Modeling Risk

Contents......Page 19
Preface......Page 27
What’s New in the Second Edition......Page 29
Acknowledgments......Page 31
About the Author......Page 33
Introduction......Page 39
Part One. Risk Identification......Page 47
A Brief History of Risk: What Exactly is Risk?......Page 49
Uncertainty versus Risk......Page 50
Why is Risk Important in Making Decisions?......Page 52
Dealing with Risk the Old-Fashioned Way......Page 56
The Look and Feel of Risk and Uncertainty......Page 59
Integrated Risk Management Framework......Page 61
Questions......Page 67
Part Two. Risk Evaluation......Page 69
Taming the Beast......Page 71
The Basics of Risk......Page 73
The Statistics of Risk......Page 74
The Measurements of Risk......Page 80
Appendix—Computing Risk......Page 82
Questions......Page 92
Document the Model......Page 94
Separate Inputs, Calculations, and Results......Page 97
Protect the Models......Page 99
Make the Model User-Friendly: Data Validation and Alerts......Page 100
Track the Model......Page 102
Automate the Model with VBA......Page 103
Model Aesthetics and Conditional Formatting......Page 104
Appendix—A Primer on VBA Modeling and Writing Macros......Page 105
Exercises......Page 114
Part Three. Risk Quantification......Page 117
Chapter 4. On the Shores of Monaco......Page 119
Why Are Simulations Important?......Page 120
Comparing Simulation with Traditional Analyses......Page 123
Using Risk Simulator and Excel to Perform Simulations......Page 126
Questions......Page 132
Getting Started with Risk Simulator......Page 133
Running a Monte Carlo Simulation......Page 135
Using Forecast Charts and Confidence Intervals......Page 146
Correlations and Precision Control......Page 150
Appendix—Understanding Probability Distributions......Page 156
Appendix—ROV Compiler: Protects and Converts Excel Files into Executable EXE......Page 180
Appendix—ROV Extractor and Evaluator: Runs Extreme Super Speed Simulations and Converts Excel Models into a Calculator Environment......Page 184
Exercises......Page 187
Tornado and Sensitivity Tools in Simulation......Page 216
Sensitivity Analysis......Page 225
Distributional Fitting: Single Variable and Multiple Variables......Page 230
Bootstrap Simulation......Page 234
Hypothesis Testing......Page 237
Data Extraction, Saving Simulation Results, and Generating Reports......Page 241
Distributional Analysis Tool......Page 242
Segmentation Clustering Tool......Page 247
Structural Break Analysis......Page 248
Principal Component Analysis......Page 250
Appendix—Goodness-of-Fit Tests......Page 251
Questions......Page 253
Exercises......Page 254
Part Four. Industry Applications......Page 321
Chapter 7. Extended Business Cases I: Pharmaceutical and Biotech Negotiations, Oil and Gas Exploration, Financial Planning with Simulation, Hospital Risk Management, Risk-Based Executive Compensation Valuation, and Risk-Based Schedule Planning......Page 323
Case Study: Pharmaceutical and Biotech Deal Structuring......Page 324
Case Study: Oil and Gas Exploration and Production......Page 344
Case Study: Financial Planning with Simulation......Page 356
Case Study: Hospital Risk Management......Page 366
Case Study: Risk-Based Executive Compensation Valuation......Page 386
Case Study: Risk-Based Schedule Planning with Simulation......Page 395
Part Five. Risk Prediction......Page 407
Different Types of Forecasting Techniques......Page 409
Running the Forecasting Tool in Risk Simulator......Page 413
Time-Series Analysis......Page 414
Multivariate Regression......Page 418
Stepwise Regression......Page 421
Stochastic Forecasting......Page 424
Nonlinear Extrapolation......Page 428
Box–Jenkins ARIMA Advanced Time-Series......Page 430
Auto ARIMA (Box–Jenkins ARIMA Advanced Time-Series)......Page 435
Basic Econometrics......Page 437
J-Curve and S-Curve Forecasts......Page 439
GARCH Volatility Forecasts......Page 441
Markov Chains......Page 444
Maximum Likelihood Models on Logit, Probit, and Tobit......Page 446
Questions......Page 449
Exercise: Forecasting......Page 451
Time-Series Forecasting Methodology......Page 464
No Trend and No Seasonality......Page 465
With Trend but No Seasonality......Page 471
No Trend but with Seasonality......Page 473
With Seasonality and with Trend......Page 477
Regression Analysis......Page 479
The Pitfalls of Forecasting: Outliers, Nonlinearity, Multicollinearity, Heteroskedasticity, Autocorrelation, and Structural Breaks......Page 495
Other Technical Issues in Regression Analysis......Page 509
Regression and Forecasting Diagnostic Tool......Page 511
Statistical Analysis Tool......Page 521
Appendix—Forecast Intervals......Page 527
Appendix—Ordinary Least Squares......Page 528
Appendix—Detecting and Fixing Heteroskedasticity......Page 531
Appendix—Detecting and Fixing Multicollinearity......Page 532
Appendix—Detecting and Fixing Autocorrelation......Page 534
Exercise......Page 535
Part Six. Risk Diversification......Page 537
What Is an Optimization Model?......Page 539
The Traveling Financial Planner......Page 540
The Lingo of Optimization......Page 542
Solving Optimization Graphically and Using Excel’s Solver......Page 545
Questions......Page 551
