Risk Analysis Models

Capturing Dependencies with Correlations – Part I: Defining Correlation Coefficients

Thursday, September 2, 2010 by DMUU Training Team

When doing risk analysis simulation modeling, it’s critical to represent the fact that many variables are related. Very rarely are all variables completely independent of one another. For example, when interest rates are low, housing starts tend to go up. This relationship is represented by a correlation coefficient, a number between -1 and 1. -1 means the two variables are perfectly negatively correlated; that is, when interest rates go up 1 unit, housing starts go down 1 unit. A coefficient of 1 is exactly the opposite, and 0 means there is no relationship between the variables at all. Typical coefficients are between these extremes. This correlation between input variables can and must be captured in your financial risk analysis models. Even if you are using expert opinion, estimating these relationships is better than ignoring them completely.

@RISK provides an easy way to define correlation coefficients. Through the use of a slider bar, you can dynamically update coefficients between variables as well as scatter plots representing those variables. This helps you visualize and more easily define these relationships.

For a quick video demonstrating this, see:

» View short videos on recently added @RISK risk software features

@RISK Quick Tips: Automating @RISK risk analysis software with VBA

Tuesday, August 31, 2010 by DMUU Training Team

Presented at the Palisade Risk & Decision Analysis Conference New York City

Chris Albright, author of the book VBA for Modelers, presented a number of examples of how to automate @RISK, RISKOptimizer, and StatTools in Excel using Excel's VBA and Palisade's built-in object-oriented Excel Developer Kit. These examples include production applications, scheduling applications, World Series simulation, and more. All examples include macros written by Dr. Albright, so you'll need to enable macros when you open them.

» Download the examples
» Order Dr. Albright's book "VBA for Modelers"

Free Webcast This Thursday: The Use of the DecisionTools Suite in Biotechnology Project and Portfolio Decision Making

Monday, August 30, 2010 by DMUU Training Team

Vertex Pharmaceuticals, Inc. is a global biotechnology company based out of Cambridge, MA. The Company's strategy is to commercialize its products both independently and in collaboration with major pharmaceutical companies. Vertex's product pipeline is focused on viral diseases, cystic fibrosis, inflammation, autoimmune diseases, cancer, and pain.

Given the uncertainty of outcomes in the biotech industry, consideration of variability is an inherent part of the decision process. Often, the mean (average) is not a relevant decision criteria. This is especially true for smaller biotech companies like Vertex – the opportunity costs are extremely high because scarce capital resources would be invested elsewhere, with a higher probability of realistic return. For example, a company may reject a project which is profitable on average (positive Net Present Value) because some of the possible outcomes are unacceptable to the decision maker. Consideration of variability allows a decision maker to bring in their own risk tolerance into the decision. A similar argument applies when estimating a safety margin above a base case (e.g. in cost budgeting).

Vertex’s strategy and analytics group within the corporate finance division seeks to provide the senior management with dynamic revenue and profit forecasting methodology that helps to identify types of drugs that should be developed given a finite amount of cash and resources. A traditional financial view allows the user to identify scenarios and potential outcomes, but lacks the ability to show the range of potential values within each and every outcome. Vertex’s team uses the DecisonTools Suite to establish the average outcome, the variability of outcomes and to pressure-test risk and uncertainty of a particular scenario throughout the decision process.

Vertex’s team built a complex financial risk analysis model using @RISK to enhance its portfolio process. Monte Carlo simulation and optimization are used to analyze and optimize project and portfolio decisions, given short and long-term corporate strategy. @RISK is also frequently used throughout the business development process: simulating across multiple sales forecasts provides BD team with a range of potential outcomes, making it easy to pinpoint a particular scenario on a curve, along with its probability and value. TopRank turns the sensitivity analysis into a quick and seamless exercise, answering multiple what-if questions within minutes. Franchise and program leaders can now see a dollar effect of their program being delayed or advanced, adding supplementary indications to the development plan and even addressing the price uncertainties all at the same time. The simple interface of PrecisionTree along with tornado chart outputs makes it easy to explain the effect and importance of a particular assumption / decision to an audience with no finance background.

