A comprehensive framework for assessing strategies for managing risk and uncertainty, integrating theory and practice and synthesizing insights from many fields.

This book offers a framework for making decisions under risk and uncertainty. Synthesizing research from economics, finance, decision theory, management, and other fields, the book provides a set of tools and a way of thinking that determines the relative merits of different strategies. It takes as its premise that we make better decisions if we use the whole toolkit of economics and related fields to inform our decision making.

The text explores the distinction between risk and uncertainty and covers standard models of decision making under risk as well as more recent work on decision making under uncertainty, with a particular focus on strategic interaction. It also examines the implications of incomplete markets for managing under uncertainty. It presents four core strategies: a benchmark strategy (proceeding as if risk and uncertainty were low), a financial hedging strategy (valuable if there is much risk), an operational hedging strategy (valuable for conditions of much uncertainty), and a flexible strategy (valuable if there is much risk and/or uncertainty). The book then examines various aspects of these strategies in greater depth, building on empirical work in several different fields. Topics include price-setting, real options and Monte Carlo techniques, organizational structure, and behavioral biases. Many chapters include exercises and appendixes with additional material. The book can be used in graduate or advanced undergraduate courses in risk management, as a guide for researchers, or as a reference for management practitioners.

A comprehensive framework for assessing strategies for managing risk and uncertainty, integrating theory and practice and synthesizing insights from many fields.

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—A Discussion 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 the 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 181 Exercises 187 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 239 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 Decision 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 Herding Model 326 Exercises 330 References 333 Index 357