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Slides_for_class_4 - Relevant tools and concepts from...

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Relevant tools and concepts from finance, part 2 Psychology, beliefs and incentives Each firm: Beliefs about future prices (“market view”) Risk preference (for certainty vs. uncertainty, type and magnitude of risk) “Net hedging demand” “Average” or aggregate beliefs about future prices and risk preference  across buyers and sellers Rumors and manipulation of beliefs Role of management incentives in decisions about uncertainty Replication Role as basis of valuation of financial derivatives Limited relevant to physical products and supply chain 1
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Role of “market view” and risk tolerance in  contracting Role of market views of parties to contract: Contracting unlikely if one party very optimistic that conditions will  change in their favor, or Both parties somewhat optimistic that conditions will move in their favor Role of risk tolerance of parties to contract: More risk averse   more likely to contract, even if contract price is  worse than expectations More risk tolerant   willing to bet on future market conditions unless  contract price advantageous “Net hedging demand” = relative desire of buyers (in aggregate) vs.  sellers to hedge risk Key driver of forward contract price vs. “average” market view Understand and leverage differences across prospective  counterparties! Market view, risk tolerance 2
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Net hedging demand: Examples Buyer capacity investments in semiconductor industry Seasonality and risk exposure (e.g. electricity, agricultural goods,  etc.) 3
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Manipulation of beliefs: Why and how Beliefs (expectations) about the future are critical to buyer and supplier  decisions Market views: Ours, and those of others Expected actions of others: Capacity and production decisions of suppliers Demand requirements and contracting strategies of buyers Beliefs are based on facts, but also assumptions and incomplete  information How complete is available data about past, present and future: Prices (“market” prices, contract prices by contract type and counterparty) Supply (available capacity, fixed and variable cost structure) Demand (trends, buyer contracting strategies) When data is incomplete, beliefs can be influenced by “signaling” actions  and rumors Can become self-fulfilling, but often only temporarily Examples Rumor of DRAM price spike Real estate bubble Sir James Goldsmith and gold futures 4
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iSuppli Market research for high tech components Price (current market, forward contract), availability, lead time,  market share, technologies, trends Data sources
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