As the company continues to grow, adding more drugs and collaborations to its development pipeline, we will see in this free live webcast how the DecisionsTools Suite remains one of Vertex’s analytical tools of choice to enhance and guide the decision making process.

» Register now (FREE)
» View archived webcasts

The Better to Be Believed

Friday, August 27, 2010 by Holly Bailey

In his blog yesterday for Smart Data Collective, Dean Abbott, makes a worthy, commonsense observation: no matter how accurate a predictive model is, it is of no use to the enterprise unless it is presented in such a way that all the decision makers understand what factors and techniques went into the analysis and why.

The reason that the 'best understood' model is more effective than the 'best' model is that when the people with authority over a particular decision are presented with a statistical analysis that is beyond their ken, they may or may not pretend to understand it. But in any event, they are not likely to buy into the results if they can't retell the story the model describes.

Take for instance, a Monte Carlo simulation that focuses on credit risk analysis for a particular loan. Everyone in the line of authority will be held responsible for real world outcome of what the Monte Carlo software describes in the Excel spreadsheet. And if you are one of these decision makers, how can you take responsibility for something you may not quite understand?

The problem of acceptance of a predictive model presents the analyst with a tough question: Do I present the model that I know is true and statistically accurate? Or do I present a ruder, cruder analysis that presents a story that can be immediately understood?

Abbott suggests a compromise: streamline your plot by masking (Abbott says "removing") fields that contribute to the robustness of the analysis but involve statistical twists and turns that are distracting to decision makers who may not be fascinated with technique and just want to see how the story turns out. This, he explains, allows you to work from a model both you and the decision makers can believe in.

Your thoughts?

Are solar panels a sound investment? A risk analysis case study

Friday, August 27, 2010 by DMUU Training Team

The UK's new coalition government has said that, as part of its 'Green Deal', it will encourage home energy efficiency improvements paid for by savings from energy bills. It seems likely that, in the year that energy regulator Ofgem warned of 20 percent electricity price hikes by 2020, this initiative will include solar panel technology

Currently the UK still lags behind many other countries in Europe and the rest of the world when it comes to harnessing solar power. Not only do we have less hours of sunshine than many regions, but there is a lack of clarity as to the 'payback' time when it comes to users seeing a return on investment.

This is where Palisade customer, the California-based Tioga Energy, makes an interesting case study. Whilst it may seem unfair to compare the UK with the west coast of America when talking about solar-related matters, the sunnier climate does not reduce the need to prove ROI for customers with solar energy agreements.

Tioga Energy provides project financing through its solar Power Purchase Agreements (PPAs), and maintains and operates solar systems on behalf of its customers. Tioga’s offering delivers predictably priced power and enables organisations to to both 'green' their operations and reduce energy costs. To illustrate the benefits of solar, estimating future electricity prices and making comparisons by showing the savings from a new solar system, Tioga enlisted the help of @RISK for risk analysis solutions.

To forecast possible price increases, Tioga Energy inputs California's historical electricity rate data into a quantitative risk analysis model developed using @RISK. This generates a probability distribution for electricity rate rises over the 20-year PPA period, which shows that there is a 25 percent likelihood that price increases will be less than 4.8 percent, and a 25 percent chance that rate rises would be more than 8.7 percent.

The @RISK risk analysis model therefore helps Tioga Energy evaluate the likelihood that a customer will save money for a variety of PPA scenarios (i.e. the rate at which electricity would initially be charged and the amount by which it would then increase each year). It also calculates the magnitude of savings for the different combinations of first year costs and subsequent rises. Consumers are therefore able to better understand the pricing and make an informed decision about whether to sign up for a PPA.

Using historical data and @RISK's risk modelling software capacity, Tioga offers consumers a robust view of the potential benefits of a solar PPA. This enables them to hedge against rising electricity rates, as well as feel confident that they are playing a part in tackling global warming.

