Strategic Risk Taking A Framework for Risk Management

Front Flap

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.

•   Risk: the history and the psychology

The non-financial realities you must understand to successfully manage risk

•   Risk assessment: from the basics to the cutting edge

Risk Adjusted Value, probabilistic approaches, Value at Risk, and more

•   Utilizing the power of real options

Extending option pricing models to reflect the potential upside of risk exposure

•   Risk management: the big picture

Integrating traditional finance with corporate strategy–and using risk strategically

Back Flap

About the Author

Aswath Damodaran, Professor of Finance at NYU’s Stern School of Business, has been profiled in BusinessWeek as one of the United States’ top twelve business school professors. His researchinterests include valuation, portfolio management, and applied corporate finance. He is the author of Damodaran on Valuation; Investment Valuation; The Dark Side of Valuation; Corporate Finance: Theory and Practice; Applied Corporate Finance; and most recently, Investment Fables.

Damodaran has published in The Journal of Financial and Quantitative Analysis, The Journal of Finance, The Journal of Financial Economics, and The Review of Financial Studies.

Back Cover

Beyond Traditional Hedging: How to Use Risk Management Financial Techniques Strategically!

•How to determine which risks to ignore, which to protect against, and which to actively exploit

•By Aswath Damodaran, leading finance authority and one of BusinessWeek’s top 12 business school professors

•For every corporate finance executive, manager, analyst, consultant, researcher, and student

In recent years, risk management has been defined as merely eliminating or reducing

risk exposure. Companies are learning today that is far too narrow and constraining a definition. Risk, exploited judiciously, is absolutely central to business success. In Strategic Risk Taking: A Framework for Risk Management, Aswath Damodaran covers both sides of the risk equation, offering a complete framework for maximizing profit by limiting some risks and exploiting others.

Damodaran presents a thorough and insightful review of the state-of-the-art in risk measurement, hedging, and mitigation. He covers a broad spectrum of risk assessment tools, including risk adjusted value, scenario analysis, decision trees, VAR, and real options. But Damodaran goes far beyond other treatments of the subject, helping you decide when to deliberately increase exposure to certain risks, and clearly assess the potential dangers and payoffs of doing so.

http://pages.stern.nyu.edu/~adamodar/

Front Flap

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.

•   Risk: the history and the psychology

The non-financial realities you must understand to successfully manage risk

•   Risk assessment: from the basics to the cutting edge

Risk Adjusted Value, probabilistic approaches, Value at Risk, and more

•   Utilizing the power of real options

Extending option pricing models to reflect the potential upside of risk exposure

•   Risk management: the big picture

Integrating traditional finance with corporate strategy–and using risk strategically

Back Flap

About the Author

Aswath Damodaran, Professor of Finance at NYU’s Stern School of Business, has been profiled in BusinessWeek as one of the United States’ top twelve business school professors. His researchinterests include valuation, portfolio management, and applied corporate finance. He is the author of Damodaran on Valuation; Investment Valuation; The Dark Side of Valuation; Corporate Finance: Theory and Practice; Applied Corporate Finance; and most recently, Investment Fables.

Damodaran has published in The Journal of Financial and Quantitative Analysis, The Journal of Finance, The Journal of Financial Economics, and The Review of Financial Studies.

Back Cover

Beyond Traditional Hedging: How to Use Risk Management Financial Techniques Strategically!

•How to determine which risks to ignore, which to protect against, and which to actively exploit

•By Aswath Damodaran, leading finance authority and one of BusinessWeek’s top 12 business school professors

•For every corporate finance executive, manager, analyst, consultant, researcher, and student

In recent years, risk management has been defined as merely eliminating or reducing

risk exposure. Companies are learning today that is far too narrow and constraining a definition. Risk, exploited judiciously, is absolutely central to business success. In Strategic Risk Taking: A Framework for Risk Management, Aswath Damodaran covers both sides of the risk equation, offering a complete framework for maximizing profit by limiting some risks and exploiting others.

Damodaran presents a thorough and insightful review of the state-of-the-art in risk measurement, hedging, and mitigation. He covers a broad spectrum of risk assessment tools, including risk adjusted value, scenario analysis, decision trees, VAR, and real options. But Damodaran goes far beyond other treatments of the subject, helping you decide when to deliberately increase exposure to certain risks, and clearly assess the potential dangers and payoffs of doing so.

http://pages.stern.nyu.edu/~adamodar/

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

CHAPTERS 5–8

Risk Assessment: Tools and Techniques . . . . . . . . . . . . . . . . . . 97

CHAPTER 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

CHAPTER 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

CHAPTER 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

CHAPTER 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