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Strategic risk taking: a framework for risk management

Author: Damodaran, Aswath Publisher: Wharton School Publishing, 2008. ; Pearson Education, 2008.Language: EnglishDescription: 388 p. : Graphs/Ill. ; 24 cm.ISBN: 9780131990487 ; 978013704377Type of document: BookBibliography/Index: Includes index
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Book Europe Campus
Main Collection
Print HD61 .D36 2008
(Browse shelf)
001228539
Available 001228539
Book Europe Campus
Main Collection
Print HD61 .D36 2008
(Browse shelf)
001198716
Available 001198716
Book Middle East Campus
Textbook Collection
Print HD61 .D36 2008
(Browse shelf)
500017768
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Includes index

Digitized

Strategic Risk Taking A Framework for Risk Management Contents INTRODUCTION A Roadmap for Understanding Risk....................................................... xvii CHAPTERS 1-4 The Economists' View of Risk Aversion and the Behavioral Response.............................................................. CHAPTER 1 1 What Is Risk?.............................................................................................. 3 A Very Short History of Risk................................................................................................ 3 Defining Risk.......................................................................................................................... 5 Dealing with Risk................................................................................................................... 7 Risk and Reward....................................................................................................................7 Risk and Innovation............................................................................................................... 7 Risk Management..................................................................................................................... 8 The Conventional View and Its Limitations.......................................................................... 8 A More Expansive View of Risk Management...................................................................... 9 Conclusion .............................................................................................................................. 9 CHAPTER 2 Why Do We Care About Risk? ...........................................................................................................................................11 The Duality of Risk............................................................................................................... 11 I Am Rich, But Am I Happy? Utility and Wealth.............................................................. 12 The St. Petersburg Paradox and Expected Utility: The Bernoulli Contribution................... 12 Mathematics Meets Economics: Von Neumann and Morgenstern ......................................14 The Gambling Exception? ..................................................................................................................................................................... 16 Small Versus Large Gambles...............................................................................................17 Measuring Risk Aversion .................................................................................................... 18 Certainty Equivalents........................................................................................................ 18 Risk Aversion Coefficients ................................................................................................. 20 Other Views on Risk Aversion .......................................................................................... 23 Prospect Theory..................................................................................................................26 Consequences of Views on Risk ............................................................................................28 Investment Choices.............................................................................................................28 Corporate Finance ............................................................................................................. 29 Valuation.............................................................................................................................30 Conclusion ............................................................................................................................. 30 CHAPTER 3 What Do We Think About Risk? ..................................................................................35 General Principles...................................................................................................................35 Evidence on Risk Aversion.....................................................................................................36 Experimental Studies .........................................................................................................36 Survey Measures ................................................................................................................47 Pricing of Risky Assets ......................................................................................................50 Evidence from Racetracks, Gambling, and Game Shows .................................................57 Propositions about Risk Aversion...........................................................................................61 Conclusion ............................................................................................................................. 63 CHAPTER 4 How Do We Measure Risk? ......................................................................................... 65 Fate and Divine Providence.................................................................................................... 65 Estimating Probabilities: The First Step to Quantifying Risk................................................ 66 Sampling, The Normal Distributions, and Updating.............................................................. 68 The Use of Data: Life Tables and Estimates.......................................................................... 70 The Insurance View of Risk................................................................................................... 70 Financial Assets and the Advent of Statistical Risk Measures...............................................71 The Markowitz Revolution .................................................................................................... 73 Efficient Portfolios ............................................................................................................ 73 The Mean-Variance Framework ........................................................................................74 Implications for Risk Assessment ..................................................................................... 76 Introducing the Riskless Asset--The Capital Asset Pricing Model (CAPM) Arrives.............................................................................................................. 77 Mean Variance Challenged.....................................................................................................78 Fat Tails and Power-Law distributions ............................................................................. 79 Asymmetric Distributions ................................................................................................. 81 Jump Process Models......................................................................................................... 83 Data Power: Arbitrage Pricing and Multifactor Models.......................................... 83 Arbitrage Pricing Model..................................................................................................... 84 Multifactor and Proxy Models............................................................................................85 The Evolution of Risk Measures ............................................................................. 86 Conclusion ............................................................................................................... 86 CHAPTERS 5-8 Risk Assessment: Tools and Techniques......................................... 97 CHAPTER 5 Risk-Adjusted Value.......................................................................................... 99 Discounted Cash Flow Approaches.......................................................................... 99 The DCF Value of an Asset............................................................................................. 100 Risk-Adjusted Discount Rates ............................................................................ 