» Read the Tioga Energy case study

Craig Ferri
EMEA Managing Director of Risk & Decision Analysis

Market decline versus speed to market – ‘A bird in the hand...’

Wednesday, August 25, 2010 by DMUU Training Team

I recently saw an interesting @RISK cashflow model from the portable phone industry. It modeled the uncertainty in the length and decline of overall market demand for a particular technology against five strategies for getting various application products to market as soon as possible.

Using @RISK’s Simtable function, combined with Excel’s Index function, it was possible to run multiple simulations and see which strategy could take best advantage of the potential market, given the uncertainties in the development process, the possibility of competitors, the market take-up and the margins that might be achieved.

As is often the case in all aspects of life, the simulation revealed that ‘a bird in the hand is better than two in the bush’; it’s very comforting to know that @RISK risk analysis solutions can cut through loads of detail and come back with an answer that echoes received wisdom!

Ian Wallace, ACMA
Palisade Training Team

@RISK Quick Tips: Event and Operational Risk Analysis

Tuesday, August 24, 2010 by DMUU Training Team

@RISK risk analysis software using Monte Carlo simulation is used for a wide variety of applications. In this model, we have an example of a general usage to address Operational Risk.

In many circumstances one wishes to calculate the aggregate impact of many possible yes/no type events. For example, it is often important to answer questions such as "What is the loss amount that will not be exceeded in 95% of cases?" @RISK simulation can be used to answer such questions.

» Download the example: EventandOperationalRisks.xls

Graphing with your Mouse – Part III: Scatter Plots from Tornado Diagrams in @RISK

Friday, August 20, 2010 by DMUU Training Team

You can quickly generate a graph of any simulated output relative to a given input using the tornado graphs in @RISK risk analysis software. Just drag a bar from the tornado graph onto a blank space, and a scatter plot of that input relative to the simulated output appears. This is a great communication tool when you’re trying to assess the most important risk variables in your risk analysis model and want to “zoom in” on a particular input to see what’s going on. It can really help understand relationships in your modeling.

See this video for a quick demo:

» View "Getting Started in @RISK" video tutorials

@RISK Quick Tips: Six Sigma Design of Experiments: Welding

Tuesday, August 17, 2010 by DMUU Training Team

A key application of @RISK is Six Sigma and quality analysis. This model demonstrates how @RISK can be used for a DOE analysis of a welding project.

Suppose you are analyzing a metallic burst cup manufactured by welding a disk onto a ring. You need to make sure weld strength is within safety limits. The model relates the weld strength to process and design factors, models the variation for each factor, and forecasts the product performance in relation to the engineering specifications. @RISK is used to model the variation in each factor, and simulate different outcomes for weld strength. Output includes After Six Sigma statistics for Cpk-Upper, Cpk-Lower, Cpk, and PPM Defects (or DPM). Standard @RISK statistical analysis functions (like RiskMean) are also used.

» Download the example: SixSigmaDOE.xls

Graphing with your Mouse – Part II: Overlay Graphs

Wednesday, August 11, 2010 by DMUU Training Team

In @RISK (risk analysis software using Monte Carlo simulation), you can easily overlay two graphs directly from any graph window. Just click on a button to identify the variables to overlay, and you’re done. Alternatively, you can drag thumbnails of different simulated results onto the same graph to create overlays. These overlays in the risk analysis models are useful for comparing different strategies, showing trends over time, and more.

A quick video showing how to do this:

» View short videos on recently added @RISK features

@RISK Quick Tips: RiskSimtable to Perform Multiple Simulations

Tuesday, August 10, 2010 by DMUU Training Team

@RISK's use of Monte Carlo simulation allows for powerful features, like RiskSimtable.

The RiskSimtable feature can be used to run multiple simulations to test the sensitivity of the risk analysis model, for example to changes in the parameters of a distribution. This model is of a business with a base case expected revenue of 100 and cost of 80, giving a profit of 20.

