Homework From Slides

New expected revenue = 106, Cost of capital = 0.05, 99% confidence level CaR (z=2.326). Should the pharmaceutical company invest in the new drug?

Calculate CaR with 99% confidence:

• 2.326*20=46.52 (new)
• 2.326*25=58.15 (current)
• 2.326*35= 81.41 for combined(calculated by finding the variance of the cash flows, taking the square root and then multiplying by Z=2.326)

Calculate PV of cash flows:

• New drug=106/(1.05)-100=0.9524
  

The new drug also increases firm risk:

• 106/1.05-100-.11*(change in CaR from old to new) = 106/1.05-100-.11*(81.41-58.15)=-1.6062
  

If introducing this new product did not create extra risk to the firm, it would be wise of the company to invest in the new drug since it has a positive NPV. But when risk is also taken into account, the NPV changes to less than zero, meaning that this investment will not be profitable and the company should not invest in the new drug.

9 Commandments of Risk Mangement

I, let's just say stumbled upon an interesting article explaining the 9 rules of risk management developed by the RiskMetrics group. I was excited at first as the author of the article suggested that these simple rules are the only guidelines a risk manager needs to make confident risk management decisions. Before I started reading the 9 rules I was excited to find out that I would know everything that there is to know regarding risk management in a matter of minutes...
Oh, but I was wrong! I started reading the 9 rules and it reminded me of the 10 commandments of the bible. Short sentences that tells us what to do even though we all know it already. For example, the first rule says:"There is no return without risk", the 8th rule says:"Use common sense". The entire list of rules are common sense and also all the material we covered in the first five minutes of our first lecture. There is no way that this article is all that I would personally need to be a successful risk manager. Sorry, try again RiskMetrics.

Supply Chain Risk Management Strategy

Many of us always look at ways to reduce the costs of risk in our firms or companies, but we never think about our suppliers. Come to think of it, you can make use of all the risk management strategies out on the market and reduce you risk cost to zero, however this could be essentially worthless if you have no supplier to supply you with products to sell and make some sort of profit. Many of us might think that it would be absolutely useless to implement some sort of supply chain risk management strategy, but think about it in this manner: What would happen if not your own office building burns down, but your supplier's office building burns down? Your supplier would not be able to supply you with your good thus you would not be able to sell it and run a profitable business. So supply chain management will ultimately affect you in one way or another. For example when China was hit by that huge earthquake last year, it affected many US companies that received their supplies from that part of China.

I found a video on youtube.com that discusses supply chain risk management. Supply chain risk management has become an increasing factor in many business strategies due to some of the changes involved in supply chains over the last few years. Supply chains are moving towards reducing inventory size which in turn reduces the buffer size that suppliers have in case something goes wrong. Also global sourcing is happening at a rapid pace, where we are no longer buying things from around the corner, but we are buying from all over the place, especially from outside the country. Companies also have a much larger supply base now and many different suppliers all of which require better and more efficient communicating skills. Lastly, a business' customers have greater demands for variability in products, so if you do not have the product that they want, they will go somewhere else to get it, thus you supply chain management is key.

This is where supply chain management kicks in. First and foremost companies need asses the risk associated with their supply chains. Tools to achieve this are described in detail in the video. Secondly the company needs to develop risk mitigation strategies for foreseeable risks, but these take time, effort and are expensive. The most important part of these strategies is a plan of how to respond as quickly as possible if an unlikely event was to occur and to minimize the cost of this event. This involves creating models to simulate what would happen in the case of an unlikely event happening.

A Risk-Averse Generation

Many people are now asking what they should invest in or if they should invest at all during this economic recession? I found an interesting article in the New York Times, that comments on how the generation of investors in their 20's and 30's are becoming risk-averse or "shy investors" investing only in low risk, low return investments. People have always been taught to have a well-diversified portfolio and then you will have high, consistent returns, but due to the recent meltdown, many investors houses' equities and investment portfolios have gone down and their college degrees are not protecting them from unemployment. Also the possibility of unemployment and inconsistent cash flows makes risky investments less desirable. People are now considering less risky investments even though it means a lower return and a smaller retirement RV.

