Michel Benaroch

Managing Information Technology Investment Risk: A Real Options Perspective

Past information systems research on real options has focused mainly on evaluating information technology (IT)investments that embed a single, a priori known option (such as, deferral option, prototype option). In other words, only once a specific isolated option is identified as being embedded in a target IT investment, does this research call upon using real options analysis to evaluate the option. In effect, however, because real options are not inherent in any IT investment, they usually must be planned and intentionally embedded in a target IT investment in order to control various investment-specific risks, just like financial risk management uses carefully chosen options to actively manage investment risks. Moreover, when an IT investment involves multiple risks, there could be numerous ways to reconfigure the investment using different series of cascading (compound) options. In this light, we present an approach for managing IT investment risk that helps to rationally choose which options to deliberately embed in an investment so as to optimally control the balance between risk and reward. We also illustrate how the approach is applied to an IT investment entailing the establishment of an Internet sales channel.

Real options in information technology risk management: an empirical validation of risk-option relationships

Recently, an option-based risk management (OBRiM) framework has been proposed to control risk and maximize value in information technology investment decisions. While the framework is prescriptive in nature, its core logic rests on a set of normative risk-option mappings for choosing which particular real options to embed in an investment in order to control specific risks. This study tests empirically whether these mappings are observed in practice. The research site is a large Irish financial services organization with well established IT risk management practices not tied to any real options framework. Our analysis of the risk management plans developed for a broad portfolio of 50 IT investments finds ample empirical support for OBRiMs risk-option mappings. This shows that IT managers follow the logic of option-based risk management, although purely based on intuition. Unfortunately, reliance on this logic based on intuition alone could lead to suboptimal or counterproductive risk management practices. We therefore argue that managerial intuition ought to be supplemented with the use of formal real option models, which allow for better quantitative insights into which risk mitigations to pursue and combine in order to effectively address the risks most worth controlling.

Option-Based Risk Management: A Field Study of Sequential Information Technology Investment Decisions

This field study research evaluates the viability of applying an option-based risk management (OBRiM) framework, and its accompanying theoretical perspective and methodology, to real-world sequential information technology (IT) investment problems. These problems involve alternative investment structures that bear different risk profiles for the firm, and also may improve the payoffs of the associated projects and the organizations performance. We sought to surface the costs, benefits, and risks associated with a complex sequential investment setting that has the key features that OBRiM treats. We combine traditional, purchased real options that subsequently create strategic flexibility for the decision maker, with implicit or embedded real options that are available with no specific investment required provided the decision maker recognizes them. This combination helps the decision maker to both (1) explicitly surface all of his or her strategic choices and (2) accurately value those choices, including ones that require prior enabling investments. The latter permits senior managers to adjust a projects investment trajectory in the face of revealed risk. This normally is important when there are uncertain organizational, technological, competitive, and market conditions. The context of our research is a data mart consolidation project, which was conducted by a major airline firm in association with a data warehousing systems vendor. Field study inquiry and data collection were essential elements in the retrospective analysis of the efficacy of OBRiM as a means to control risk in a large-scale project. We learned that OBRiMs main benefits are (1) the ability to generate meaningful option-bearing investment structures, (2) simplification of the complexities of real options for the business context, (3) accuracy in analyzing the risks of IT investments, and (4) support for more proactive planning. These issues, which we show are more effectively addressed by OBRiM than the other methods, have become crucial as more corporate finance-style approaches are applied to IT investment and IT services problems. Our evaluative study shows that OBRiM has the potential to add value for managers looking to structure risky IT investments, although some aspects still require refinements.

Option-based management of technology investment risk

Real operating (flexibility) options embedded in a technology investment are valuable because they allow management to take rational, value-adding actions that could favorably affect operational traits of the investment (timing, scale, scope, etc.). These options, however, are not inherent in technology investments. Rather, they usually must be carefully planned and designed to fit each investment differently. Building on concepts from the area of financial risk management, this paper presents a methodology for planning the creation of specific operating options designed to maximize the value of a technology investment in light of the risks underlying that investment. The paper also illustrates the use of the methodology in the context of a Web-based information technology investment.

Should We Go Our Own Way? Backsourcing Flexibility in IT Services Contracts

The emergence of new service science approaches to business problems in information technology (IT) services offers new, unusually relevant insights for the senior management of vendors in this business area. This research examines how service-level agreement contract flexibility should be designed when the technological and business market environments result in volatility of demand, based on an understanding of related changes in the cost drivers that underlie IT services contracts. Our approach draws on a blend of well-known methods from financial economics—the real option pricing method and the contingent claims analysis method. In particular, our research examines a setting in which a vendor provides IT services to a client according to a prenegotiated IT services contract in the presence of demand volatility. We analyze the motivation of and value consequences for a vendor that offers the client the flexibility to opt out of the contract. For example, the client might switch to another vendor, or backsource and provide its own services internally. Our core results offer important foundational thinking for how to specify various forms of IT service-related flexibility in terms of put and call options from the point of view of an IT services vendor, so that their value and exercise timing can be estimated. We show that the client firms demand trigger value for deciding when to backsource its IT services varies, and it depends on the degree of demand volatility as well as the usage-based fees charged by the vendor. Working from our modeling approach, we also are able to characterize the extent to which a vendor can benefit from bearing the costs of making a backsourcing flexibility option available to its client.

