Incorporating Risk in Strategic
Decision Making Processes
S T R A T E G I C
INFORMATION
CONSULTANTS
Donna Hill
Prudence Thompson
Emma Smith
Dr John Henstridge
Data Analysis Australia
Overview
Uncertainty of predicted values
Ignored in many instances
Equates to risk in many instances
Case studies
Agricultural investment company
 Modelling uncertainty in expected value of a
crop
Improvement strategies
 Reviewed client’s modelling of risk
Simulation approach to estimate uncertainty
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
Page 2
Uncertainty
Provide clients with an
estimated or predicted value
Based on models
Based on survey results
Based on simulations
Uncertainty of that value
We can explain that there is uncertainty
We can quantify the uncertainty
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
Page 3
Case 1 – The Problem
Agricultural investment
company
Can estimate expected yield
 Historic data
Can get predictions of price
 Forward pricing on stock market
Hence can get predictions of value
 Yield times price
Investor return based on crop value and fees
charged
What fees should be charged?
Need to use uncertainty in predicted values
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
Page 4
Case 1 – Our Approach
Understand the distributions
 Of historic yield data
 At farmer level
 At shire level
 At state level
 Of pricing data
 Forward prices
 What the market thinks the grain is going to be worth
 Final prices
 What the grain actually sold for
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
Page 5
0.7
Historic Yield Distributions
0.4
0.3
0.0
0.1
0.2
Density
0.5
0.6
2001
2002
2003
2004
2005
2006
2007
2008
0
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
1
2
3
Yield (g/t)
4
5
6
Page 6
300
250
150
200
Final Price ($)
350
400
Historic Pricing Data
50
100
150
200
250
300
350
Forward Price ($)
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
Page 7
0.010
Forward Price
Final Price
0.000
0.005
Density
0.015
Historic Pricing Distributions
100
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
150
200
Price ($)
250
Page 8
Case 1 – Our Approach (cont.)
Appropriately combine models for
yield and pricing
 Leads to understanding of the distribution of crop values
Obtain predictions for crop value
 And uncertainty
Calculate the distribution for investor
return
 For a given fee structure
Expected value and probability of
achieving a particular investor return
 Customise fee structure to give high probability of
achieving desired return
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
Page 9
Case 1 – The Result
Provided client with modelling
tool
User sets desired investor return
User sets desired probability of achieving this
Tool models distributions at farmer level
Tool sets appropriate costs at farmer level
 Distribution of returns for an individual
 To obtain a portfolio level return
Client can test different
scenarios
STRATEGIC
INFORMATION
CONSULTANTS.
By changing many of the inputs
www.daa.com.au
Page 10
Case 2 – The Problem
Client wanted to implement a
set of improvement strategies
Needed to model the impact
Predict benefits
Incorporating and combining uncertainty of
each strategy
Justify expenditure
Monte Carlo approach
Wanted Data Analysis Australia to review
methodology and results
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
Page 11
Case 2 – The Review
Identify major areas of
uncertainty
Four areas
Review model assumptions
Assumes a triangular probability density
function for each improvement strategy
STRATEGIC
INFORMATION
CONSULTANTS.
worst case
scenario
www.daa.com.au
most likely
scenario
best case
scenario
Page 12
Case 2 – The Result
Suggested a simpler, more
transparent approach
Sum means and variances
Same results as Monte Carlo approach
Recommended an approach to
evaluate future improvement
strategies
Expand on the Monte Carlo approach
Include other areas of uncertainty
Incorporate different distributions
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
Page 13
Case 3 – The Problem
 Client needed to determine appropriate
pricing structure for future contracts
 Client’s costs affected by overall peak demand for their product
 Higher demand means higher costs to meet that demand
 Customer’s contract based on how much their usage is
expected to add to overall peak
 Key questions
 What will the overall peak demand be?
 Can model this based on historic data
 How much will a customer contribute to that peak?
 Use last year’s data for that customer to predict
 What if last year’s data was ‘unusual’?
 Usage often influenced by weather
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
Page 14
35
30
25
15
20
Maximum Temp
40
45
Historic Temperature Data
0
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
20
40
Index
60
80
Page 15
0.08
Historic Temperature Distributions
0.04
0.00
0.02
Density
0.06
2002
2003
2004
2005
2006
2007
2008
2009
15
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
20
25
30
35
Maximum Temp
40
45
50
Page 16
Case 3 – Our Approach
Modelling and simulation approach
 Model overall demand
 Several years’ data available
 Model individual customer usage
 Only one year’s data available
Obtain historic weather data
 Over many years
For each year of weather data
 Calculate fitted values for overall demand
 Determine peaks for each year
 Calculate fitted values for customer usage
 At the peak times for each year
Distribution for each customer
STRATEGIC
INFORMATION
CONSULTANTS.
 Variation in contribution to peaks
www.daa.com.au
Page 17
Case 3 – The Result
Analysed results by customer
group
Many had high variability in demand
High risk in using a single year’s data for
setting contract prices
Allowed client to understand
customer groups better
Develop strategies to set more appropriate
pricing for future contracts
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
Page 18
Summary
Clients do care about
uncertainty
They realise it represents risk
They want to incorporate it into
their decision making
STRATEGIC
INFORMATION
CONSULTANTS.
www.daa.com.au
Page 19
Thank You
Donna Hill
S T R A T E G I C
INFORMATION
CONSULTANTS
[email protected]
www.daa.com.au
(08) 9386 3304