Definition of Risk from Uncertain Environments - General

Uncertainty refers to the state of information about a variable or parameter of interest, whereas variability refers to a parameter varying across a sample.  Risk is defined as the uncertainty associated with a key value criterion. 

Example from Ship Investment

As mentioned above, the shipping market is formed by four sub-markets linked by cash flow that form each part of an overlapping market, such as the freight market, the sale and purchase market, the new building market, and the demolition markets.
The shipping market is further constituted by separate segment differentiation for type of cargo, type of ship, trade routes, and type and duration of charter.
In every segment the segmentation criteria are differentiated according to:
  • the type of ships, the shipping market may be divided into,
  • the type of cargo, the shipping market may be broadly divided into,
  • the type of trade routes, the shipping market may be divided into,
  • the duration of the charter, the shipping market is divided into,
  • the type of charter the market is divided into.

The great majority of ship types can be differentiated into several broad market segments, such as cargo carriers, passenger carriers, industrial ships, service vessels, and non-commercial. Each market segment can be subdivided, with the cargo carriers by far the greatest number of subdivisions. However, only two kinds of services are predominant in the shipping market industry, namely the liner shipping service and the tramp service. 

The liner service operates within a schedule and has a fixed port rotation with published dates of calls at the advertised ports. The tramp service on the other hand is a ship that has no fixed routing or itinerary or schedule and is available to load any cargo from any port to any port.

Operational Risk

Operational risk means the risk that a company has to face due their own operation and decisions made for the investment. Operational risk summarizes the uncertainties in day-to-day activities, including the uncertainty that relates to the market segment in question, the risk that is connected with to operate the ship, and the uncertainty surrounding the general economic development. 

Freight Derivatives

Methods to manage commercial or operational risk, are for example with derivative instruments in the freight marked. Baltic International Freight Future Exchange, BIFFEX, was set up in 1985 to protect the shipping sector from the damaging effects to be dependent on one of the most volatile sources of income, namely freight rates. BIFFEX was developed on basis of dry cargo contracts, based on Baltic Freight Index (BFI). The index, that is composed of several brokers and published on a daily basis, is a weighted average of freight rates on all the most important trades. 

Freight derivatives include exchange-traded futures, swap futures, forward freight agreements (FFAs), container freight swap agreements, container freight derivatives, and physical deliverable freight derivatives. The instruments are settled against various freight rate indexes published by the Baltic Exchange and the Shanghai Shipping Exchange

Financial Risk

Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans. The four standard market risk factors are equity risk, interest rate risk, currency risk, and commodity risk. 

Equity risk is the risk that stock prices in general or the implied volatility will change. When it comes to long-term investing, equities provide a return that will hopefully exceed the risk-free rate of return. The difference between return and the risk-free rate is known as the equity risk premium. 

Interest rate risk is defined as the financial consequences of a change in the interest rate. It is the risk that interest rates or the implied volatility will change. The change in market rates can lead to interest rate risk. In present context it would mean the effect on the ship value imposed by an interest rate change. The ship value on the second-hand market is determined by expectations to future earnings. An estimate of the interest rate risk must therefore be based on a calculation of the ship value and its sensitivity to interest rate changes. 

Currency risk is the risk that foreign exchange rates or the implied volatility will change, which affects the value of an asset held in that currency. Currency fluctuations in the marketplace can have a drastic impact on value because of the price effect on the value of foreign currency denominate assets and liabilities. 

Commodity risk is the risk that commodity prices or implied volatility will change. 

Financial risk measurement, pricing of financial instruments, and portfolio selection are all based on statistical models. If the model is wrong, risk numbers, prices, or optimal portfolios are wrong. Model risk quantifies the consequences of using the wrong models in risk measurement, pricing, or portfolio selection. The main element of a statistical model in finance is a risk factor distribution. 

Credit risk management is a profession that focuses on reducing and preventing losses by understanding and measuring the probability of those losses. Credit risk management is used by banks, credit lenders, and other financial institutions to mitigate losses primarily associates with nonpayment of loans. A credit risk occurs when there is potential that a borrower may default or miss on an obligation as stated in a contract between the financial institution and the borrower. 

This is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). There are two types of liquidity risk, namely asset liquidity and/or funding liquidity. 

Other risks are seen from the third party, i.e., banks, credit lenders, and other financial institutions, and can be bound in the investment projects operational and financial risk.

Include Uncertainty & Risk using Probabilistic Simulation

In a simulated capital budgeting problem, distributions are used to randomly generate and sample a large number of variable inputs for the following input variables:

  • Initial investment - Distribution to describe the min to max capital distribution.
  • Discount rate - Distribution to describe the variable discount rate.
  • Income/revenue - Distribution to describe the variable energy income growth distribution.
  • Operating cost margin - Distribution to describe the variable EBITDA margin cost distribution (for example as a fraction of income/revenue).
  • Net working capital - Distribution to describe the variable NWC distribution (for example as a fraction of income/revenue).
  • Terminal value - Distribution to describe the variable terminal value.

 The method can be summarized as follows,

  • Creating a parametric model, y = f(x1, x2, ..., xn)
  • Generation of random input set of data, x1,i, x2,i, ..., xn,i
  • Calculations and memorizing results as yi
  • Repeating steps 2 and 3 for for i = 1 to n
  • Analysing the results using histograms, confidence intervals, other statistic indicators resulting from the simulation, etc.


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