Controlling the complexity of investment decisions using qualitative reasoning techniques

Abstract Assembling financial instruments such as equities, bonds, options, and other derivatives into a portfolio requires a thorough understanding of how the portfolio will behave in response to changes of specific economic variables and parameters of the instruments. With more information about a more diverse set of instruments becoming available to traders, it is becoming important to limit the complexity of the analysis involved. We show how this complexity can be limited by using qualitative analysis, where the objective is to construct a few good vehicles which can then be analyzed quantitatively. We illustrate how two qualitative reasoning techniques — qualitative simulation and qualitative synthesis — are used to design investment vehicles for risk management purposes. These techniques are currently employed by a prototype expert system that aims at assisting traders solving a risk management problem called hedging.

Information Retrieval with a Hybrid Automatic Query Expansion and Data Fusion Procedure

We propose a hybrid information retrieval (IR) procedure that builds on two well-known IR approaches: data fusion and query expansion via relevance feedback. This IR procedure is designed to exploit the strengths of data fusion and relevance feedback and to avoid some weaknesses of these approaches. We show that our IR procedure is built on postulates that can be justified analytically and empirically. Additionally, we offer an empirical investigation of the procedure, showing that it is superior to relevance feedback on some dimensions and comparable on other dimensions. The empirical investigation also verifies the conditions under which the use of our IR procedure could be beneficial.

An Integrative Economic Optimization Approach to Systems Development Risk Management

Despite significant research progress on the problem of managing systems development risk, we are yet to see this problem addressed from an economic optimization perspective. Doing so entails answering the question: What mitigations should be planned and deployed throughout the life of a systems development project in order to control risk and maximize project value? We introduce an integrative economic optimization approach to solving this problem. The approach is integrative since it bridges two complementary research streams: one takes a traditional microlevel technical view on the software development endeavor alone, another takes a macrolevel business view on the entire life cycle of a systems project. Bridging these views requires recognizing explicitly that value-based risk management decisions pertaining to one level impact and can be impacted by decisions pertaining to the other level. The economic optimization orientation follows from reliance on real options theory in modeling risk management decisions within a dynamic stochastic optimization setting. Real options theory is well suited to formalizing the impacts of risk as well as the asymmetric and contingent economic benefits of mitigations, in a way that enables their optimal balancing. We also illustrate how the approach is applied in practice to a small realistic example.

Contract design choices and the balance of ex ante and ex post transaction costs in software development outsourcing

This paper examines multiple contract design choices in the context of transaction and relational attributes and consequent ex ante and ex post transaction costs. It focuses on two understudied themes in the IT outsourcing literature. First, while the literature is predominantly concerned with opportunism and consequent ex post hazard costs that contracts can safeguard against, parties to a contract also economize on ex ante transaction costs by their choice of contract type and contract extensiveness. Second, the literature studies the aggregate extensiveness of contracts rather than of distinct contract functions: safeguarding, coordination, and adaptability. Against this backdrop, our research model portrays a nuanced picture that is anchored in the following theoretical interpretation: transaction and relational attributes have implications on specific ex ante and ex post transaction costs, and these implications can be balanced by respective choices in both contract type and the extensiveness of specific contract functions. These two contract design choices complement and substitute for each other in their ability to economize on specific transaction costs. Our analysis of 210 software development outsourcing contracts finds that explanatory power increases when analyzing the extensiveness of individual contract functions rather than the aggregate contract extensiveness, highlighting subtle competing influences that are otherwise masked by an aggregate measure. Our analysis also shows that a preference for time-and-material contracts counteracts the effect of certain transaction attributes on contract extensiveness, and even cancels it out in the case of transaction uncertainty.

Specifying Local Ontologies in Support of Semantic Interoperability of Distributed Inter-organizational Applications

Semantic interoperability through shared ontologies aims to ensure the semantic soundness of exchanges of services and data among distributed information systems (ISs). Collaboration via shared ontologies, however, requires that the local ontology of every co-operating IS be explicit. Unfortunately, common IS requirements specification methods are not geared towards producing the local ontology of an IS; they usually translate requirements into procedural notations that make a local ontology largely implicit in the software code. This paper presents a method for eliciting IS requirements and specifying them declaratively, in a way that makes explicit the local ontology. The resulting declarative requirements constitute explicit metadata that can be used to support semantic interoperability as well as enterprise modeling and knowledge management. We have already successfully applied our method to knowledge-based systems (KBSs). Since KBSs are also ISs, albeit more complex ones, our method offers a solid basis for creating ISs whose local ontologies are explicit.