I think people should should still invest, but they should make wise decisions when doing so. Firstly, people should pay off high interest debt such as credit card debt and student loans, which in turn will free up some money for investments. Secondly, they should consider the reliability of the employment, such as a tenured professor has great job security and could invest more in equities. However, someone working in the stock market has less job security and should consider less risky investments. Whatever you decide to invest in, make sure you invest in something below your limit, something that you can easily afford.

Invest wisely...

Should VaR be thrown in the trash can?

No it should not. Event though the VaR model is based on a normal distribution and can only predict losses 99% of the time, it does not take into account that 1% that could be a fat tail on the distribution model that represents huge losses. Some blame the financial meltdown on these risk management tools and they say that they should be abandoned. Just because the financial meltdown occurred in that 1% of unknown risk, it does not mean that we cannot use this in the 99% of the other (normal) financial times. The financial meltdown did not happen because these risk management tools failed, but more because of a lack of proper management and Wall Street greed. Value at Risk models are far from perfect and they need to be adjusted from only taking past statistics into account to predict future risk, but they cannot simply be discarded, they just need to be refined to consider that 1% fat tail.

http://www.nytimes.com/2009/01/18/magazine/18letters-t-.html?scp=3&sq=value%20at%20risk&st=cse

Salmonella in your peanut butter

Since we have had so many discussions of how important reputations are to a company's success, I decided to investigate how a company like Peter Pan Peanut Butter could have used help from Government authorities that use proper risk management to handle situation like this.

The USDA, FDA and CDC started a risk assessment model in response to over 600 000 illnesses per year in the US from contaminated Salmonella eggs. From this risk assessment, they produced a farm-to-table model that could determine the effects of an intervention of an illness. This risk assessment process consists of 4 steps: The first step is to collect and organize all the information of the pathogen or nutrient. Secondly, determine the relationship between the pathogen and any harmful effects. Thirdly, is to determine how the pathogen may spread throughout the population. Lastly, is risk characterization which is just evaluating the risk involved.

Now the questions is, if Peter Pan makes use of these strategies; is it too late? Should Peter Pan rely on the government to fix their mishaps and make it public news or should they implement their own risk management program to prevent this mishap from happening from the start?

I believe that this farm should make use of their own risk management strategies for example, some farmers in the UK have taken out insurance contracts that covers their losses of flocks of birds that are slaughtered since they tested positive for Salmonella.

Nutrition, Food Safety, And Risk Assessment

Wall Street lied to their computers

I found another article on the NY times that is in slight contrast to my last post. This article entitled, "How Wall Street lied to their computers" discusses a different opinion to that of the previous one entitled, "Risk Mismanagement". In this article, the writer states that the risk management models that were in place were actually functioning correctly and that they were giving top executives strong warning signs about the mortgage-backed loans, yet they still chose to be greedy and took on huge bets/risks even though they were advised against it. This is a big contrast to what the Risk Mismanagement article claimed that these risk models were faulty. I would also disagree with the Risk Mismanagement article as I showed in my previous post how Goldman Sachs top executives used their risk management models wisely to avoid the financial meltdown.

Wall Street executives supplied their risk models with over simplified data. This caused the risk models not to consider hard financial times and thus the warning signs were not as strong as it should have been with the correct data. The executives provided data to their risk models of the last few years when the market was reasonably stable, instead of providing them with up to date data so that they could show the proper results. Executives did this as they were required by regulators to monitor their risk positions and thus adjust their their bets or set aside more capital to cover the extra risk that is being taken on. By lying to their risk management models, these executives could bypass the regulators and their risk models and invest in the failing mortgage securities, even though all the warning signs were there not to invest.