1. Risk Management & Real Options Wrap-up
Stefan Scholtes
Judge Institute of Management
University of Cambridge
MPhil Course
Course website with accompanying material

2. Course content Introduction The forecast is always wrong
The industry valuation standard: Net Present Value
Sensitivity analysis
The system value is a shape
Value profiles and value-at-risk charts
SKILL: Using a shape calculator
CASE: Overbooking at EasyBeds
Developing valuation models
Easybeds revisited
Designing a system means sculpting its value shape
CASE: Designing a Parking Garage I
The flaw of averages: Effects of system constraints
Coping with uncertainty I: Diversification
The central limit theorem
The effect of statistical dependence
Optimising a portfolio
Coping with uncertainty II: The value of information
SKILL: Decision Tree Analysis
CASE: Market Research at E-Phone
Coping with uncertainty III: The value of flexibility
Investors vs. CEOs
CASE: Designing a Parking Garage II
The value of phasing
SKILL: Lattice valuation
Example: Valuing a drug development projects
The flaw of averages: The effect of flexibility
Hedging: Financial options analysis and Black-Scholes
Contract design in the presence of uncertainty
SKILL: Two-party scenario tree analysis
Project: Valuing a co-development contract
Wrap-up and conclusions
2 September 2004
© Scholtes 2004

3. Aims and objectives of the course
General issue:
How can we use (simple) models to help us understand uncertainty and the consequences of our decisions in an uncertain world?
General objectives:
This is a skills-based course. You will learn to use a computer to help you understand and improve system value
Computational tools based on Excel plus a few add-ins
But it is also intellectually stretching. I hope to change the way you think about uncertainty in your everyday life
2 September 2004
© Scholtes 2004

4. Examples of systems we have in mind
Harbour expansion in Sidney
Designing communications satellites at Motorola
Terminal 5, 3rd run-way at Heathrow
Satellite-based toll collection system in Germany
Sonic cruiser vs 7E7 at Boeing
Fleet planning at BA
Bidding for G3 telecom licenses
Production sharing contract between BP and Petronas, Malaysia
Drug co-development contract between Cambridge Antibody Technology and Astra Zeneca
2 September 2004
© Scholtes 2004

5. Key challenges Understanding the system value
Improving the system design
This course focuses on the valuation and design optimisation of systems that operate in an unpredictable dynamic environment
We will mainly focus on economic valuations ($$) as system values but the general framework applies to non-monetary value measures, too
E.g. service level
2 September 2004
© Scholtes 2004

6. What were we concerned with
What were we concerned with? Starting point: System value is more than a number
Big Points
We lack an intuitive understanding and clear communication of the effects of uncertainty on system value
We work with forecasts of uncertain variables to generate a single output – the “value” – to re-assure ourselves
BUT: The forecast is always wrong
2 September 2004
© Scholtes 2004

7. What were we concerned with. I
What were we concerned with? I. Recognising uncertainty: Values as shapes
Big points
Uncertainty is best represented by a SHAPE
If we want to work with shapes, we need a shape calculator
SKILL: LEARNED HOW TO USE A SHAPE CALCULATOR
2 September 2004
© Scholtes 2004

8. What were we concerned with. II
What were we concerned with? II. Developing valuation models: No right answer
Big points
Engineering models focus on “the right answers” - economic valuation of systems must acknowledge that THERE IS NO RIGHT VALUE
Disheartened response: “Hard” modelling is useless
My (and hopefully our) response: “Hard” modelling is even more important BUT we have to revise our expectations on modelling
Good models test and improve our intuition about the value
Good models help us communicate insight - models are vehicles for story telling
Work with many valuation models – each of them is part of the “Valuation puzzle”
2 September 2004
© Scholtes 2004

9. What were we concerned with? The flaw of averages
The system value calculated on the basis of average conditions is not the average system value
Constraints imply that the system value calculated on the basis of average conditions OVERESTIMATES the average system value
Flexibility implies that the system value calculated on the basis of average conditions UNDERESTIMATES the average system value
Scenario-based analyses, such as decision trees or Monte Carlo simulation, avoid the flaw
2 September 2004
© Scholtes 2004

10. What were we concerned with. III
What were we concerned with? III. How to cope with uncertainty: The 3 weapons
Diversification: Don’t put all your eggs in one basket
Information: Gather information to narrow down the level of uncertain
Flexibility: Make sure you can act to avoid losses and amplify gains as uncertainties unfold
Skill: HAVE SEEN SOME SIMPLE MODELLING TEMPLATES THAT ALLOW YOU TO ANALYSE THE EFFECTS OF THESE WEAPONS
2 September 2004
© Scholtes 2004

11. What were we concerned with. IV. Whose risk is it anyway
What were we concerned with? IV. Whose risk is it anyway? Risk sharing in contracts
Contracts are the building blocks of business
Need to understand the effect of contract terms on risk exposure and opportunity sharing
Skill: DEVELOPING SIMPLE MODELS FOR CONTRACT VALUATION
2 September 2004
© Scholtes 2004

12. I HOPE YOU HAVE ENJOYED THE COURSE
THAT’S IT!
I HOPE YOU HAVE ENJOYED THE COURSE
2 September 2004
© Scholtes 2004