Risk Analysis Investment

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Risk Analysis in Investment Appraisal
by Savvakis C. Savvides

Published in “Project Appraisal”,
Volume 9 Number 1, pages 3-18, March 1994

© Beech Tree Publishing 1994
Reprinted with permission

ABSTRACT*

This paper was prepared for the purpose of presenting the methodology and uses of the Monte Carlo simulation technique as applied in the evaluation of investment projects to analyse and assess risk. The first part of the paper highlights the importance of risk analysis in investment appraisal. The second part presents the various stages in the application of the risk analysis process. The third part examines the interpretation of the results generated by a risk analysis application including investment decision criteria and various measures of risk based on the expected value concept. The final part draws some conclusions regarding the usefulness and limitations of risk analysis in investment appraisal. The author is grateful to Graham Glenday of Harvard University for his encouragement and assistance in pursuing this study and in the development of the RiskMaster and Riskease computer software which put into practice the concepts presented in this paper. Thanks are also due to Professor John Evans of York University, Canada, Baher El Hifnawi, Professor Glenn Jenkins of Harvard University and numerous colleagues at the Cyprus Development Bank for their assistance.

*

Savvakis C. Savvides is a Project Manager at the Cyprus Development Bank, a Research Fellow of the International Tax Program at the Harvard Law School and a visiting lecturer on the H.I.I.D. Program on Investment Appraisal and Management at Harvard University.

CONTENTS

I. INTRODUCTION .............................................................................................................1 Project uncertainty ..........................................................................................................1 II. THE RISK ANALYSIS PROCESS .................................................................................2 What is risk analysis? ......................................................................................................2 Forecasting model ............................................................................................................3 Risk variables ...................................................................................................................5 Probability distributions .................................................................................................7 Defining uncertainty ......................................................................................................7 Setting range limits ........................................................................................................7 Allocating probability....................................................................................................9 Correlated variables ......................................................................................................11 The correlation problem ..............................................................................................11 Practical solution .........................................................................................................12 Simulation runs ..............................................................................................................14 Analysis of results ..........................................................................................................15 III. INTERPRETING THE RESULTS OF RISK ANALYSIS.........................................18 Investment decision criteria..........................................................................................18 The discount rate and the risk premium ......................................................................18 Decision...
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