The risk model assumes that the revenue and cost distributions are determined from a mean and standard deviation. The RiskSimtable feature is used to test the sensitivity of the distribution of profit to changes in the standard deviation of the revenues. Three values are tested of which the first is our original @RISK model. The number of simulations is therefore set at 3. A RiskSimtable can be set up either by directly typing in the required format, or by inserting it as for other Excel functions via the Insert Function menu option. The model also uses some @RISK statistical analysis functions to report the probability for each simulation that the profit exceeds 50.

» Download the example: BasicBusiness.Simtable.xls

Oops! Didn’t see that coming! Part 4

Monday, August 9, 2010 by Steve Hunt

This is the conclusion of Dave Roy’s guest blog, we hope you have found them informative. Again, Dave comes to us from SSPI, Six Sigma Professionals, Inc., and taught Jack Welch and his entire staff their Six Sigma Green Belt training. Also, look for Dave’s free live webcast on August 19^th, Assessing your New Product, Process or Service Introduction Methodology: Is yours premier? Does it enable Six Sigma performance?

Oops! Didn’t see that coming! Part 4

As a continuation from the July blog, we are now concluding with the “Optimize” and “Validate” phases of the ICOV (Identify-Conceptualize-Optimize-Validate) framework of a rigorous new design process as explained in “Services Design for Six Sigma – A Roadmap for Excellence”.

These phases are important because it allows time and methodology to optimize the design, develop all of the detailed documentation, verify performance and capability under operating conditions and manage an orderly transition to the new state.

The Optimize phase consists of a single stage (Design Optimization) and associated Tollgate 5 to validate successful completion of the requirements.

The Design Optimization stage involves completing all of the detailed design documentation, building Prototypes of the design, simulating/analyzing Process Capability, preparing all Control Plans and updating the Design and Process Scorecards.

Tollgate 5 Exit Criteria:

o Agreement that functionality and performance meet the customers’ and business requirements under the intended operating conditions.

o Approval to proceed with the Validate stage.

Formal tools which can be used in this phase are Design Scorecard, Process Management, Mistake Proofing, Simulation, Change Management, Control Plans, Reliability and Robustness.

The Validate phase consists of two stages (Verification and Launch Readiness) and associated Tollgates (6 and 7) to validate successful completion of the requirements.

The Verification stage involves developing Pilot plans, Piloting the new design and process and analyzing and making adjustments to achieve the desired functionality and performance under operating conditions.

Tollgate 6 Exit Criteria:

o Agreement that functionality and performance from the pilot meet the customers’ and business requirements under the intended operating conditions.

o Approval to proceed with the Launch Readiness stage.

Formal tools which can be used in this phase are Design Scorecard, Process Management, Mistake Proofing, Change Management, Control Plans, Statistical Process Control (SPC), and Confidence Analysis.

The Launch Readiness stage involves developing Pilot plans, Piloting the new design and process and analyzing and making adjustments to achieve the desired functionality and performance under operating conditions.

Tollgate 7 Exit Criteria:

o Agreement that transition plans and training plans have been developed and are executable.

o Approval to proceed with the Production stage.

Formal tools which can be used in this phase are Transition Plans, Training Plans, Process management, Change Management and Control Plans.

Following the ICOV model we have now used a formal methodology that allows us to validate performance at progressive economical stages and have improved the ability to detect unknown risks thus avoiding the Oops! Didn’t see that coming!. It should be mentioned that the methodology should be flexible and scalable to adjust for level of invention and risk. A brand new invention (Research & Development) that has never been deployed in similar conditions is much different than implementing a known solution (Application Engineering) under new conditions.

» Part 1
» Part 2
» Part 3

BIO:

David Roy is an integral part of the Six Sigma community. He taught GE’s Jack Welch and entire staff Six Sigma, as well as served as Senior Vice President of Textron Six Sigma. He is a Certified GE Master Black Belt, was instrumental in developing GE’s DMADV (DFSS) methodology, and has taught 3 waves of DFSS Black Belts. David holds an BS in Mechanical Engineering from The University of New Hampshire. He is also the co-author “Services Design for Six Sigma – A Roadmap for Excellence”

Graphing with your Mouse – Part I: Drag and Drop

Thursday, August 5, 2010 by DMUU Training Team

Monte Carlo simulation is a very powerful tool for modeling uncertainty. But perhaps the most critical step in any simulation analysis is the meaningful presentation of results to others. Decision makers won’t act on the results of a simulation if they don’t understand what they are seeing. Graphs are the most powerful way to communicate these important insights.

