RISK MEASUREMENT TECHNIQUES 1

Risk Measurement Techniques Paper

Nathan Gorr

FIN/415

February 14, 2011

Geoffery Connie
RISK MEASUREMENT TECHNIQUES 2

Risk Measurement Techniques Paper

Risk management is a process that involves the identification of specific risks that face

an organization, predicting their size and possible impact, developing a plan to mitigate the risks,

and implementing and monitoring that plan. The measurement of risk is achieved by using a

quantitative risk analysis technique. According to Merna & AL-Thani (2008), “quantitative

techniques attempt to determine absolute value ranges together with probability distributions for

the business or project outcome”. This paper will focus on three of the various techniques that

are available for risk measurement: decision trees, probability-impact grid analysis, and

sensitivity analysis. An explanation as to the use and application of each technique will show the

benefits and relevance to risk measurement.

Decision Trees

The decision tree is technique that can be used to evaluate the expected outcomes of

many different courses of action. The beginning point of a decision tree represents the decision

that needs to be made and is depicted as a square. From this point a line, or branch, is drawn for

each of the possible solutions. At the end of each of these lines, a determination needs to be

made as to whether this will lead to another decision, represented by another square, or an

uncertainty, represented by a circle. This process is continued from each of the new decision

squares until only the circles representing the uncertain outcomes remain. Lines can then be

drawn from the circles to represent the various possible outcomes.

The potential outcomes that are generated by the decision tree are assigned a value and a

probability of their occurrence. The potential outcomes can then be quantified by multiplying the

value of the expected outcome by the probability of it occurring. The resulting figures are the

final values for each of the decisions. The best decision would be the one that is calculated as

having the highest value.

RISK MEASUREMENT TECHNIQUES 3

The advantage of using a decision tree is that it assists a decision maker to choose from

several different courses of action by assigning values to their expected outcomes. A

comprehensive diagram of the consequences of a decision is generated that can provide a better

understanding of the risks and rewards that are associated with solutions to a specific problem.

Probability-Impact Grid Analysis

Probability-impact grid analysis is a technique that is used to quantify the possible

impact of a specific risk. This is a useful tool that can be used to prioritize the risks when

determining risk responses. In order to rank the probability of the risks occurring, a scale can be

used such as 1 to 5 where 1 = low and 5 = high. The same scale can be used to rank the impact

of the threat. The results can then be quantified by multiplying the probability by the impact for

each risk. The resulting risk ranking can then be used to prioritize the risks and generate an

appropriate risk management plan.

This technique is important as a company may be exposed to many risks that range in

severity. Certain risks may be low on the impact scale, but have a relatively high probability of

occurrence. Alternatively, there will be risks that are high in severity, but have a low probability

of occurring. This technique can identify those risks that have a high impact and a high

probability so that the risks can be responded to immediately.

Sensitivity Analysis

Sensitivity analysis is a widely used technique that helps to determine the effect on a

project when one of its risk variables, such as foreign exchange rates, is changed. It helps by

examining the uncertainties that may exist when planning. According to Merna & AL-Thani

(2008), “sensitivity analysis is carried out to identify the most sensitive variables affecting the

project’s estimated worth”.

RISK MEASUREMENT TECHNIQUES 4

The benefit of sensitivity analysis is that is can help with identifying a range of acceptable

limits for specific risk variables. It uses “what is” questions and calculates the effects of the

changes in the overall costs for a project.

Conclusion

There are many different techniques that can be used to measure risks so that the

appropriate responses can be developed. Decision trees, probability-impact grid analysis, and

sensitivity analysis are three examples of such techniques that have been shown to assist in

quantifying risks. Each technique has its benefits, and there is no “correct” technique that an

organization should use. The use of these techniques may occur at different levels of the

organization and may depend upon the number and types of risks that need to be measured.
RISK MEASUREMENT TECHNIQUES 5

References

Merna, T., & AL-Thani, F. (2008). Corporate Risk Management (2nd ed.). Hoboken, NJ: John

Wiley & Sons.

 RISK MEASUREMENT TECHNIQUES
Student: Nathan Gorr
RUBRIC FOR THE EVALUATION OF WRITTEN ASSIGNMENTS
CRITERIA NEEDS IMPROVEMENT
Minimum Points
CONTENT The writer does not
40% demonstrate cursory
understanding of subject
matter, and the purpose of
the paper is not stated. The
objective, therefore, is not
addressed and supporting
materials are not correctly
referenced.
27.9 or FEWER POINTS
ORGANIZATION Paragraphs do not focus
around a central point, and
30% concepts are disjointedly
introduced or poorly
defended (i.e., stream of
consciousness).
20.9 or FEWER POINTS
FORMAT The paper does not conform
5% to APA style.
3.4 or FEWER POINTS
GRAMMAR, The writer demonstrates
PUNCTUATION, & limited understanding of
SPELLING formal written language use;
writing is colloquial (i.e.,
10% conforms to spoken
language). Grammar and
punctuation are consistently
incorrect. Spelling errors are
numerous.
7 or FEWER POINTS
SATISFACTORY
Medium Points
The writer demonstrates
limited understanding of the
subject matter in that theories
are not well connected to a
practical experience or
appropriate examples, though
the attempt to research the
topic is evident, and materials
are correctly referenced.
28 to 35.9 POINTS
Topics/content could be
organized in a more logical
manner. Transitions from one
idea to the next are often
disconnected and uneven.
21 to 26.9 POINTS
The paper does not conform
completely to APA style (e.g.,
margins, spacing, pagination,
headings, headers, citations,
references, according to the
APA Manual).
3.5 to 4.4 POINTS
The writer occasionally uses
awkward sentence
construction or overuses
and/or inappropriately uses
complex sentence structure.
Problems with word usage
(e.g., evidence of incorrect use
of Thesaurus) and punctuation
persist, often causing
difficulties with grammar.
7.1 to 8.9 POINTS
6
EXCEPTIONAL
Maximum Points
The writer demonstrates an
understanding of the subject
matter by clearly stating the
objective of the paper and links
theories to practical experience.
The paper includes relevant
material that is correctly
referenced, and this material
fulfills the objective of the paper.
36 to 40 POINTS
The writer focuses on ideas and
concepts within paragraphs, and
sentences are well-connected and
meaningful. Each topic logically
follows the objective. The
introduction clearly states the
objective or ideas leading to the
purpose of the paper, and a
conclusion draws the ideas
together.
27 to 30 POINTS
The paper is correctly formatted to
APA style (e.g., margins, spacing
pagination, headings, headers,
citations, references, according to
the APA Manual).
4.5 to 5 POINTS
The writer demonstrates correct
usage of formal English language
in sentence construction.
Variation in sentence structure
and word usage promotes
readability. There are no spelling,
punctuation, or word usage errors.
9 to 10 POINTS
 RISK MEASUREMENT TECHNIQUES
READABILITY & The writer struggles with
STYLE limited vocabulary and has
difficulty conveying meaning
15 % such that only the broadest,
most general messages are
presented.
10.4 or FEWER POINTS
STUDENT’S NAME: SEE ABOVE; DATE: GRADE: out of 100
ASSIGNMENT:
Total Percent as points: out of 10
Some words, transitional
phrases, and conjunctions are
overused. Ideas may be
overstated, and sentences with
limited contribution to the
subject are included.
10.5 to 13.4 POINTS
7
The reading audience is correctly
identified, demonstrated by
appropriate language usage (i.e.,
avoiding jargon and simplifying
complex concepts appropriately).
Writing is concise, in active voice,
and avoids awkward transitions
and overuse of conjunctions.
13.5 to 15 POINTS