August 2006

Industry Application
DecisionTools and Options Valuation
The notion of derivatives and options is relatively recent, as quantitative analysis has come of age. Palisade entered the market for analytical software as desktop computing was just emerging, and its decision analysis tools have supported the increasing sophistication of options valuation.

:: What are Derivatives and Options?
"Derivatives" is a general term used to indicate that the value of a contract is derived from the value of another asset or process, e.g. insurance contracts on disasters, or penalty clauses in contracts relating to whether performance targets are met.

"Options" is a term that refers to a specific type of derivative contract where the holder has a right to exercise the contract in certain circumstances, e.g. a call option on a stock. However, the term "option" is often used loosely to refer to any type of derivative:

• Insurance contracts
• Penalty clauses in contracts according to whether performance targets are met by a supplier
• Value of a business dependent on whether a future legal ruling is favorable or not
• Option to postpone or expand an investment until further information or test results become available
• Call option on a stock in the financial markets

:: Valuing Derivatives using @RISK
In order to perform a valuation on derivatives, you must model the random behavior of the underlying asset over time. The model must include the form of the payoff (e.g. insurance policy coverage and payout conditions), and account for the discount rate. The purpose of the discount rate is to calculate, in today's terms, the value of the option when it is either exercised or expires after taking into account the risks associated with the randomness of the asset's price. For real options (that is, non-traded assets), the issue of the discount rate is complex, as the correct "price of risk" is difficult to pin down.

@RISK can be used in a number of steps of derivatives valuation:

• Simulate the payoffs using Monte Carlo simulation.
• Simulate the discount rate, or “price of risk.”
• Take the average of the calculated discounted payoffs over all simulations to give you the fair value of the derivative in today’s terms

:: PrecisionTree at Procter and Gamble
Procter and Gamble was one of the first customers to apply Palisade software to real options problems. Bob Hunt, former Associate Director for Investment Analysis in P&G's Corporate Finance division, cited the company's use of PrecisionTree in particular. "PrecisionTree's attraction is its capacity to value complex decisions, which often involve multiple, sequential decision steps. We considered using financial option calculators to analyze the real options that are embedded in our complex decisions, but we found that they simply can't solve for the real option value in projects with multiple, sequential investment decisions. Decision trees are really the only tool that can correctly value multiple sequential decisions where uncertainty is private risk." Procter & Gamble has since deployed PrecisionTree to major business units around the world.

:: Essential Preparation for Business
The increasing real-world use of options valuation has made @RISK and the DecisionTools Suite essential business tools, and they are being taught both in graduate business programs and on the job. Palisade's software is used by M.B.A. students at such institutions as the London School of Business, Harvard Business School, the Wharton School of Business at the University of Pennsylvania, Columbia University, the S. C. Johnson School of Business at Cornell University, the Kellogg School of Management at Northwestern University, the Kelley School of Business at Indiana University, and the Jesse H. Jones Graduate School at Rice University. Professors report that they like the Palisade software because the tools do their work without involving students in the computational complexities.

:: Options Training Seminars
For those who are already on the job and want to expand their skill set to include options valuation, Palisade offers hands-on seminars. Options valuation is a frequent topic in Palisade seminars.

View seminar schedule
Procter and Gamble case study
More on @RISK
More on PrecisionTree
More on DecisionTools Suite

Case Study:
Gannett Fleming uses @RISK for Project for Public Transit
When it comes to public transit projects, cost and schedule overruns are of such major concern to stakeholders that the U.S. Federal Transit Administration (FTA), the federal body which oversees public transit risk assessments before federal funds are granted, expects project completion confidence levels of 70-80% or better. That's compared to 50% or less for entrepreneurs and other risk-takers.

