Managing Risk and Uncertainty: A Strategic Approach

Managing Risk and Uncertainty: A Strategic Approach

by Richard Friberg

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Product Details

ISBN-13: 9780262528191
Publisher: MIT Press
Publication date: 11/13/2015
Series: The MIT Press
Pages: 400
Product dimensions: 6.90(w) x 8.90(h) x 0.80(d)
Age Range: 18 Years

About the Author

Richard Friberg is Jacob Wallenberg Professor of Economics and Chairman of the Department of Economics at Stockholm School of Economics.

Table of Contents

Preface xiii

Acknowledgments xvii

1 Introduction 1

1.1 A Motivation and an Overview of the Chapters 1

1.2 Models or Gut Feeling? A Motivation 4

1.3 Some Definitions 6

2 Framework of the Book 9

2.1 A Matrix of Risk and Uncertainty 10

2.2 Four Strategies 11

2.3 A Comparison of Strategies 16

I Decision-Making under Risk 21

3 A First Look at Risk: Probability Distributions 23

3.1 Risk and Uncertainty 23

3.2 One Random Variable: Univariate Statistical Distributions 27

3.3 Several Random Variables: How to Describe Interrelations 39

Appendix 3A Weak Law of Large Numbers 46

Appendix 3B Central Limit Theorems 48

Exercises 49

4 Modeling Decisions under Risk: From Individuals to Firms 53

4.1 Introductory Notes on Functions 55

4.2 Economics of Choice under Risk: Von Neumann-Morgenstern Expected Utility 55

4.3 Concavity and Convexity of Profit Functions 62

4.4 Modigliani-Miller and the Management of Risks 66

Appendix 4A Concavity and Convexity of Functions and the Notation Used in This Book 73

Appendix 4B Combining Functions 75

Appendix 4C Jensen's Inequality 76

Appendix 4D Capital Asset-Pricing Model 78

Appendix 4E Borrowing Constraints and a Lower Threshold 81

Exercises 83

5 Calculating the Value of Investments 85

5.1 Calculating Net Present Value 85

5.2 More on the Appropriate Discount Rate-And What about Risk? 90

5.3 Other Methods of Judging Which Investments to Pursue 94

5.4 How Is the Value of Projects Evaluated? 95

Exercises 96

6 Risk Management with Financial instruments: The Evidence 97

6.1 Financial Instruments and Their Use: A Quick Reminder 97

6.2 Different Forms of Exposure and Their Measurement 99

6.3 What Is the Extent of Financial Hedging, and What Instruments Are Used? 102

6.4 Differences across Firms in the Use of Financial Instruments for Hedging 104

6.5 Hedging versus Speculation 108

6.6 What Is the Effect of Financial Hedging on Earnings and Valuation? 110

6.7 Financial Hedges: Short Term or Long Term? 111

Exercises 114

II Uncertainty and Four Strategies 115

7 Incomplete Contracts in Financial Markets and Evidence on the Role of Operational Means of Dealing with Risk and Uncertainty 117

7.1 Risk, Uncertainty, and the Possibility of Hedging on Financial Markets 120

7.2 Financial and Operational Means of Managing Risk and Uncertainty 124

Exercises 126

8 Decision Trees and Game Theory 127

8.1 Decision Trees 129

8.2 Uncertainty due to Strategic Interaction-Game Theory 132

8.3 Strategic Commitments 137

Exercises 141

9 Uncertainty 143

9.1 Subjective Probability 146

9.2 Commonly Proposed Rules for Decision under Uncertainty 149

9.3 Modeling Rational Choice with Ambiguity Aversion 152

9.4 The Decision Criterion Used to Evaluate Strategies in Chapter 10 154

9.5 A Discussion of Some Assumptions 157

Appendix 9A Axiomatic Approaches to Rational Choice under Risk and Uncertainty 163

Appendix 9B Ellsberg's Experiment 167

Appendix 9C Example of the Decision Rule with Uniform Distribution of Shocks to "Uncertainty" 169

