RISK MANAGEMENT AND REAL OPTIONS
COURSE ORGANISER: Stefan Scholtes
TIMING OF COURSE:6-10 December 2004, 9am – 5pm
PREREQUISITES
All participants are expected to
a)be familiar with probability and statistics at the level of an introductory undergraduate course. This background may be acquired through prior courses or independent reading.
b)be familiar with simple Excel spreadsheet modelling (see e.g. for a tutorial).
c)have access to the textbook Decision Making with Insight and to a laptop computer with the textbook software installed. Up to 3 participants can share one computer but the sharing has to be arranged prior to the course.
INTRODUCTION
This module introduces students to mental paradigms and computational models that will help them understand the possible consequences of their decisions in an uncertain world. The emphasis throughout the course is pragmatic rather than ideological. We ask “How can we make more informed and more confident decisions?” rather than “What’s the ‘correct’ decision?” The slant of the course is vocational, rather than academic. A particular emphasis of the course will be on the emerging real options paradigm as a project design and evaluation tool. Options thinking emphasises the value of flexibility in project design and appraisal. Flexibility enables active risk and opportunity management as it allows engineers and managers to adapt the system in different ways, depending on how the future unfolds. Research and development (R&D) projects, for example, give companies the option of a future launch of a product, which they may or may not exercise, depending on the success of R&D and on market conditions. Similarly, building a small plant with an expansion option as opposed to building a big plant from the start gives the project manager the flexibility to expand if demand is high, without committing to high capacity a priori, thus avoiding “white elephants”. Thus, flexibility has value. However, flexibility also costs money: R&D expenditure, for example in the biotech industry, can be huge. By building small and allowing for expansion the company foregoes the economies of scale of building one large plant. So how much flexibility shall we built into the system? System designers and project managers need tools that help them decide if added flexibility is worth the money. This course provides the students with a mindset and a suite of tools to tackle such problems.
TEACHING STYLE
The course is delivered as a mix of conceptual lectures and computer-based casework in study groups.
OBJECTIVES
Students will
a)learn how to frame problems that involve uncertainty and how to ask useful questions,
b)learn to use a computer to help them set up and analyse scenarios and understand and improve system value,
c)revisit and hopefully revise their own personal way of thinking about uncertainty.
COURSE CONTENT
I.Introduction to the course aims and objectives
II.The forecast is always wrong
1.The industry valuation standard: Net Present Value
2. How reliable are forecasts?
3. Sensitivity analysis
III.The system value is a shape
1.Value profiles and value-at-risk charts
2.SKILL: Using a shape calculator
3.CASE:Overbooking at EasyBeds
IV.Developing valuation models
1. Easybeds revisited
V.Designing a system means sculpting its value shape
1.CASE: Designing a Parking Garage I
2.The flaw of averages: Effects of system constraints
VI.Coping with uncertainty I: Diversification
1.The central limit theorem
2.The effect of statistical dependence
3.Optimising a portfolio
VII.Coping with uncertainty II: The value of information
1.SKILL:Decision Tree Analysis
2.CASE: Market Research at E-Phone
VIII.Coping with uncertainty III: The value of flexibility
1.Where you stand is where you sit: Investors vs. CEOs
2.CASE: Designing a Parking Garage II
3.The value of phasing
4.SKILL: Lattice valuation
5.Example: Valuing a drug development projects
6.The flaw of averages: The effect of flexibility
7.Hedging: Financial options analysis and Black-Scholes
IX.Contract design in the presence of uncertainty
1.SKILL:Two-party scenario tree analysis
2.Project: Valuing a co-development contract
X.Wrap-up and conclusions
ASSESSMENT consists of a group project with an individual report and an essay
REQUIRED TEXT AND SOFTWARE: S. Savage, Decision Making with Insight, Thomson 2003
REFERENCES and further information: see