A simple definition would be it is a presence of uncertainty or in other words, it is a scenario in which there exists a possibility of deviation from a desired or expected outcome.
A more elaborate explanation requires understanding that implementation of any company strategy often involves a portfolio of options. The certainty of uncertainty requires organizations to systematically evaluate the impact of risks. This is where the risk management and proactive that is comes into picture. Risk management involves the total process of identifying, measuring, controlling, and minimizing or eliminating the likelihood of a risk occurring.
What is a Risk Analysis?
It is a process of assessing the range of possible outcomes, their probabilities, causal factors, and their interrelationships. Some approaches used in risk analysis are Decision trees, Monte Carlo simulation etc which help determine the acceptability of expected performance and risk of each of the decision alternatives.
Risk analysis can help provide useful insights to management, for example:
- How likely am I to make my target?
- How different are two competing strategies, risk adjusted?
- What is the main risk to a successful strategy?
- What will the impact of competitors be?
- What technical or regulatory factors influence the success?
- How much confidence can I place in the strategic results or analysis?
What are the various steps in a risk analysis?
Any risk analysis approach comprise of following steps:
1) Plan a model (Develop a modeling strategy which should specify an objective(s)):
It is very important to specify what objective is being fulfilled with the analysis and the model should be quantifiable such as NPV, total sales, market share etc. Model not only helps to identify possible outcomes but also augments better understanding of the problem itself. Moreover, this is a great tool to communicate any judgement made accordingly. Moreover, a model helps to highlight key factors related to any outcome. So, plan a model that is best aligned for the business.
2) Identify possible source of risks:
When identifying risks, following three factors should be considered: Variability, Uncertainty and Subjectivity. Variability is a the random nature in any process or situation even though the process and its parameters are understood (e.g. coin-tossing, sampling from a normal distribution with given parameters etc.). Uncertainty is the lack of knowledge about the value of some parameter, or the factors that determine the behavior of a process. Subjectivity is the actual impact of different outcomes on the observer or its economic “utility”.
2) Identify possible source of risks:
When identifying risks, following three factors should be considered: Variability, Uncertainty and Subjectivity. Variability is a the random nature in any process or situation even though the process and its parameters are understood (e.g. coin-tossing, sampling from a normal distribution with given parameters etc.). Uncertainty is the lack of knowledge about the value of some parameter, or the factors that determine the behavior of a process. Subjectivity is the actual impact of different outcomes on the observer or its economic “utility”.
3) Risks layout and Quantification
In this step, risks are tabulated for example using a spreadsheet model of the strategy that includes the risks and their mechanism of influence. Each risk factor should be quantified in probabilistic terms (usually probability distributions). Other statistical concepts such as the correlation of various uncertain factors may be employed.
In this step, risks are tabulated for example using a spreadsheet model of the strategy that includes the risks and their mechanism of influence. Each risk factor should be quantified in probabilistic terms (usually probability distributions). Other statistical concepts such as the correlation of various uncertain factors may be employed.
4) Explore results with Sensitivity analysis
Perform sensitivity analysis on the model to explore various scenarios.The objective would be to identify the main drivers of the risk for proactive risk responses. For example, Monte Carlo Simulation can be implemented for which there are various add-ons to Excel available, for instance @RISK from palisade.com
Perform sensitivity analysis on the model to explore various scenarios.The objective would be to identify the main drivers of the risk for proactive risk responses. For example, Monte Carlo Simulation can be implemented for which there are various add-ons to Excel available, for instance @RISK from palisade.com
5) Post analysis
With a better understanding of bottom-line performance outcomes through risk analysis, we will have expected values from various decisions based on which decisions should be adjusted or given appropriate values if applicable. Also, various mitigation approaches for the risks should be formulated. The finding of the risk analysis should be clearly summarized to decision makers.
Following diagram best summarize the total process:
With a better understanding of bottom-line performance outcomes through risk analysis, we will have expected values from various decisions based on which decisions should be adjusted or given appropriate values if applicable. Also, various mitigation approaches for the risks should be formulated. The finding of the risk analysis should be clearly summarized to decision makers.
Following diagram best summarize the total process:
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