Managing Risk and Uncertainty

A Strategic Approach

by Friberg

ISBN: 9780262331555 | Copyright 2015

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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.

An extremely useful go-to book for thinking about financial risk and both operational and financial means of mitigating it.

Kenneth A. Froot André R. Jakurski Professor of Business Administration, Harvard Business School

Managing Risk and Uncertainty brings academic rigor to the topic of risk management in a way that is both approachable and thoroughly enjoyable to read. I highly recommend it for current and future managers interested in really learning about risk management.

Lanier Benkard Gregor G. Peterson Professor of Economics, Stanford Graduate School of Business
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Contents (pg. vii)
Preface (pg. xiii)
Acknowledgments (pg. xvii)
1 Introduction (pg. 1)
1.1 A Motivation and an Overview of the Chapters (pg. 1)
1.2 Models or Gut Feeling? A Motivation (pg. 4)
1.3 Some Definitions (pg. 6)
2 Framework of the Book (pg. 9)
2.1 A Matrix of Risk and Uncertainty (pg. 10)
2.2 Four Strategies (pg. 11)
2.3 A Comparison of Strategies (pg. 16)
3 A First Look at Risk: Probability Distributions (pg. 23)
3.1 Risk and Uncertainty (pg. 23)
3.2 One Random Variable (pg. 27)
3.3 Several Random Variables (pg. 39)
Appendix 3A: Weak Law of Large Numbers (pg. 46)
Appendix 3B: Central Limit Theorems (pg. 48)
4 Modeling Decisions under Risk (pg. 53)
4.1 Introductory Notes on Functions (pg. 55)
4.2 Economics of Choice under Risk (pg. 55)
4.3 Concavity and Convexity of Profit Functions (pg. 62)
4.4 Modigliani–Miller and the Management of Risks (pg. 66)
Appendix 4A: Concavity and Convexity of Functions and the Notation Used in This Book (pg. 73)
Appendix 4B: Combining Functions (pg. 75)
Appendix 4C: Jensen’s Inequality (pg. 76)
Appendix 4D: Capital Asset-Pricing Model (pg. 78)
Appendix 4E: Borrowing Constraints and a Lower Threshold (pg. 81)
5 Calculating the Value of Investments (pg. 85)
5.1 Calculating Net Present Value (pg. 85)
5.2 More on the Appropriate Discount Rate—And What about Risk? (pg. 90)
5.3 Other Methods of Judging Which Investments to Pursue (pg. 94)
5.4 How Is the Value of Projects Evaluated? (pg. 95)
6 Risk Management with Financial Instruments (pg. 97)
6.1 Financial Instruments and Their Use (pg. 97)
6.2 Different Forms of Exposure and Their Measurement (pg. 99)
6.3 What Is the Extent of Financial Hedging, and What Instruments Are Used? (pg. 102)
6.4 Differences across Firms in the Use of Financial Instruments for Hedging (pg. 104)
6.5 Hedging versus Speculation (pg. 108)
6.6 What Is the Effect of Financial Hedging on Earnings and Valuation? (pg. 110)
6.7 Financial Hedges (pg. 111)
7 Incomplete Contracts in Financial Markets and Evidence on the Role of Operational Means of Dealing with Risk and Uncertainty (pg. 117)
7.1 Risk, Uncertainty, and the Possibility of Hedging on Financial Markets (pg. 120)
7.2 Financial and Operational Means of Managing Risk and Uncertainty (pg. 124)
8 Decision Trees and Game Theory (pg. 127)
8.1 Decision Trees (pg. 129)
8.2 Uncertainty due to Strategic Interaction—Game Theory (pg. 132)
8.3 Strategic Commitments (pg. 137)
9 Uncertainty (pg. 143)
9.1 Subjective Probability (pg. 146)
9.2 Commonly Proposed Rules for Decision under Uncertainty (pg. 149)
9.3 Modeling Rational Choice with Ambiguity Aversion (pg. 152)
9.4 The Decision Criterion Used to Evaluate Strategies in Chapter 10 (pg. 154)
9.5 A Discussion of Some Assumptions (pg. 157)
Appendix 9A: Axiomatic Approaches to Rational Choice under Risk and Uncertainty (pg. 163)
Appendix 9B: Ellsberg’s Experiment (pg. 167)
Appendix 9C: Example of the Decision Rule with Uniform Distribution of Shocks to “Uncertainty” (pg. 169)
10 Operational and Financial Responses to Risk and Uncertainty (pg. 173)
10.1 Four Strategies to Deal with Risk and Uncertainty (pg. 175)
10.2 A Comparison of Strategies (pg. 178)
10.3 A Parametric Example (pg. 182)
11 Risk and Uncertainty in Different Markets (pg. 189)
11.1 A Matrix of Risk and Uncertainty (pg. 190)
11.2 What Are the Shocks in Different Markets? (pg. 191)
12 Operational Responses (pg. 197)
12.1 A General Intuition (pg. 198)
12.2 Costs (pg. 202)
12.3 Revenue Aspects of Dealing with Risk and Uncertainty (pg. 209)
12.4 Relation to Other Work on Operational Hedging and Risk Management (pg. 222)
Appendix 12A: Lagrange (pg. 222)
Appendix 12B: Marginal Revenue, Marginal Costs, and Variable Profits in a Graph (pg. 225)
13 Pricing (pg. 231)
13.1 Price-Taker or Price-Maker? (pg. 231)
13.2 How Should Prices Respond to Shocks? (pg. 232)
13.3 Empirical Evidence on Price Movements in Response to Cost and Demand Shocks (pg. 240)
Appendix 13A: Solving the Bertrand Model (pg. 243)
Appendix 13B: Dornbusch Cournot Model (pg. 244)
14 Valuing Projects (pg. 249)
14.1 Counterfactual Prediction (pg. 249)
14.2 What to Use When? (pg. 250)
14.3 Reasoned Guesstimates of Cost and Revenue Items (pg. 250)
14.4 Adding Risk to Guesstimates (pg. 251)
14.5 Using Econometric Analysis (pg. 254)
14.6 Experiments (pg. 256)
14.7 Valuing Real Options Using Tools from the Pricing of Financial Assets (pg. 258)
14.8 Monte Carlo Simulation Using Oligopoly Theory (MCSOLT) (pg. 261)
14.9 Don’t Even Try. (pg. 278)
14.10 What to Use and When (pg. 279)
Appendix 14A: Vectors and Matrices—A Refresher (pg. 280)
Appendix 14B: Matrix Algebra (pg. 281)
15 Structuring Information Flows and Decision Processes to Respond to Risk and Uncertainty (pg. 287)
15.1 Role of Organization and Management in Profitability and Survival (pg. 288)
15.2 Organizational Structures for Responding to Uncertainty (pg. 291)
15.3 Information (pg. 298)
15.4 Responding to Trends and New Technologies (pg. 301)
Appendix: Total Factor Productivity (pg. 306)
16 Decisions Based on Biased Estimates (pg. 309)
16.1 Systematic Errors We Make on Our Own (pg. 311)
16.2 Interaction as a Reason for Biased Estimates (pg. 315)
16.3 Avoiding Systematic Errors (pg. 319)
Appendix 16A: Bayes’s Law (pg. 325)
Appendix 16B: A Simple Model of Herding (pg. 326)
References (pg. 333)
Index (pg. 357)

Richard Friberg

Richard Friberg is Jacob Wallenberg Professor of Economics and Chairman of the Department of Economics at Stockholm School of Economics.

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