There are lots of ways to make graphs from the data generated by Monte Carlo simulations. But what is the easiest? Microsoft Excel statistics offers its own graphing engine, but you have to tell it which data to use for what.

@RISK comes with a powerful graphing engine built-in, and you can create meaningful graphs just by dragging and clicking things with your mouse. In this three-part series, we’ll cover the most common ways to get valuable graphical results in @RISK without ever touching your keyboard.

First off, @RISK automatically generates thumbnail graphs of input variables and output results during a simulation. These are accessible in the @RISK Model window (for inputs) and @RISK Results window (for outputs). You can expand any small thumbnail graph from these windows to full size just by dragging it off the window and onto the spreadsheet.

Here is a quick video showing how easy it is to do this:

» View short videos on recently added @RISK features

@RISK Quick Tips: Using Percentile Distribution Parameters

Tuesday, August 3, 2010 by DMUU Training Team

@RISK, Palisade's risk analysis software using Monte Carlo simulation, has many features that help you create powerful models for decision making under uncertainty.

This model demonstrates the use of the alternate, percentile parameter formulation. In this case we assume that we have decided to use a Normal distribution to represent the arrival time of someone at work. The use of traditional parameters would require knowledge of the standard deviation of the arrival time, which may be hard to estimate. The use of the alternative parameter formulation allows data to be estimated by others in a more natural way. In the first case, the traditional parameters are used (mean and standard deviation). In the second case, the mean is still used, and the P90 is used in place of the standard deviation, i.e. the time before which the person arrives in 90% of cases. In the second case, the P10 and the P90 is used in place of the standard deviation i.e. the time before which the person arrives in 10% of cases, and in 90% of cases respectively.

» Download the example: AltPars.ArrivalTime.xls

Tackling the energy crisis by managing demand, using risk modeling software

Thursday, July 29, 2010 by DMUU Training Team

One of the side-effects of the recession appeared to be a reduction in the demand for electricity as businesses and consumers alike looked to make savings on their outgoings. However, economic recovery seems to render this trend as temporary, meaning that the global need to tackle energy-consumption is as pressing as ever.

BC Hydro, Canada's third largest electrical utility provides an interesting case study in how to ascertain the most effective ways to tackle the gap between supply and demand of electricity in British Columbia. Trends such as an expanding population growth, and the increase in energy usage per customer, have led to a rise in the demand for electricity across the region. By legislation, BC Hydro must aim to meet these energy needs through implementing cost-effective energy conservation approaches before it can turn to increasing the supply.

The company has set itself one of the most aggressive targets in North America, with a plan to meet almost 75 percent of its incremental load through Demand Side Management (DSM) over the next 20 years. DSM projects include compact fluorescent light promotions; subsidies for energy efficient appliances; variable speed motor promotions (for home furnaces); and promotional activity aimed at motivating customers to use less energy.

BC Hydro uses @RISK risk analysis software to measure the uncertainty around its energy conservation efforts, both at the project stage and at a higher portfolio level. Around 60 projects were analysed on a case-by-case basis, and a probability distribution around the forecast outcome was developed. @RISK helps BC Hydro to capture the level of uncertainty of the estimated savings for each individual DSM venture.

In recognition that projects do not operate in isolation, BC Hydro also uses @RISK to explore the interrelationships between key uncertainties: the participation and savings per participant, and the participation across projects. The analysis showed that if a 'conservation culture' was developed in the province, it would result in an increase in energy savings across all programmes. However, it also illustrated that, if this culture failed to materialise, the performance of all programmes will be dragged down.

