What is 'Risk Analysis'

Risk analysis is the process of assessing the likelihood of an adverse event occurring within the corporate, government, or environmental sector. Risk analysis is the study of the underlying uncertainty of a given course of action and refers to the uncertainty of forecasted cash flow streams, variance of portfolio/stock returns, the probability of a project's success or failure, and possible future economic states. Risk analysts often work in tandem with forecasting professionals to minimize future negative unforeseen effects.

BREAKING DOWN 'Risk Analysis'

A risk analyst starts by identifying what could go wrong. The negative events that could occur are then weighed against a probability metric to measure the likelihood of the event occurring. Finally, risk analysis attempts to estimate the extent of the impact that will be made if the event happens.

Quantitative Risk Analysis

Risk analysis can be quantitative or qualitative. Under quantitative risk analysis, a risk model is built using simulation or deterministic statistics to assign numerical values to risk. Inputs which are mostly assumptions and random variables are fed into a risk model. For any given range of input, the model generates a range of output or outcome. The model is analyzed using graphs, scenario analysis, and/or sensitivity analysis by risk managers to make decisions to mitigate and deal with the risks.

A Monte Carlo simulation can be used to generate a range of possible outcomes of a decision made or action taken. The simulation is a quantitative technique that calculates results for the random input variables repeatedly, using a different set of input values each time. The resulting outcome from each input is recorded, and the final result of the model is a probability distribution of all possible outcomes. The outcomes can be summarized on a distribution graph showing some measures of central tendency such as the mean and median, and assessing variability of the data through standard deviation and variance.

The outcomes can also be assessed using risk management tools such as scenario analysis and sensitivity tables. A scenario analysis shows the best, middle, and worst outcome of any event. Separating the different outcomes from best to worst provides a reasonable spread of insight for a risk manager. For example, an American Company that operates on a global scale might want to know how its bottom line would fare if the exchange rate of select countries strengthens. A sensitivity table shows how outcomes vary when one or more random variables or assumptions are changed. A portfolio manager might use a sensitivity table to assess how changes to the different values of each security in a portfolio will impact the variance of the portfolio. Other types of risk management tools include decision trees and break-even analysis.

Qualitative Risk Analysis

Qualitative risk analysis is an analytical method that does not identify and evaluate risks with numerical and quantitative ratings. Qualitative analysis involves a written definition of the uncertainties, an evaluation of the extent of impact if the risk ensues, and countermeasure plans in the case of a negative event occurring. Examples of qualitative risk tools include SWOT Analysis, Cause and Effect diagrams, Decision Matrix, Game Theory, etc. A firm that wants to measure the impact of a security breach on its servers may use a qualitative risk technique to help prepare it for any lost income that may occur from a data breach.

Almost all sorts of large businesses require a minimum sort of risk analysis. For example, commercial banks need to properly hedge foreign exchange exposure of oversees loans while large department stores must factor in the possibility of reduced revenues due to a global recession. It is important to know that risk analysis allows professionals to identify and mitigate risks, but not avoid them completely.

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