101 Certainty-Equivalent Cash Flows .................................................................................... 106 Hybrid Models.................................................................................................................. 111 DCF Risk Adjustment: Pluses and Minuses .................................................................... 116 Post-Valuation Risk Adjustment............................................................................. 117 Rationale for Post-Valuation Adjustments....................................................................... 117 Downside Risks................................................................................................................ 118 Other Discounts .................................................................................................. 125 Upside Risks..................................................................................................................... 126 The Dangers of Post-Valuation Adjustments................................................................... 127 Relative Valuation Approaches ............................................................................. 128 Basis for Approach ............................................................................................. 128 Risk Adjustment .............................................................................................................. 129 DCF Versus Relative Valuation....................................................................................... 130 The Practice of Risk Adjustment............................................................................ 130 Conclusion ............................................................................................................. 131 Fixed Discount ....................................................................................................... 136 Firm-Specific Discount ........................................................................................................ 137 Determinants of Illiquidity Discounts ............................................................................. 137 Estimating Firm-Specific Illiquidity Discount................................................................. 139 Synthetic Bid-Ask Spread.....................................................................................................142 Option-Based Discount......................................................................................................... 143 CHAPTER 6 Probabilistic Approaches: Scenario Analysis, Decision Trees, and Simulations............................................................................ 145 Scenario Analysis .................................................................................................................145 Best Case/Worst Case ......................................................................................................146 Multiple Scenario Analysis...............................................................................................147 Decision Trees.......................................................................................................................153 Steps in Decision Tree Analysis ...................................................................................... 153 An Example of a Decision Tree .......................................................................................156 Use in Decision Making................................................................................................... 160 Issues ................................................................................................................................161 Risk-Adjusted Value and Decision Trees.........................................................................162 Simulations............................................................................................................................164 Steps in Simulation........................................................................................................... 164 An Example of a Simulation ............................................................................................168 Use in Decision Making................................................................................................... 173 Simulations with Constraints............................................................................................174 Issues ................................................................................................................................176 Risk-Adjusted Value and Simulations..............................................................................177 An Overall Assessment of Probabilistic Risk Assessment Approaches................................ 179 Comparing the Approaches.............................................................................................. 179 Complement or Replacement for Risk Adjusted Value................................................... 180 In Practice ........................................................................................................................ 181 Conclusion ............................................................................................................................. 182 Fitting the Distribution .........................................................................................................183 Is the Data Discrete or Continuous? 183 How Symmetric Is the Data? ...........................................................................................188 Are There Upper or Lower Limits on Data Values? ....................................................... 194 How Likely Are You to See Extreme Values of Data, Relative to the Middle Values?..195 Tests for Fit .......................................................................................................................... 196 Tests of Normality................................................................................................................ 198 Conclusion ........................................................................................................................... 199 CHAPTER 7 Value at Risk (VaR) .........................................................................................201 What Is VaR?...................................................................................................................... 201 A Short History of VaR........................................................................................................ 202 Measuring VaR..................................................................................................................... 204 Variance-Covariance Method .......................................................................................... 204 Historical Simulation ....................................................................................................... 210 Monte Carlo Simulation................................................................................................... 214 Comparing Approaches ................................................................................................... 217 Limitations of VaR................................................................................................................218 VaR Can Be Wrong.......................................................................................................... 218 Narrow Focus ...................................................................................................................221 Suboptimal Decisions....................................................................................................... 222 Extensions of VaR................................................................................................................ 223 VaR as a Risk Assessment Tool............................................................................................ 225 Conclusion ............................................................................................................................ 227 CHAPTER 8 Real Options..................................................................................................... 231 The Essence of Real Options................................................................................................. 231 Real Options, Risk-Adjusted Value, and Probabilistic Assessments.................................... 233 Real Option Examples .......................................................................................................... 235 The Option to Delay an Investment .................................................................................235 The Option to Expand....................................................................................................... 