Question

Once you create a financial model, you need to address the issue of uncertainty.

• Compare and contrast two methods for including and assessing risk in a financial model.
• What are the key variables that should be included in a model that can increase risk and how?

Answer 1

1) The two methods to include risk and assess them in a financial model are:- a) Doing sensitivity analysis to analyse the impact of change in one variable on the outcome b) Doing a monte carlo simulation to understand the expected values of the model.

In the sensitivity analysis, one can easily understand the marginal impact of each variable and thus understand and manage the impact of the most important and significant variable. While a simulation allows one to change all variables at the same time (akin to a real world scenario) and understand the impact on the outcome.

2) The key variables that should be included in a model are the standard deviation of each input variable and the probability of the variables assuming each state. These ensure that the model becomes more probabilistic and hence introduces riskiness and uncertainty in the whole computation process.