some variables will have more uncertainty than others, For example, it is quite difficult to predict price or market growth with confidence. * Fourth, develop a computer programme that randomly selects one variable from the profitability distinction of each variable and uses these values to calculate the projects’ net present value. The computer generates a large number of such scenarios, calculates net present values and stores them. The stored values are printed as a profitability distribution of the projects’ values
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