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Risk Management & Real Options Wrap-up. Stefan Scholtes Judge Institute of Management University of Cambridge MPhil Course 2004-05 Course website with accompanying material http://www.eng.cam.ac.uk/~ss248/real_options. Introduction The forecast is always wrong

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Risk Management & Real Options Wrap-up

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Risk management real options wrap up l.jpg

Risk Management & Real OptionsWrap-up

Stefan Scholtes

Judge Institute of Management

University of Cambridge

MPhil Course 2004-05

Course website with accompanying material http://www.eng.cam.ac.uk/~ss248/real_options


Course content l.jpg

Introduction

The forecast is always wrong

The industry valuation standard: Net Present Value

Sensitivity analysis

The system value is a shape

Value profiles and value-at-risk charts

SKILL: Using a shape calculator

CASE:Overbooking at EasyBeds

Developing valuation models

Easybeds revisited

Designing a system means sculpting its value shape

CASE: Designing a Parking Garage I

The flaw of averages: Effects of system constraints

Coping with uncertainty I: Diversification

The central limit theorem

The effect of statistical dependence

Optimising a portfolio

Coping with uncertainty II: The value of information

SKILL:Decision Tree Analysis

CASE: Market Research at E-Phone

Coping with uncertainty III: The value of flexibility

Investors vs. CEOs

CASE: Designing a Parking Garage II

The value of phasing

SKILL: Lattice valuation

Example: Valuing a drug development projects

The flaw of averages: The effect of flexibility

Hedging: Financial options analysis and Black-Scholes

Contract design in the presence of uncertainty

SKILL:Two-party scenario tree analysis

Project: Valuing a co-development contract

Wrap-up and conclusions

Course content

© Scholtes 2004


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Aims and objectives of the course

General issue:

  • How can we use (simple) models to help us understand uncertainty and the consequences of our decisions in an uncertain world?

    General objectives:

  • This is a skills-based course. You will learn to use a computer to help you understand and improve system value

    • Computational tools based on Excel plus a few add-ins

  • But it is also intellectually stretching. I hope to change the way you think about uncertainty in your everyday life

© Scholtes 2004


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Examples of systems we have in mind

  • Harbour expansion in Sidney

  • Designing communications satellites at Motorola

  • Terminal 5, 3rd run-way at Heathrow

  • Satellite-based toll collection system in Germany

  • Sonic cruiser vs 7E7 at Boeing

  • Fleet planning at BA

  • Bidding for G3 telecom licenses

  • Production sharing contract between BP and Petronas, Malaysia

  • Drug co-development contract between Cambridge Antibody Technology and Astra Zeneca

© Scholtes 2004


Key challenges l.jpg

Key challenges

  • Understanding the system value

  • Improving the system design

  • This course focuses on the valuation and design optimisation of systems that operate in an unpredictable dynamic environment

  • We will mainly focus on economic valuations ($$) as system values but the general framework applies to non-monetary value measures, too

    • E.g. service level

© Scholtes 2004


What were we concerned with starting point system value is more than a number l.jpg

What were we concerned with?Starting point: System value is more than a number

Big Points

  • We lack an intuitive understanding and clear communication of the effects of uncertainty on system value

  • We work with forecasts of uncertain variables to generate a single output – the “value” – to re-assure ourselves

  • BUT: The forecast is always wrong

© Scholtes 2004


What were we concerned with i recognising uncertainty values as shapes l.jpg

What were we concerned with?I. Recognising uncertainty: Values as shapes

Big points

  • Uncertainty is best represented by a SHAPE

  • If we want to work with shapes, we need a shape calculator

  • SKILL: LEARNED HOW TO USE A SHAPE CALCULATOR

© Scholtes 2004


What were we concerned with ii developing valuation models no right answer l.jpg

What were we concerned with?II. Developing valuation models: No right answer

Big points

  • Engineering models focus on “the right answers” - economic valuation of systems must acknowledge that THERE IS NO RIGHT VALUE

  • Disheartened response: “Hard” modelling is useless

  • My (and hopefully our) response: “Hard” modelling is even more important BUT we have to revise our expectations on modelling

  • Good models test and improve our intuition about the value

  • Good models help us communicate insight - models are vehicles for story telling

  • Work with many valuation models – each of them is part of the “Valuation puzzle”

© Scholtes 2004


What were we concerned with the flaw of averages l.jpg

What were we concerned with?The flaw of averages

  • The system value calculated on the basis of average conditions is not the average system value

  • Constraints imply that the system value calculated on the basis of average conditions OVERESTIMATES the average system value

  • Flexibility implies that the system value calculated on the basis of average conditions UNDERESTIMATES the average system value

  • Scenario-based analyses, such as decision trees or Monte Carlo simulation, avoid the flaw

© Scholtes 2004


What were we concerned with iii how to cope with uncertainty the 3 weapons l.jpg

What were we concerned with?III. How to cope with uncertainty: The 3 weapons

  • Diversification: Don’t put all your eggs in one basket

  • Information: Gather information to narrow down the level of uncertain

  • Flexibility: Make sure you can act to avoid losses and amplify gains as uncertainties unfold

  • Skill: HAVE SEEN SOME SIMPLE MODELLING TEMPLATES THAT ALLOW YOU TO ANALYSE THE EFFECTS OF THESE WEAPONS

© Scholtes 2004


What were we concerned with iv whose risk is it anyway risk sharing in contracts l.jpg

What were we concerned with?IV. Whose risk is it anyway? Risk sharing in contracts

  • Contracts are the building blocks of business

  • Need to understand the effect of contract terms on risk exposure and opportunity sharing

  • Skill: DEVELOPING SIMPLE MODELS FOR CONTRACT VALUATION

© Scholtes 2004


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THAT’S IT!

I HOPE YOU HAVE ENJOYED THE COURSE

© Scholtes 2004


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