:: Stringent FTA Guidelines
To ensure sufficient recognition and treatment of project risk, the FTA guidelines require a comprehensive risk assessment – assessments that @RISK for Project is well suited to address:

• A detailed analysis of baseline scope, schedule and costs, following a prescribed process
• The identification of all forms of risk with respective qualitative and quantitative values
• The establishment of a probability range for the total project costs using Monte Carlo type simulations
• The identification of correlated risks and their treatment in the analysis
• The identification of the most significant risks to the project and strategies for their management
• The assessment of risk by a qualified, independent, third party

:: Gannett Fleming Measures Success
Gannett Fleming, a national planning, design, management, and consulting firm, has performed numerous successful risk assessments for government projects.  The firm looks to exceed FTA confidence levels as a means to ensure their success, and they do so by using Palisade’s @RISK for Project to help identify inherent confidence levels.

According to Dan Estrada, Project Manager for Gannett Fleming, “We’ve been very successful assessing project risk on several major transit projects. The key is to perform an integrated cost and schedule risk analysis, one that recognizes the interplay of time and money.”  Additionally, as respective confidence levels are compared to preliminary budgets and schedules, contingency and schedule float may be evaluated for sufficiency.

Estrada continues by asserting that “@RISK for Project facilitates an integrated approach to quantifying schedule and cost risks, and offers concise evaluations of their potential impacts. The software allows us to confidently address FTA requirements.”

more about Gannett Fleming
read about @RISK for Project
read other case studies

Product Spotlight:
@RISK for Project: Advanced Risk Analysis for Project Management
@RISK for Project helps project managers realize the effects of uncertainty at every stage in their proposed strategy. Moreover, as an add-in to Microsoft Project it integrates seamlessly into project plans, virtually eliminating training time, and allowing for quick and effective presentation of realistic forecasts. This level of control and ease of use supports effective allocation of resources, thus mitigating the chance of finishing late or over budget, or having the project cancelled outright.

:: @RISK for Project Shows You Many Possible Outcomes
@RISK for Project employs Monte Carlo simulation as the basis for creating a picture of all possible outcomes. Simply by running a simulation, @RISK for Project takes your project model from representing just one possible outcome to representing thousands, if necessary. With @RISK for Project, you can answer questions like, "What is the probability of completing this milestone on time and under budget?" or "What are the chances that this project phase will be completed by this day?”

:: Uncertainty is Easily Defined
@RISK for Project allows you to replace uncertain values in your spreadsheet with @RISK probability distribution functions such as normal ("bell curve"), uniform, and triangular distributions. Plus, the built-in distribution viewer lets you preview various distributions before selecting them, quickly and easily. You can also use your own historical data and @RISK for Project's integrated data fitting tool to select the best function and the right parameters.

:: Branching and Conditional Modeling
@RISK Professional for Project allows you to build logic into your Project schedules for even greater realism.  Probabilistic Branching lets a project branch from one task to any number of other tasks during simulation to account for chance events.  IF/THEN Conditional Modeling changes project values, or branches to another task, if a pre-defined condition occurs during simulation.

:: @RISK for Project Features

• 37 Built-in Distribution Functions
  
• Integrated Distribution Viewer
• Risk Categories
• “Vary” Function
• Correlation of Inputs
• Sensitivity & Scenario Analysis
• Variety of Result Graphs and Charts
• Risk Results in Gantt Chart
• VBA Macro Support
• Integrated Data Fitting
• Probabilistic Branching
• IF/THEN Conditional Branching
• Probabilistic Calendars
• Global Variables
• Parameter Entry Tables

learn more about @RISK for Project
download a free trial version of @RISK for Project

@RISK and DecisionTools Expanding in Finance continued from above
The theme: how @RISK and the DecisionTools Suite could help them gain and maintain the edge needed to prosper in today’s incredibly volatile markets.

:: Palisade User Conference Europe Spans Industries, Applications
The event was Palisade's 2006 User Conference: Europe, held June 22-23. Practitioners attended from companies such as GE Money Home Lending, Hitachi, Unilever, Network Rail, Halcrow Group, Siemens, Infineon AG, IKB Deutsche Industriebank, AG Soluziona, ioMosaic Corporation, Pantektor, Istria, and Moore Stephens, among other distinguished organizations. Applications of Palisade software ranged from how to structure and price credit assets to the management of project risk in a portfolio to assessing investment risk in energy markets. Industries represented ran the gamut, and included real estate, construction, banking, consumer products, microchip manufacturing, transportation, and more.

