- Standard Deviation as an absolute measure of risk
5.1 The dispersion of cash flows is the difference between the possible cash
flows that can occur and their expected value. Risk analysis can also be
made by finding out the dispersion of cash flows because such dispersion
indicates the degree of risk. Risk is measured through Standard Deviation
(SD). It measures the deviation about expected cash flow of each of the
possible cash flows. A project with higher SD is a riskier one. In case of
making a decision to choose a project by analyzing risk in absolute terms,
the risk may be measured in relative terms. Such relative measure of risk
is the coefficient of variation. Coefficient of variation is the standard
deviation of the probability distribution divided by its expected value.
5.2 Probability distribution may be of a different nature. For example, cash
flows may be independent over time i.e., the probability distributions for
future periods are not dependent on each other. The second possibility is
that the cash flow in one single time may influence the cash flow in
another time.
5.3 A group exercise will be given to the participants to understand the
intricacies of probability distribution under different situations, where the
decision-maker will have to accept or reject the investment based projects.
- Decision Trees
6.1 One investment decision may influence a number of future investment
decisions. The present choices modify future alternatives. The activities
invariably lead to sequence of decisions from time to time. Therefore,
decisions links form a chain from present to future commitments. The
technique to analyze such sequential decisions is known as decision tree
approach.
6.2 One will take a decision based upon the future expectations, say
accomplishment of events/s. The decision that we make today may
influence the various alternative decisions in the future and thereby
accomplishment of future events will also get affected. The decisions may
also lead to chance event. Even though such chance event is not known
still a probability distribution may be assigned to it. The displaying of
relationship between a present decision and future events, relationship
between a same present decision and the future decisions and their
consequences. It will be mapped out like the branches of tree. Such
graphic display is known as a decision tree.
