Non-Financial Risk Management

David Apgar
Managing Director, Corporate Executive Board
Adjunct Professor, Johns Hopkins School of Advanced International Studies
(202) 777-5302
apgard@executiveboard.com

Course Objectives
This course provides students with the essential frameworks and tools needed to manage business risks.
The basic topics covered are evaluating risky projects, selecting risky projects, and mitigating project
risks.
Evaluating risky projects includes risk-adjusted project evaluation and risk-based performance
measurement. Selecting risky projects goes beyond purely financial risk management practice to
consider the impact of a risk-taking firms information advantages and disadvantages, or its risk
intelligence, on the likely results of risky projects. Mitigating project risks includes commodity hedge and
real option evaluation.
The main goal is to prepare students for the growing emphasis on risk management in core business
functions such as operations, procurement, R&D, strategy, information technology, human resources, and
direct investment in emerging markets.
Frameworks
The course focuses on frameworks that executives use to solve widespread risk and finance problems.
These frameworks are best introduced in the context that professionals are most likely to need them:
making a business case for a risky project.
The principal risk and finance frameworks to be introduced include:
Risk types and the distinction between random and learnable risks
Value at risk (VAR) approaches to risk assessment
Risk-adjusted performance measures
Risk-based capital allocation
Valuation of projects with changing capital structures
Bayesian methods to assess the impact of learning on risk
Risk intelligence scorecards and risk strategy audits
Commodity hedging and the relation of forward, spot and expected future prices
Binomial approaches to real options
Risk networks and risk-role matrices

Course Prerequisites and Materials

Prerequisites
The course assumes basic corporate finance. It also assumes some exposure to statistics and
microeconomics.
Materials
Primary texts include:
Apgar, David, Risk Intelligence: Learning to Manage What We Dont Know, Harvard Business School
Press, 2006. ISBN 1591399548, Product #9548
Brealey, Richard A., and Stewart C. Myers. Principles of Corporate Finance. Seventh edition.
McGraw Hill College Division, 2002
th
Hull, John C. Options, Futures, and Other Derivatives, 5 ed. Prentice-Hall, 2005.
Course Content: Weekly Session Outline
Evaluating risky projects
1) Categorizing risks by randomness, market intensity and source
2) Determining value at risk
3) Adjusting hurdle rates for market risk
4) Allocating risk-based capital
5) Evaluating projects with changing risks
6) Adjusting performance goals for market risk

Selecting risky projects

7) Assessing the impact of organizational learning on risk (Bayes theorem)
8) Assessing risk intelligence
9) Conducting risk strategy audits

Mitigating project risks

10) Hedging commodities and foreign exchange
11) Evaluating real options
12) Building effective risk networks

Course Content: Session Plan

Part I: Evaluating risky projects
Session 1: Categorizing risks by randomness, market intensity and source
Content:
Overview of risk types and review of the concept of market risk
Importance of risk randomness in risk assessment
Reading:
Roberto, Michael A. General Eisenhower and the D-Day Invasion. Harvard Business School case
306052, 2005.
Apgar, D. Risk Intelligence, Chapters 1 and 2.

Session 2: Determining value at risk

Content:
Basic value at risk framework
How diversification affects value at risk
Reading:
Hull, John C., Options, Futures and other Derivative Securities, Chapter 16. Or: Linsmeier,
Thomas J., and Neil D. Pearson. Risk Measurement: An Introduction to Value at Risk.
University of Illinois at Urbana-Champaign, 1996.
Das, Sanjiv and Stephen Lynagh. Value-At-Risk. Harvard Business School case 297069, 1997.
Session 3: Adjusting hurdle rates for market risk
Content:
How capital structure and volatility affect equity hurdle rates
Hurdle rate adjustments for foreign exchange risk and high volatility markets
Reading:
Brealey & Myers, Principles of Corporate Finance. Chapters 7 and 8.
Robert E. Kennedy. Project Valuation in Emerging Markets, Harvard Business School Note #
702077, May 14, 2002.
Stulz, Rene M. Globalization of Capital Markets and the Cost of Capital: the Case of Nestle.
Journal of Applied Corporate Finance, Fall 1995, 8:3.

Session 4: Allocating risk-based capital

Content:
Entity risk, single solvency standards and economic capital
How to capitalize a subsidiary
Reading:
Kimball, Ralph. Economic Profit and Performance Measurement in Banking. New England
Economic Review, July/August 1998, pp. 35-53.
Meulbroek, Lisa. Risk Management at Apache. Harvard Business School case 201113, 2001.
Session 5: Evaluating projects with changing risks
Content:
Pitfalls of typical project valuation models
Michelins variable capitalization model
Reading:
Tierny, Jacques, and Charles Smithson. Implementing Economic Capital in an Industrial
Company: the Case of Michelin. Journal of Applied Corporate Finance, Fall 2003, 15:4, pp. 8194.
Session 6: Adjusting performance goals for market risk
Content:
Basic economic profit framework for performance measurement
Typical investment bank risk charge methodology
Reading:
Brealey & Myers, Principles of Corporate Finance. Chapters 9 and 12.
Chacko, George, Peter Hecht, Vincent Dessain and Anders Sjoman. Deutsche Bank: discussing
the Equity Risk Premium. Harvard Business School case 205040, 2005.
Part II: Selecting risky projects
Session 7: Assessing the impact of organizational learning on risk (Bayes theory)
Content:
Bayesian probability and the impact of evidence on beliefs
How to apply Bayes theory to organizational learning and risk

Reading:
Joyce, J. M. Bayes Theorem in Stanford Encyclopedia of Philosophy.
http://plato.stanford.edu/entries/bayes-theorem/.
And: Talbott, William. Bayesian Epistemology in Stanford Encyclopedia of Philosophy.
http://plato.stanford.edu/entries/epistemology-bayesian/.
Lovallo, Dan and Daniel Kahneman. Delusions of Success: How Optimism Undermines
Executives Decisions. Harvard Business Review, # R0307D, July 2003.
Session 8: Assessing risk intelligence
Content:
Risk assessment and competitive advantage
Approaches to estimating a firms intelligence about specific risks
Reading:
Tufano, Peter and Jonathan S. Headley. Why Manage Risk? Harvard Business School Note
#294107, 1994.
Apgar, D. Risk Intelligence, Chapter 3.
Session 9: Conducting risk strategy audits
Content:
Non-financial risk life cycles
Framework for evaluating a portfolio of operating and strategic risks
Reading:
Apgar, D. Risk Intelligence, Chapter 4.
Part III: Mitigating project risks
Session 10: Hedging commodities and foreign exchange
Content:
Arbitrage pricing for forward contracts
Normal backwardation and contango
Reading:
Hull, John C. Options, Futures and other Derivative Securities, Chapter 3.
Gallati, Reto. Metallgesellschaft, chapter 6.3. Risk Management and Capital Adequacy.
McGraw-Hill, 2003.

Session 11: Evaluating real options

Content:
Review of risk-less arbitrage and risk neutral valuation pricing methods
Simple binomial valuation of a real option
Reading:
Hull, John C. Options, Futures and other Derivative Securities, Chapters 9 and 11.
Copeland, Tom and Peter Tufano. A Real-World Way to Manage Real Options, Harvard Business
Review, # R0403G, March 2004.
Session 12: Building effective risk networks
Content:
Risk networks
Approaches to evaluating a firms optimal risk roles
Reading:
Apgar, D. Risk Intelligence. Chapters 5 and 6.
Lewis, William. The Power of Productivity: Wealth, Poverty and the Threat to Global Stability.
University of Chicago Press, 2004. Chapters 9-11.