Exercises 170

10 Operational and Financial Responses to Risk and Uncertainty: Four Strategies 173

10.1 Four Strategies to Deal with Risk and Uncertainty 175

10.2 A Comparison of Strategies 178

10.3 A Parametric Example 182

Exercises 186

11 Risk and Uncertainty in Different Markets 189

11.1 A Matrix of Risk and Uncertainty 190

11.2 What Are the Shocks in Different Markets? 191

III Strategies: A Closer Look 195

12 Operational Responses 197

12.1 A General Intuition: The Value of Fewer Constraints 198

12.2 Costs 202

12.3 Revenue Aspects of Dealing with Risk and Uncertainty 209

12.4 Relation to Other Work on Operational Hedging and Risk Management 222

Appendix 12A Lagrange 222

Appendix 12B Marginal Revenue, Marginal Costs, and Variable Profits in a Graph 225

Exercises 228

13 Pricing 231

13.1 Price-Taker or Price-Maker? 231

13.2 How Should Prices Respond to Shocks? 232

13.3 Empirical Evidence on Price Movements in Response to Cost and Demand Shocks 240

Appendix 13A Solving the Bertrand Model 243

Appendix 13B Dornbusch Cournot Model 244

Exercises 247

14 Valuing Projects 249

14.1 Counterfactual Prediction: A View from Science 249

14.2 What to Use When? 250

14.3 Reasoned Guesstimates of Cost and Revenue Items 250

14.4 Adding Risk to Guesstimates: The Hertz Method 251

14.5 Using Econometric Analysis 254

14.6 Experiments 256

14.7 Valuing Real Options Using Tools from the Pricing of Financial Assets 258

14.8 Monte Carlo Simulation Using Oligopoly Theory (MCSOLT) 261

14.9 Don't Even Try 278

14.10 What to Use and When 279

Appendix 14A Vectors and Matrices-A Refresher 280

Appendix 14B Matrix Algebra 281

Exercises 285

15 Structuring Information Flows and Decision Processes to Respond to Risk and Uncertainty 287

15.1 Role of Organization and Management in Profitability and Survival 288

15.2 Organizational Structures for Responding to Uncertainty 291

15.3 Information 298

15.4 Responding to Trends and New Technologies: An Extension 301

Appendix: Total Factor Productivity 306

Exercises 307

16 Decisions Based on Biased Estimates: Errors We Make on Our Own or as a Group and Some Hints for Limiting Them 309

16.1 Systematic Errors We Make on Our Own 311

16.2 Interaction as a Reason for Biased Estimates 315

16.3 Avoiding Systematic Errors 319

Appendix 16A Bayes's Law 325

Appendix 16B A Simple Model of Herding 326

Exercises 330

References 333

Index 357

What People are Saying About This

Kenneth A. Froot

An extremely useful go-to book for thinking about financial risk and both operational and financial means of mitigating it.

Lanier Benkard

Managing Risk and Uncertainty brings academic rigor to the topic of risk management in a way that is both approachable and thoroughly enjoyable to read. I highly recommend it for current and future managers interested in really learning about risk management.

From the Publisher

An extremely useful go-to book for thinking about financial risk and both operational and financial means of mitigating it.

Kenneth A. Froot , André R. Jakurski Professor of Business Administration, Harvard Business School

Managing Risk and Uncertainty brings academic rigor to the topic of risk management in a way that is both approachable and thoroughly enjoyable to read. I highly recommend it for current and future managers interested in really learning about risk management.

Lanier Benkard , Gregor G. Peterson Professor of Economics, Stanford Graduate School of Business

Endorsement

Managing Risk and Uncertainty brings academic rigor to the topic of risk management in a way that is both approachable and thoroughly enjoyable to read. I highly recommend it for current and future managers interested in really learning about risk management.

Lanier Benkard, Gregor G. Peterson Professor of Economics, Stanford Graduate School of Business

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