Quantifying Risks

One way to quantify a risk is to consider the standard deviation and the coefficient of variation. The standard deviation will measure the values and probabilities for each possible outcome, while the coefficient of variation, which is the ratio of the standard deviation to the expected value, can be used to make a comparison. Based on the data provided below, quantify the risks to the organization by calculating the expected impact of each of the risks, the standard deviation, and the coefficient of variation. Interpret your results in a 1- to 2-page memo to the organization's senior management.

Application Data

You have been asked to assess certain risks of an organization and quantify their potential impact on the organizations profitability. As a result of your inquiry, you have determined that the firm is exposed to two primary risks. One is a commodity price risk, namely the cost of oil, which is a large component of the organizations production costs. The second risk is sovereign risk because the organization maintains significant facilities in another country that is considering imposing new taxes on foreign-owned businesses.

You have further determined that there is a 25% chance that oil prices will increase, which would reduce profits by $25,000. However, there is a 25% chance that oil prices will fall significantly, which would increase profits by $50,000. There is also a 50% chance that oil prices will only fall slightly, improving profits by $5,000. With regard to the sovereign risk, there is a 50% chance that the countrys government will impose a new tax, which would reduce profits by $50,000, and a 50% chance that no change will be made to the tax code.

Quantitatively evaluate this data by calculating the expected impact, the standard deviation, and the coefficient of variation for each risk. What do these statistics tell you about the possible risks?

DATA:

A. Oil Price Risk
	Scenario (S)	Probability (P)	Impact (I)	Prob. X Impact (PI)	(I-EIAS)	(I-EIAS)2	[(I-EIAS)2 x P]
	Oil Price Increase	0.25	25,000	6,250	3,750	14,062,500	3,515,625
	Oil Price Large Decrease	0.25	50,000	12,500	28,750	826,562,500	206,640,625
	Oil Price Small Decrease	0.5	5,000	2,500	(16,250)	264,062,500	132,031,250
	Expected Impact from All Scenarios (EIAS)			$ 21,250
					Variance of Impact (VarI)		342187500
					Standard Deviation of Impact (SDI)		$ 18,498
					Coefficient of Variation of Impact (CVI)		0.9
B. Sovereign Risk
	Scenario (S)	Probability (P)	Impact (I)	Prob. X Impact (PI)	(I-EIAS)	(I-EIAS)2	[(I-EIAS)2 x P]
	New Tax Imposed	0.5	50,000	25,000	28,750	826,562,500	413,281,250
	No New Tax	0.5	0	0	(21,250)	451,562,500	225,781,250
	Expected Impact from All Scenarios (EIAS)			$ 25,000
					Variance of Impact (VarI)		639062500
					Standard Deviation of Impact (SDI)		$ 25,280
					Coefficient of Variation of Impact (CVI)		1.0