Want a NOOK? Explore Now
In business and investing, risk has traditionally been viewed negatively: investors and companies can lose money due to risk and therefore we typically penalize companies for taking risks. That’s why most books on risk management focus strictly on hedging or mitigating risk.
But the enterprise’s relationship with risk should be far more nuanced. Great companies become great because they seek out and exploit intelligent risks, not because they avoid all risk. Strategic Risk Taking: A Framework for Risk Management is the first book to take this broader view, encompassing both risk hedging at one end of the spectrum and strategic risk taking on the other.
World-renowned financial pioneer Aswath Damodaran–one of BusinessWeek’s top 12 business school professors–is singularly well positioned to take this strategic view. Here, Damodaran helps you separate good risk (opportunities) from bad risk (threats), showing how to utilize the former while protecting yourself against the latter. He introduces powerful financial tools for evaluating risk, and demonstrates how to draw on other disciplines to make these tools even more effective.
Simply put, Damodaran has written the first book that helps you use risk to increase firm value, drive higher growth and returns, and create real competitive advantage.
his book is written for three very diverse and different audiences—people who have to manage and make the big decisions on risk (risk managers), analysts and others whose job it is to assess risk (risk assessors), and students of risk who are interested in getting a perspective on how the thinking on risk has evolved over time.
The study of risk has its deepest roots in economics and insurance. For centuries, researchers have attempted to grapple with the basic question of what risk is and how to measure risk aversion. Chapters 1 through 4 represent my attempt to give some historical perspective on how our thinking has evolved over the past few centuries, with a healthy dose of what psychologists have discovered in recent years about how human beings react to risk. In particular, these studies find that human beings are neither as rational nor as easy to categorize when it comes to behavior when confronted with risk as traditional economists had assumed them to be. Although much of this work would usually be categorized as behavioral economics or finance, understanding the findings is the first step to managing risk.
The next four chapters (Chapters 58) look at how risk assessment techniques have evolved over time. Chapter 5 has its roots in portfolio theory and examines ways in which we can adjust the value of risky assets for that risk. Chapter 6 borrows heavily from the decision sciences and statistics and discusses ways in which probabilistic approaches can be used to evaluate risk. Chapter 7 takes a closer look at value at risk (VaR), an extension of the probabilistic approach that has acquired a substantial following particularly in commercial and investment banks. Chapter 8 returns to financial theory and looks at how extensions of option pricing models can be used to incorporate the potential upside from risk exposure.
The last four chapters of this book represent an attempt to meld traditional finance and corporate strategy to arrive at a complete story for risk management, which goes beyond just risk hedging (which has been the finance focus) or competitive advantages (which has been the strategic imperative). These chapters represent the most innovative part of this book, because they attempt to bring together analyses and insights from different functional areas into a big picture of risk management.
The three groups—economists, risk assessors, and risk managers—have different skills and interests, and the tension shows in the book, with each part of the book reflecting these differences. Each group will find a portion of the book most attuned to their interests with the other parts representing more of a hike into unfamiliar but rewarding territory.
This book is modular and can be read in parts. In other words, there is little in the first eight chapters that I draw on in the last four chapters. Much as I would love to believe that you will buy this book and read it cover to cover, I am a realist. Given your time constraints and interests, you may skip through sections to get to the parts you want to read. In other words, if you are already familiar with risk assessment tools and are more interested in the big picture of risk management, skip forward to Chapter 9. If, on the other hand, you are more interested in risk assessment and how the different approaches fit together, you can browse through Chapters 5 through 8. Having said that, there is value added to looking at the parts not specifically aimed at you. In other words, risk assessors and analysts will be able to do their jobs better if they understand how what they do (from risk adjusting discount rates to simulations) fits into the big picture of risk management. At the same time, risk managers will be able to define what risk assessments they need if they can see the whole array of choices. Finally, economists studying risk aversion may gain from knowing the practical issues facing both risk assessors and risk managers. As I note, there is an extraordinary number of basic and critical questions that are unanswered in the theory.
There are excellent books and papers in each of the three areas right now, but they focus on one of the three, largely because different disciplines have been involved in each one: traditional economics and behavioral economics for the first part, corporate finance for the second, and corporate strategy for the third. I have tried to bridge the different functional areas across this book. It is entirely possible that people in any one of these functional areas will view what I say (in the section directed at them) as too simplistic or already well established, but I hope I have been able to bring insights into each of the three areas from being aware of the other two.
