Conceptual Issues in Financial Risk Analysis: A Review for Practitioners

Abstract

This paper presents a critical review of the conceptual issues involved in accounting for financial risk in project appraisal. It begins by examining three of the main approaches to assessing risk: the use of the probability distributions of project outcomes, such as the NPV, the use of a single risk-adjusted discount rate for the life of the project, and the use of certainty equivalents. The first two approaches are very common, while the third is used less often. Next, it proposes an approach based on annual "certainty equivalents" that is conceptually similar to using multiple risk-adjusted discount rates and which involves specifying the risk profile of a project over its lifetime. Finally, this approach is illustrated with a simple numerical example.

The certainty equivalent approach is compelling because it clearly separates the time value of money from the issue of risk valuation. While the authors point out the analytical challenges of the certainty equivalent approach, they note that its informational requirements are no greater than those posed by the older, more traditional approaches, while avoiding the numerous inadequacies of the latter.

Keywords: Risk analysis; Discount rates; Criteria for assessing risk; Certainty equivalents; Multiple risk-adjusted discount rates

JEL Classification: D61, D81, G31, H43