Exploring uncertainty using @RISK allowed BC Hydro to find the best balance between the uncertainties of supply side resources and those of relying heavily on energy conservation. Employing Decision Making Under Uncertainty helps BC Hydro to meet both financial risk analysis and environmental risk analysis goals. As a result, it expects to meet the majority of its incremental load growth through conservation measures.

» Read the BC Hydro case study

Craig Ferri
EMEA Managing Director of Risk & Decision Analysis

A Little Limelight

Tuesday, July 27, 2010 by Holly Bailey

Limelight--and by this I mean positively glowing publicity-- shines only occasionally on quantitative analysis, and rarely on Monte Carlo simulation. But there was, 6 years ago, Michael Lewis's Moneyball, which established a place for statistical analysis in major league baseball. Now there is Relativity Media, LLC, currently one of the heaviest hitting movie production companies in the business, and, more specifically, there is Ryan Kavanaugh, its CEO, and Ramon Wilson, its executive vice-president of business development.

Two things about Kavanaugh and Wilson make them unusual: they are leading a movie production firm that is not only alive but growing, and they use quantitative analysis for lots of decision making under uncertainty. What can be more uncertain than investing in a movie? Only somewhat unusual for the movie business is the fact that these two decision makers are under thirty-five--it's a youth oriented business--and maybe this is correlated with their emphasis on making decisions by the numbers.

"You can't think of it as money," Kavanaugh has been quoted as saying. "You have to think of it as math." Given the multimillion-dollar budgets Relativity underwrites--the raw size of the risks involved--it's probably more comfortable for everybody at Relativity to think math. The kind of math Kavanaugh is particularly devoted to is Monte Carlo simulation, and he talks quite openly about his company's use of it. When it comes to variables, he names names: principal actor, genre, director, release date, PG or R, although in all probability (sorry), each of these variables is probably a set of variables.

"Everything has to run on the principle of profit. We'll never let creative decisions rule our business decisions. If it doesn't fit the model, it doesn't get done." That doesn't mean, he has explained, that if he really likes a project, he and Wilson can't juggle the variables to make the film project fit the model. They change the parameters to reveal the path to profit. And profit he has--the estimated assets of Relativity are about $2 billion.

So Kavanaugh qualifies as a mogul, a math-for-movies mogul. When the spotlight falls on him, Monte Carlo simulation isn't far out of it.

@RISK Quick Tips: Correlation of Input Variables

Tuesday, July 27, 2010 by DMUU Training Team

This financial risk analysis example demonstrates the use of the Corrmat function to correlate multiple @RISK distributions. The distributions are correlated using a matrix of coefficients that specify the relationship between each pair of functions. The coefficients must be between -1 and +1, with a value of +1 indicating a perfect correlation, 0 indicating no correlation, and -1 indicating a perfect negative correlation. In this example three variables, the current US interest rate, the Pound/$ exchange rate, and the Euro/$ exchange rate, are correlated using a 3x3 matrix. Correlation matrix inconsistency occurs when a matrix that is mathematically impossible to realize is entered. If this happens, @RISK will try to adjust your matrix. However, you may have some correlation coefficients that you do not wish to be adjusted, while others are more or less free to be changed. This information may be entered using an adjustment weight matrix.

» Download the example:
CorrmatWithAdjustmentWeightMatrix.xls
» See more Financial Risk Analysis models here
» Case Study: FiduciaryVest uses @RISK's correlation
matrices in asset allocation modeling

Sharing Simulation Models – Part III: The @RISK Library

Friday, July 23, 2010 by DMUU Training Team

Another great way to collaborate with others is through the @RISK Library. This is a SQL-based database that lets you store customized @RISK functions with the specific parameters that you need. Then others can pull the same @RISK function for their risk analysis models, directly from the standard Define Distribution window. This way you can be sure everyone is using consistent parameters in the statistical analysis.

You can also store simulation results in the @RISK Library. This is a great tool for auditing simulations to see exactly what happened, what changed, and what affected the outcome. Furthermore, these simulation results can be used as inputs for other simulations.

A quick video on the @RISK Library: