Abstract
The paper begins by reviewing the available procedures for measuring value and risk in pharmaceutical research projects. These include Net Present Value (NPV) and its variance, Real Options Valuation (ROV), the Capital Asset Pricing Model (CAPM), Value at Risk (VaR) and Utility. None of these measures focuses specifically on risk as it is perceived by the research manager, except arguably for Utility, which has the serious disadvantage of being by definition a subjective measure. This paper proposes two additional risk measures to go some way towards plugging the gap in what is available. Their advantages are that they: focus on maximum exposure to adverse outcomes, a metric most decision makers have in mind when they wish to evaluate risk; are objective rather than subjective, in contrast to utilities; are easier to specify and more transparent than utilities, since they are in cash terms; are project specific unlike CAPM; satisfy the technical test of coherence, unlike VaR, so it is not possible that diversifying a portfolio could increase the measured risk. The new measures are shown to measure different things from the variance of NPV, which is in some ways similar, and a start is made on exploring what their values are for different patterns of cash flow.
Highlights
In the wake of the recent financial crisis, it is clear that efficient and comprehensive financial risk management is of paramount importance across business sectors
Capital Asset Pricing Model (CAPM) provides a risk-related rationale for choosing the discount rate to be used in Net Present Value (NPV) calculations, but only for the risks associated with overall stock market fluctuations
As Baker [15] notes, this lack of coherence of Value at Risk (VaR) can lead to questionable investment decisions, which is why the expected shortfall (ES) is becoming increasingly recommended as a better choice of risk measure
Summary
In the wake of the recent financial crisis, it is clear that efficient and comprehensive financial risk management is of paramount importance across business sectors. Motivated to explore current methods of measuring financial risk in this inclement risk management landscape, the research began with a survey of how financial risk and decision analysis are currently handled in one of the most uncertain and dynamic sectors of business, the pharmaceutical industry. This particular industry provided an ideal backdrop for us to begin a risk management investigation, as it has long been defined by explosive growth, long drug development timelines, and massive uncertainty.
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