A Risk Management Approach to IT Services Contract Design A DISSERTATION SUBMITTED TO THE FACULTY OF THE GRADUATE SCHOOL OF THE UNIVERSITY OF MINNESOTA BY Ryan Scott Sougstad IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY Robert J. Kauffman July, 2009 © Ryan Sougstad 2009 Acknowledgements I would like to acknowledge the ongoing support, guidance, and friendship of my advisor, Rob Kauffman, which began prior to my admission in the doctoral program at the Carlson School of Management. I thank my committee members, Alok Gupta, Glenn Pederson and Gordon Alexander for the constructive feedback and support they have provided. I would also like to thank Indranil Bardhan, Fred Riggins, Ray Patterson, Bruce Weber, Ram Kumar, Alain Beim, Rama Akkiraju and Rob Guttman for their helpful suggestions and comments during presentations of this work. The faculty and Ph.D. students in the Information and Decision Sciences Department have outstanding support and feedback throughout my tenure at the University of Minnesota and I thank them for it. Parts of Chapter 2 of this dissertation have been previously published: INTERNATIONAL JOURNAL OF SERVICES SCIENCES, 1, 3-4, 2008: 225-246 Copyright © 2008 Inderscience. Reprinted with permission. All rights reserved. Not for reproduction Parts of Chapter 3 of this dissertation have been previously published: From JOURNAL OF MANAGEMENT INFORMATION SYSTEMS, 25, 1, Summer 2008: 17-48. Copyright © 2008 by M.E. Sharpe, Inc. Reprinted with permission. All Rights Reserved. Not for reproduction. i Dedication I dedicate this work to Sara and Avery... ii Abstract Information Technology (IT) service contracts imply a transfer of risk between parties. There has been little research conducted on how firms can apply quantitative analysis of risk factors in IT service delivery and contract negotiation. This dissertation applies risk management theory and methods from financial economics to inform negotiation of contractual parameters in IT Services agreements. The research offers contributions to the development and application of risk management and investment under uncertainty models to the problem space of information technology services investment. I develop a new model for managing risk in IT services contracts. In addition, I develop new analytic models to provide both valuation and strategic direction for benchmarking IT services under opaque conditions of market opaqueness and price volatility. Essay 1 develops the optimal trade-offs of risk and return in contract negotiation and introduces a new method IT Services Profit-at-Risk for evaluating contractual concessions. Essay 2 provides a model of valuing price benchmark provisions in IT services contracts and gives guidance on how to value and when to execute these provisions. Essay 3 examines the role of visibility of the market prices of IT services and provides a model for valuing market price information in the context of IT services price benchmarks. iii Table of Contents List of Tables………………............................................................................................ix List of Figures..................................................................................................................xi 1. Chapter 1. Introduction………......................................................................................1 1.1. Research Overview………....................................................................................1 1.2. Overview of the Three Essays…...........................................................................2 1.2.1 Overview of Essay One……..........................................................................2 1.2.2 Overview of Essay Two..................................................................................3 1.2.3 Overview of Essay Three................................................................................5 1.3 Note on the Style of Dissertation……....................................................................5 2. Chapter 2. A Framework for Risk Management in Information Technology Services and Investments.................................................................................................................7 2.1 Introduction: The Information Technology Investment Decision..........................7 2.2. Methods for Managing IT-enabled Services investments.....................................9 2.2.1 Investments in IT-Enabled Services: General Characteristics......................10 2.2.2 Real Options Analysis in IS Research..........................................................10 2.3 Overview of Value-at-Risk and VaR Methods.....................................................13 2.3.1 Value-at-Risk Requirements.........................................................................15 2.3.2 Mark-to-Market Position..............................................................................16 2.3.3 Measuring the Variability of Risk Factors....................................................17 2.3.4 Timeframe for Value-at-Risk Analysis.........................................................17 2.3.5 Confidence Interval and Portfolio-Level VaR..............................................18 2.4 Value-at-Risk Analysis of IT-Enabled Services Investments..............................19 iv 2.4.1 When the Use of VaR Analysis Makes Sence..............................................19 2.4.2 Matching VaR Requirements to IT-Enabled Services Investments.............21 2.5 A Framework for IT-Enabled Services Investment Analysis..............................22 2.6 Applications and Limitations of Value-at-Risk Techniques to IT Investments and Services......................................................................................................................25 3 Chapter 3. Essay 1: The Profit-at-Risk Approach towards Risk Management in IT Services Contracts…….................................................................... ..............................28 3.1 Introduction……...................................................................................................28 3.2 Background literature….......................................................................................32 3.2.1 Value-at-Risk (VaR)……….........................................................................33 3.2.2 Real Options Analysis of IT Investments……….........................................34 3.2.3 IT Services Pricing……… ...........................................................................36 3.3 Model development………..................................................................................38 3.3.1 Model Specification…..................................................................................38 3.3.2 Profit-at-Risk Analysis Approach……….....................................................41 3.3.3 Simulation……….........................................................................................43 3.4 Modeling Analysis and Results…........................................................................46 3.4.1 Base Case Analysis: A Single Contract……................................................46 3.4.2 Trade-off Analysis: Profit vs. Risk Reduction…..........................................47 3.4.3 Portfolio Impacts……...................................................................................49 3.5 Extended Analysis: Correlation and Risk Factors…............................................51 3.5.1 Impact of Correlation of Risk Factors……..................................................52 3.5.2 Contract Duration……..................................................................................55 v 3.6 Efficiency and Optimality in Profit-at-Risk Analysis…......................................58 3.6.1 Efficient and Optimal Contracts…...............................................................61 3.6.2 Optimal Strategy in IT Services Contract Design….....................................63 3.6.3 Comparative Statics…..................................................................................65 3.7. Conclusion……...................................................................................................72 3.7.1 Contributions................................................................................................72 3.7.2 Future Work..................................................................................................73 3.7.3 Limitations……............................................................................................75 4 Chapter 4. Essay 2: Optimal Timing and Valuation of Price Benchmarks in IT Services Contracts...........................................................................................................78 4.1 Introduction……...................................................................................................78 4.1.1. Characteristics of Price Benchmarks for IT Services…..............................79 4.1.2. Benchmarking Strategies and Their Countervailing Benefits to Providers and Clients.............................................................................................................81 4.1.3. Existing Theory and a New Approach.........................................................82 4.2. The Model……....................................................................................................86 4.2.1. IT Services Contract and Benchmarking for Price......................................86 4.2.2. Model Specification.....................................................................................87