Optimization Procedures......Page 552
Continuous Optimization......Page 555
Discrete Integer Optimization......Page 561
Efficient Frontier and Advanced Optimization Settings......Page 564
Stochastic Optimization......Page 568
Optimization Application Example: Military Portfolio and Efficient Frontier......Page 573
Optimization Application Example: Optimal Pricing with Elasticity......Page 577
Appendix—ROV Modeler Suite: Server-Based Applications for Running Data-Intensive Models at Extremely High Speeds......Page 582
Appendix—Computing Annualized Returns and Risk for Portfolio Optimization......Page 600
Exercise: Optimization......Page 604
Questions......Page 617
Part Seven. Risk Mitigation......Page 619
What Are Real Options?......Page 621
The Real Options Solution in a Nutshell......Page 623
Issues to Consider......Page 624
Implementing Real Options Analysis......Page 625
Types of Real Options Strategies......Page 626
Industry Leaders Embracing Real Options......Page 628
More Sample Applications and Short Cases......Page 631
What the Experts Are Saying......Page 644
Criticisms, Caveats, and Misunderstandings in Real Options......Page 647
Questions......Page 650
Chapter 13. The Black Box Made Transparent: Real Options Super Lattice Solver Software......Page 651
Single Asset Super Lattice Solver......Page 653
Multiple Asset Super Lattice Solver......Page 662
Multinomial Super Lattice Solver......Page 664
SLS Excel Solution (SLS, MSLS, and Changing Volatility Models in Excel)......Page 666
SLS Functions......Page 669
Payoff Charts, Tornado Sensitivity, Scenario, and Convergence Analysis......Page 673
Key SLS Notes and Tips......Page 679
Exercises......Page 682
Part Eight. More Industry Applications......Page 711
Chapter 14. Extended Business Cases II: Real Estate, Banking, Military Strategy, Automotive Aftermarkets, Global Earth Observation Systems, Employee Stock Options, Oil and Gas Royalty Lease Negotiations, Real Options and IT Enterprise Risk Security, Basel II Credit and Market Risk Analysis, and IT Information Security Intrusion Risk Management......Page 713
Case Study: Understanding Risk and Optimal Timing in a Real Estate Development Using Real Options Analysis......Page 714
Case Study: Using Stochastic Optimization and Valuation Models to Evaluate the Credit Risk of Corporate Restructuring......Page 730
Case Study: Real Options and KVA in Military Strategy at the United States Navy......Page 736
Case Study: Manufacturing and Sales in the Automotive Aftermarket......Page 747
Case Study: The Boeing Company’s Strategic Analysis of the Global Earth Observation System of Systems......Page 757
Case Study: Valuing Employee Stock Options Under the 2004 FAS 123R......Page 767
Case Study: Oil and Gas Royalty Lease Negotiation......Page 798
Case Study: How Real Options Mitigates IT Enterprise Security Risks......Page 818
Case Study: Basel II Credit Risk and Market Risk......Page 833
Case Study: IT Information Security Intrusion Risk Management......Page 879
Part Nine. Risk Management......Page 901
The Problem of Negligent Entrustment......Page 903
Sins of an Analyst......Page 904
Reading the Warning Signs in Monte Carlo Simulation......Page 906
Reading the Warning Signs in Time-Series Forecasting and Regression......Page 917
Reading the Warning Signs in Real Options Analysis......Page 922
Reading the Warning Signs in Optimization under Uncertainty......Page 925
Questions......Page 926
Change-Management Issues and Paradigm Shifts......Page 927
Making Tomorrow’s Forecast Today......Page 931
Parting Shots and a Word of Caution from the Author......Page 932
Notes......Page 943
Tables You Really Need......Page 953
Standard Normal Distribution (partial area)......Page 954
Standard Normal Distribution (full area)......Page 955
Student’s t-Distribution (one and two tails)......Page 956
Durbin–Watson Critical Values (alpha 0.05)......Page 957
Normal Random Numbers (standard normal distribution’s random number generated ∼ (N(0, 1))......Page 958
Random Numbers (multiple digits)......Page 960
Uniform Random Numbers (uniform distribution’s random number generated between 0.0000 and 1.0000)......Page 962
Chi-Square Critical Values......Page 964
F-Distribution Critical Statistics (alpha one tail 0.10)......Page 966
F-Distribution Critical Statistics (alpha one tail 0.05)......Page 968
F-Distribution Critical Statistics (alpha one tail 0.025)......Page 970
F-Distribution Critical Statistics (alpha one tail 0.01)......Page 972
Real Options Analysis Values (1-year maturity at 5% risk-free rate)......Page 974
Real Options Analysis Values (3-year maturity at 5% risk-free rate)......Page 976
Real Options Analysis Values (5-year maturity at 5% risk-free rate)......Page 978
Real Options Analysis Values (7-year maturity at 5% risk-free rate)......Page 980
Real Options Analysis Values (10-year maturity at 5% risk-free rate)......Page 982
Real Options Analysis Values (15-year maturity at 5% risk-free rate)......Page 984
Real Options Analysis Values (30-year maturity at 5% risk-free rate)......Page 986
Answers to End of Chapter Questions......Page 989
What’s on the DVD......Page 997
Customer Care......Page 998
Index......Page 1001