Risk Management Phase Risk management Assessment, tracking and control – Tools: Risk Hierarchical modeling: Risk breakdown structures Risk matrixes Contingency plan: preventive measures, corrective actions, risk budget, etc. FEASIBILITY DESIGN PLANNING CLOSEOUT DEVELOPMENT OPERATIONS RISK MNG

Decision Making Under Risk Outline  Risk and Uncertainty Risk Preferences, Attitude and Premiums Examples of simple decision trees Decision trees for analysis Flexibility and real options

Decision making

Uncertainty and Risk “risk” as uncertainty about a consequence Preliminary questions – What sort of risks are there and who bears them in project management? – What practical ways do people use to cope with these risks? – Why is it that some people are willing to take on risks that others shun?

Some Risks Weather changes Different productivity (Sub)contractors are – Unreliable – Lack capacity to do work – Lack availability to do work – Unscrupulous – Financially unstable Late materials delivery Labor difficulties Unexpected manufacturing costs Failure to find sufficient tenants Unrealistically low bid Late-stage design changes Unexpected subsurface conditions – Soil type – Groundwater – Unexpected Obstacles Settlement of adjacent structures High lifecycle costs Permitting problems

Importance of Risk Much time in construction management is spent focusing on risks Many practices in construction are driven by risk – Bonding requirements – Insurance – Licensing – Contract structure General conditions Payment Terms Delivery Method Selection mechanism

Outline Risk and Uncertainty  Risk Preferences, Attitude and Premiums Examples of simple decision trees Decision trees for analysis Flexibility and real options

Decision making under risk Available Techniques Decision modeling – Decision making under uncertainty – Tool: Decision tree Strategic thinking and problem solving: – Dynamic modeling (end of course) Fault trees

Introduction to Decision Trees We will use decision trees both for – Illustrating decision making with uncertainty – Quantitative reasoning Represent – Flow of time – Decisions – Uncertainties (via events) – Consequences (deterministic or stochastic)

Decision Tree Nodes Decision (choice) Node Chance (event) Node Terminal (consequence) node – Outcome (cost or benefit) Time

Risk preference The preference depends on decision maker point of view

Categories of Risk Attitudes Risk attitude is a general way of classifying risk preferences Classifications – Risk averse fear loss and seek sureness – Risk neutral are indifferent to uncertainty – Risk lovers hope to “win big” and don’t mind losing as much Risk attitudes change over – Time – Circumstance

Other criteria Most likely value – For each policy option we select the outcome with the highest probability Expected value of Opportunity Loss

The Utility Theory When individuals are faced with uncertainty they make choices as is they are maximizing a given criterion: the expected utility. Expected utility is a measure of the individual's implicit preference, for each policy in the risk environment. It is represented by a numerical value associated with each monetary gain or loss in order to indicate the utility of these monetary values to the decision-maker.

Notion of a Risk Premium A risk premium is the amount paid by a (risk averse) individual to avoid risk Risk premiums are very common – what are some examples? – Insurance premiums – Higher fees paid by owner to reputable contractors – Higher charges by contractor for risky work – Lower returns from less risky investments – Money paid to ensure flexibility as guard against risk

Decision Making Under Risk Risk and Uncertainty  Risk Preferences, Attitude and Premiums Examples of simple decision trees Decision trees for analysis Flexibility and real options

Decision Making Under Risk Risk and Uncertainty Risk Preferences, Attitude and Premiums  Examples of simple decision trees Decision trees for analysis Flexibility and real options

Decision Tree Example: Procurement Timing Decisions – Choice of order time (Order early, Order late) Events – Arrival time (On time, early, late) – Theft or damage (only if arrive early) Consequences: Cost – Components: Delay cost, storage cost, cost of reorder (including delay)

Decision Making Under Risk Risk and Uncertainty Risk Preferences, Attitude and Premiums Decision trees for representing uncertainty  Decision trees for analysis Flexibility and real options

Analysis Using Decision Trees Decision trees are a powerful analysis tool Example analytic techniques – Strategy selection (Monte Carlo simulation) – One-way and multi-way sensitivity analyses – Value of information