I do not claim that anything in this book, standing by itself, is new and revolutionary. In fact, I will concede that each chapter covers a topic that has been covered in more depth elsewhere, with entire books dedicated to some topics; there are several books on real options and quite a few on VaR, for instance. What I think is lacking in the areas of risk management is a spanning of work done in different areas with a link to practical risk management. Consequently, I used my own biased perspectives to try to create a narrative that would be useful to a decision maker involved in risk analysis and management. I hope you find it useful.
© Copyright Pearson Education. All rights reserved.
CONTENTS
INTRODUCTION
A Roadmap for Understanding Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xvii
CHAPTERS 1—4
The Economists’ View of Risk Aversion and the
Behavioral Response . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
CHAPTER 1
What Is Risk? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
A Very Short History of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Defining Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Dealing with Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Risk and Reward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
Risk and Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7
Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
The Conventional View and Its Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
A More Expansive View of Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
CHAPTER 2
Why Do We Care About Risk? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
The Duality of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
I Am Rich, But Am I Happy? Utility and Wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
The St. Petersburg Paradox and Expected Utility: The Bernoulli Contribution . . . . . . . . .12
Mathematics Meets Economics: Von Neumann and Morgenstern . . . . . . . . . . . . . . . . . . .14
The Gambling Exception? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16
Small Versus Large Gambles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17
Measuring Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Certainty Equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18
Risk Aversion Coefficients . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
viii ContentsOther Views on Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23
Prospect Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26
Consequences of Views on Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Investment Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28
Corporate Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29
Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
CHAPTER 3
What Do We Think About Risk? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
General Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Evidence on Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Experimental Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36
Survey Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .47
Pricing of Risky Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50
Evidence from Racetracks, Gambling, and Game Shows . . . . . . . . . . . . . . . . . . . . . . . . . . .57
Propositions about Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
CHAPTER 4
How Do We Measure Risk? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Fate and Divine Providence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Estimating Probabilities: The First Step to Quantifying Risk . . . . . . . . . . . . . . . . . . . 66
Sampling, The Normal Distributions, and Updating . . . . . . . . . . . . . . . . . . . . . . . . . 68
The Use of Data: Life Tables and Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
The Insurance View of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Financial Assets and the Advent of Statistical Risk Measures . . . . . . . . . . . . . . . . . . . 71
The Markowitz Revolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Efficient Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .73
The Mean-Variance Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .74
Implications for Risk Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .76
Introducing the Riskless Asset—The Capital Asset Pricing Model
(CAPM) Arrives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Mean Variance Challenged . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Fat Tails and Power-Law distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .79
Asymmetric Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .81
Jump Process Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .83
Data Power: Arbitrage Pricing and Multifactor Models . . . . . . . . . . . . . . . . . . . . . . . 83
Arbitrage Pricing Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .84
Multifactor and Proxy Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85
The Evolution of Risk Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
C HAPTERS 5—8
Risk Assessment: Tools and Techniques . . . . . . . . . . . . . . . . . . 97
C HAPTER 5
Risk-Adjusted Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
Discounted Cash Flow Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
The DCF Value of an Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100
Risk-Adjusted Discount Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .101
Certainty-Equivalent Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .106
Hybrid Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .111
DCF Risk Adjustment: Pluses and Minuses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .116
Post-Valuation Risk Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
Rationale for Post-Valuation Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .117
Downside Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .118
Other Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125
Upside Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .126
The Dangers of Post-Valuation Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127
Relative Valuation Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
Basis for Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .128
Risk Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .129
DCF Versus Relative Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .130
The Practice of Risk Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Fixed Discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
Firm-Specific Discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
Determinants of Illiquidity Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137
Estimating Firm-Specific Illiquidity Discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .139
Synthetic Bid-Ask Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
Option-Based Discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
CHAPTER 6
Probabilistic Approaches: Scenario Analysis, Decision
Trees, and Simulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .145
Scenario Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
Best Case/Worst Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .146
Multiple Scenario Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .147
Decision Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Steps in Decision Tree Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153
An Example of a Decision Tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .156
Use in Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .160
Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .161
Risk-Adjusted Value and Decision Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .162
Simulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Steps in Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .164
An Example of a Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .168
Use in Decision Making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .173
Simulations with Constraints. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .174
Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .176
Risk-Adjusted Value and Simulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .177