246 The Option to Abandon an Investment ............................................................................253 Caveats on Real Options ..................................................................................................... 257 Real Options in a Risk Management Framework.................................................................. 260 Conclusion ............................................................................................................................ 261 Option Payoffs ..................................................................................................................... 262 Determinants of Option Value ............................................................................................. 264 Option Pricing Models.......................................................................................................... 266 The Binomial Model......................................................................................................... 266 The Black-Scholes Model................................................................................................. 270 CHAPTERS 9-12 Risk Management: The Big Picture................................................ 277 CHAPTER 9 Risk Management: The Big Picture............................................................................. 279 Risk and Value: The Conventional View..............................................................................280 Discounted Cash Flow Valuation..................................................................................... 280 Relative Valuation Models .............................................................................................. 285 Expanding the Analysis of Risk............................................................................................ 287 Discounted Cash Flow Valuation..................................................................................... 288 Relative Valuation............................................................................................................ 295 Option Pricing Models...................................................................................................... 298 A Final Assessment of Risk Management.............................................................................. 301 When Does Risk Hedging Pay Off? 302 When Does Risk Management Pay Off?.......................................................................... 303 Risk Hedging Versus Risk Management.......................................................................... 303 Developing a Risk Management Strategy.............................................................................. 304 Conclusion ............................................................................................................................. 306 CHAPTER 10 Risk Management: Profiling and Hedging.................................................................. 309 Risk Profile ............................................................................................................................ 309 Step 1: List the Risks........................................................................................................ 310 Step 2: Categorize the Risks............................................................................................. 310 Step 3: Measure Exposure to Each Risk........................................................................... 311 Step 4: Analyze the Risks................................................................................................. 318 To Hedge or Not to Hedge?................................................................................................. 319 The Costs of Hedging...................................................................................................... 319 The Benefits of Hedging..................................................................................................320 The Prevalence of Hedging ............................................................................................ 326 Does Hedging Increase Value?........................................................................................ 329 Alternative Techniques for Hedging Risk........................................................................... 331 Investment Choices..........................................................................................................331 Financing Choices........................................................................................................... 332 Insurance..........................................................................................................................333 Derivatives.......................................................................................................................334 Picking the Right Hedging Tool...................................................................................... 338 Conclusion .......................................................................................................................... 339 CHAPTER 11 Strategic Risk Management ............................................................................ 341 Why Exploit Risk?............................................................................................................... 341 Value and Risk Taking.................................................................................................... 342 Evidence on Risk Taking and Value............................................................................... 344 How Do You Exploit Risk? 345 The Information Advantage.............................................................................................346 The Speed Advantage .....................................................................................................348 The Experience/Knowledge Advantage.......................................................................... 350 The Resource Advantage.................................................................................................352 Flexibility.........................................................................................................................353 Building the Risk-Taking Organization ............................................................................... 356 Corporate Governance.....................................................................................................356 Personnel......................................................................................................................... 358 Reward/Punishment Mechanisms....................................................................................360 Organization Size, Structure, and Culture ......................................................................363 Conclusion ............................................................................................................................365 CHAPTER 12 Risk Management: First Principles .......................................................367 1. Risk Is Everywhere......................................................................................................... 367 2. Risk Is Threat and Opportunity ......................................................................................369 3. We Are Ambivalent About Risks and Not Always Rational About the Way We Assess or Deal with Risk............................................................................................................. 369 4. Not All Risk Is Created Equal ....................................................................................... 370 5. Risk Can Be Measured....................................................................................................372 6. Good Risk Measurement/Assessment Should Lead to Better Decisions....................... 373 7. The Key to Good Risk Management Is Deciding Which Risks to Avoid, Which Ones to Pass Through, and Which to Exploit........................................................................... 374 8. The Payoff to Better Risk Management Is Higher Value...............................................375 9. Risk Management Is Part of Everyone's Job.................................................................. 376 10. Successful Risk-Taking Organizations Do Not Get There by Accident...................... 376 Conclusion ......................................................................................................................... 378 Index ..................................................................................................... 379

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