:: @RISK and DecisionTools Suite Application Presentations Available Now
The breadth and substance of the conference is now available online in the form of presentations given by some of the industry experts. The presentations are available for free download so that the ideas can be shared with and disseminated among colleagues

:: Comments from Industry Leaders
"The Palisade Conference was the perfect opportunity for risk professionals from across Europe to come together and discuss best practice in the risk analysis field."
- Paul Wilmott, Author and founder of WILMOTT Magazine

"The Conference exceeded my expectations - a great opportunity to meet industry risk experts, exchange ideas, make new contacts and question the @RISK developers."
- Tim Wells, Senior Coastal Scientist, Halcrow Group Ltd

"The Palisade conference was a great opportunity to meet both experts from other industries and risk analyst professionals. I gained new insights both from presentations as well as discussions."
- Joerg Guenther, IKB Deutsche Industriebank AG

"I found the Palisade conference quite useful - especially because it brought together experts, both from academia and across various industries to discuss fundamental areas in risk.using Palisade software."
- Amar Dhayatker, Head of Planning and Forecasting Risk, GE Money Home Lending UK

view and download presentations
read the press release
read more delegate comments
learn more and register for the 2006 Palisade User Conference: Americas

Ask Amy continued from above

If you want to use Excel’s Solver, you can do so via macros.  @RISK has the ability to call macros between iterations.  This is especially useful when a model needs to perform some type of iterative calculation between generating the random samples and storing the output result.

To run a macro during simulation, the @RISK functions must be "locked" during the extra worksheet recalculations.  Otherwise the @RISK functions will resample and the model will not remain static during the processing of the macro.  This is especially problematic if the cells targeted by the macro are dependent on the cells with @RISK functions.

To begin, design the macro to first make static copies of the random samples for the optimization process to act on.  That is, the input samples are placed as values into the model via the macro.  It must be this way (disconnected from the model) so the Solver routine can freely recalculate the model without the @RISK functions re-sampling new values with each recalculation, thus allowing the Solver routine to solve based on the static model.  

Click on the “@RISK Solver Example” link below for a sample spreadsheet model.  In the example you will note a macro called "PlaceSampleAndRunSolver" which first places the static copy of the @RISK function sample into the model and then starts the Solver optimization.  The series of events that occur with each iteration are as follows:

1. @RISK generates random sample for the @RISK function in the cells labeled ‘Generate Sample Here’.
2. @RISK calls the "PlaceSampleAndRunSolver" macro which performs the following operations
1. Copy the value of the samples from the cells labeled ‘Generate Sample Here’ to the cells labeled ‘Copy Sampled Values Here’ in the corresponding row.
2. Start the Solver routine to find the optima.
3. @RISK saves the output results after running the optimization in the cells tagged with RiskOutput().

The result population will be a distribution of optimal results. Try it out. 

Note: Before you run a simulation on the example, you’ll need to check that the reference to the Solver add-in from within your VBA application is correct. To do this, first launch @RISK.  From your Excel menu select Tools > Macros > Visual Basic Editor.  Within the VBA module, select Tools > References.  This will bring up a list of all available references. Make sure SOLVER is checked.  If Solver is not listed, or if it’s listed but is labeled MISSING, you’ll need to locate the Solver.xla file on your computer using Windows Search. Once you’ve located the file, click on the ‘Browse’ button to the right of the References list.  A window will appear with the title ‘Add Reference’.  At the bottom of this window, in the field labeled ‘Files of type:’, click on the drop-down arrow and select ‘Microsoft Excel Files (*.xls,*.xla)’.  Browse to the location of the Solver.xla file on your computer and click ‘Open’.  Click ‘OK’ in the ‘References’ window.  You should now be ready to run a simulation on the example.

learn more about RISKOptimizer
@RISK Solver example
KnowledgeBase articles about Palisade Software

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