A REAL OPTIONS DESIGN FOR QUALITY CONTROL CHARTS

We develop a financial model for a manufacturing process where quality can be affected by an assignable cause. We value the real options associated with applying a statistical process control chart using the Black-Scholes equation, binomial and pentanomial lattices, and Monte Carlo simulation methods. This valuation gives decision makers a way to choose the appropriate quality control strategy based on an integrated view of the market dynamics with the manufacturing operational aspects. An industry case is used to demonstrate the application of real options to value control chart decisions. Web based programs are given to value the alternatives in the case study, making the valuation task accessible to other users.     

Equilibrium Exchange Rate Hedging

We assume a world like the one that gives the capital asset pricing model, but with many goods and many countries. We assume that investors in a given country have homothetic utility functions with the same weights, and a currency that has a sure end-of-period value using a price index with those weights. Siegel's paradox (derived from Jensen's inequality) makes investors want a positive amount of exchange risk. When average risk tolerance is the same across countries, every investor will hold the same mix of market risk (through the world market portfolio of all assets) and exchange risk (in a diversified basket of foreign currencies). In fact, the ratio of exchange risk to market risk is equal to the average investor's risk tolerance. We can write the ratio of exchange risk to market risk (and the fraction of the market's exchange risk that investors hedge) as depending on an average of world market risk premia, an average of world market volatilities, and an average of exchange rate volatilities. The weights in these averages are the same as the weights of the different countries in the currency basket. Given these averages, the ratio (and the fraction hedged) will not depend directly on exchange rate means or covariances. In equilibrium, we can use the ratio of exchange risk to market risk to measure average risk tolerance: in this model, risk tolerance is observable.     

The economics of the private finance initiative

This article outlines and assesses the private finance initiativein the UK. The initiative has been slow to develop despite pressurefrom governments (anxious to limit the PSBR) and several revampsto facilitate the PFI approach. Within a PFI project there arebeneficial incentives to avoid cost over-runs but not to reducecosts where they affect long-run services. These incentivesand the limits to their effectiveness are explored. Such contractsrequire the transfer of risk from the public to the privatesector. the role and pricing of risk in the PFI is analysed.It is argued that the PFI does not value risk correctly andthat the value for money test is biased against private-sectorprovision. Policy implications are discussed, including a revampof the value for money test and the introduction of explicitassessment of the impact of potential renegotiation and othercontractual difficulties.