An Overall Assessment of Probabilistic Risk Assessment Approaches . . . . . . . . . . . 179
Comparing the Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .179
Complement or Replacement for Risk Adjusted Value . . . . . . . . . . . . . . . . . . . . . . . . . . . .180
In Practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .181
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
Fitting the Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
Is the Data Discrete or Continuous? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .183
How Symmetric Is the Data? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .188
Are There Upper or Lower Limits on Data Values? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .194
How Likely Are You to See Extreme Values of Data, Relative to the Middle Values? . . . . .195
Tests for Fit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
Tests of Normality. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
C HAPTER 7
Value at Risk (VaR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .201
What Is VaR? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
A Short History of VaR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
Measuring VaR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Variance-Covariance Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .204
Historical Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .210
Monte Carlo Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .214
Comparing Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .217
Limitations of VaR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
VaR Can Be Wrong . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .218
Narrow Focus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .221
Suboptimal Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .222
Extensions of VaR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
VaR as a Risk Assessment Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
C HAPTER 8
Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .231
The Essence of Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
Real Options, Risk-Adjusted Value, and Probabilistic Assessments . . . . . . . . . . . . . 233
Real Option Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
The Option to Delay an Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .235
The Option to Expand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .246
The Option to Abandon an Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .253
Caveats on Real Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
Real Options in a Risk Management Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
Option Payoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
Determinants of Option Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
Option Pricing Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
The Binomial Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .266
The Black-Scholes Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .270
CHAPTERS 9–12
Risk Management: The Big Picture . . . . . . . . . . . . . . . . . . . . . 277
CHAPTER 9
Risk Management: The Big Picture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .279
Risk and Value: The Conventional View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
Discounted Cash Flow Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .280
Relative Valuation Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .285
Expanding the Analysis of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
Discounted Cash Flow Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .288
Relative Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .295
Option Pricing Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .298
A Final Assessment of Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
When Does Risk Hedging Pay Off? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .302
When Does Risk Management Pay Off? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .303
Risk Hedging Versus Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .303
Developing a Risk Management Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
CHAPTER 10
Risk Management: Profiling and Hedging . . . . . . . . . . . . . . . . . . . . . . . .309
Risk Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Step 1: List the Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .310
Step 2: Categorize the Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .310
Step 3: Measure Exposure to Each Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .311
Step 4: Analyze the Risks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .318
To Hedge or Not to Hedge? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
The Costs of Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .319
The Benefits of Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .320
The Prevalence of Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .326
Does Hedging Increase Value? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .329
Alternative Techniques for Hedging Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
Investment Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .331
Financing Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .332
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .333
Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .334
Picking the Right Hedging Tool . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .338
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
C HAPTER 11
Strategic Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .341
Why Exploit Risk? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
Value and Risk Taking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .342
Evidence on Risk Taking and Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .344
How Do You Exploit Risk? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
The Information Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .346
The Speed Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .348
The Experience/Knowledge Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .350
The Resource Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .352
Flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .353
Building the Risk-Taking Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .356
Personnel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358
Reward/Punishment Mechanisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .360
Organization Size, Structure, and Culture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .363
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
CHAPTER 12
Risk Management: First Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .367
1. Risk Is Everywhere . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
2. Risk Is Threat and Opportunity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
3. We Are Ambivalent About Risks and Not Always Rational About the
Way We Assess or Deal with Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
4. Not All Risk Is Created Equal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
5. Risk Can Be Measured . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
6. Good Risk Measurement/Assessment Should Lead to Better Decisions . . . . . . . 373
7. The Key to Good Risk Management Is Deciding Which Risks to Avoid,
Which Ones to Pass Through, and Which to Exploit . . . . . . . . . . . . . . . . . . . . . 374
8. The Payoff to Better Risk Management Is Higher Value . . . . . . . . . . . . . . . . . . . . 375
9. Risk Management Is Part of Everyone’s Job . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
10. Successful Risk-Taking Organizations Do Not Get There by Accident . . . . . . . 376
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .379
Overview
In business and investing, risk has traditionally been viewed negatively: investors and companies can lose money due to risk and therefore we typically penalize companies for taking risks. That’s why most books on risk management focus strictly on hedging or mitigating risk.
But the enterprise’s relationship with risk should be far more nuanced. Great companies become great because they seek out and exploit intelligent risks, not because they avoid all risk. Strategic Risk ...