Risk Analysis

Risk Analysis

Risk Analysis

I. Introduction of Risk Analysis

Risk Analysis, in economics, evaluation of the risk involved in a course of action. Most business decisions involve uncertainty or risk. It is therefore important to assess the risk of, say, an investment in an expansion project, before making a decision to go ahead with it. The two crucial elements of the analysis are the identification and quantification of the risks. Identification depends to a large extent on information; for example, the real costs of following a course of action. Quantification depends on a combination of mathematics and judgement. Calculating the maximum and minimum risk is relatively easy; what matters is the accurate judgement of the real risk: the boundaries within which the likely outcome will fall. In quantifying risks it is important for a company to determine what control (if any) it has over them.

The quality of information a company has can be improved by spending money on research; for example, conducting a survey to determine the probable market share of a new retail outlet in a specific location. Of course, money spent on getting more and more perfect information adds to the cost (and therefore reduces the pay-off) of following the course of action to which the information relates. Therefore, another judgement often has to be made that balances the desirability of having as perfect information as possible against the cost of obtaining it.

II. Risk assessment:

Risk analysis is not a static process. Assessments need to be revised as new information becomes available; for example, changes in costs or the level of competition. Often several options are analysed and their risks and pay-offs compared; for example, the risks and expected pay-offs of opening a big shop compared with opening a smaller one. One of the options that always exists is to do nothing, and put the money in the bank where it will earn interest.

The process of risk analysis is all about calculating probabilities. The ultimate decision will depend on how risk-averse those responsible for it are. Optimists will choose the option with the highest possible pay-off. Pessimists will favor the one with the lowest possible loss.