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A DISSERTATION SUBMITTED TO THE DEPARTMENT OF MANAGEMENT SCIENCE & ENGINEERING AND THE COMMITTEE ON GRADUATE STUDIES OF STANFORD UNIVERSITY IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY

Thomas C. Seyller March 2008

UMI Number: 3302870 Copyright 2008 by Seyller, Thomas C.

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I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy.

(Ronald A. Howard) Principal Adviser

I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy.

(Ali E. Abbas)

I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy.

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\j7

MA/^

(Samuel S. Chiu)

Approved for the Stanford University Committee on Graduate Studies.

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and therefore to focus his search on the most promising classes of deals. I also shed some light on the probabilistic phenomena which are at the source of hedging: in that part of the thesis. it allows him to identify the uncertainties on which it is most valuable to hedge. as an opportunity to favorably reshape the moments of the decision-maker's portfolio by adding other deals to it. and finally. The last concept I introduce is that of the value of perfect hedging. I illustrate the approach through practical examples and applications. The value of hedging concept can also be used to identify within a list of several deals the ones that best complement the portfolio. based on a specific uncertainty.Abstract In this dissertation I introduce a definition of hedging which is based on the comparison of two indifferent buying prices. the value of perfect hedging can help him establish an upper bound on his personal indifferent buying price for any uncertain deal which he might be considering acquiring. While the value of hedging captures how well a specific deal would fit within the existing portfolio. IV . Such an analysis provides three significant benefits to the decision-maker: first. Throughout the dissertation. the value of perfect hedging captures the decision-maker's willingness to pay for the best hedges one can construct to complement his portfolio. it enables him to decide how much of his resources he should devote to searching for hedges. it then becomes possible to ascribe a monetary value to the hedging provided by a specific deal with respect to the decisionmaker's existing portfolio. I present some fundamental properties of the value of hedging. in other words. secondly. Next. I show that hedging can be thought of as moment reengineering. including some which only arise if the decision-maker's u-curve satisfies the delta property. With that definition.

v . and my parents. Samuel Chiu and Jim Matheson for their guidance and for many thought-provoking classes and discussions. I would also like to thank Ross Shachter. I am very much indebted to my dissertation advisor. patience and constant encouragements. and the efficiency and elegance of simple solutions. Daphne Koller. From him I have learnt the importance of clarity in thought and communication. My years at Stanford University have been especially enriched by my experiences as a teaching assistant for decision analysis at their side. Never let it be said that it is impossible to conciliate an efficient work ethic with the desire to have fun. I finally wish to thank my friends and colleagues Ibrahim Al Mojel. I especially wish to thank my wife Aditi for her love. my sister and my brother for their support and for all they have taught me. Ronald Howard. Ali Abbas. Somik Raha. Debarun Bhattacharjya.Acknowledgements I believe that few experiences in someone's life can be as instructive and transforming as working on a doctoral thesis. Their love of and dedication to teaching has been an inspiring example for me. for his teachings and his friendship. Ram Duriseti and Christopher Han for their support and for numerous suggestions on this research. My deepest gratitude goes to the wonderful people who made this experience even more enjoyable than I imagined it would be.

a) b) c) d) 5. 4. Indifferent Buying and Selling Prices. a) b) 3. 2. and Delta Property The Decision Analysis Cycle Hedging in the Financial Literature Traditional Definitions of Hedging Mean-Variances Approaches Utility-Based Approaches iv v vi ix xi 1 1 2 5 7 8 9 11 15 32 33 35 39 Chapter 2 -Definition & Valuation of Hedging 1.Introduction 1. 2. 4. a) b) c) Dissertation Overview Motivation Research Questions Elements of Decision Analysis The Six Elements of Decision Quality The Five Rules of Actional Thought U-curves. Definition of Hedging Definition of the Value of Hedging The Value of Hedging as a Difference of Two PIBPs The Value of Hedging as the PIBP of a Translated Deal Influence Diagram Representation Basic Properties of the Value of Hedging vi 41 42 49 50 52 56 59 . 3.Table of Contents Abstract Acknowledgements Table of Contents Index of Tables & Figures List of Notations Used Chapter 1 .

. 2.a) b) c) d) e) 5. Hedging in the Risk-neutral Case Existence of Negative Hedging 59 61 Sign and Monotonicity of the Value of Hedging in the Risk-Averse Case. 2. a) b) c) d) 3.Hedging as Moment Reengineering 1. 62 Value of Hedging for Two Deals Which Differ by a Constant PIBPfor an Uncertain Deal and Value of Hedging Extension of the Value of Hedging Concept to the Sale of Deals 65 68 69 Chapter 3 . a) b) A Simpler Formula to Compute the Value of Hedging Special Properties of the Value of Hedging in the Delta Case Symmetry Upper Bound on the Value of Hedging Value of Hedging for Multiples of a Deal with Respect to Itself Value of Hedging and Irrelevance The Chain Rule for the Value of Hedging and its Implications Chain Rule Toward an Irrelevance-Based Value of Hedging A Igebra 72 73 76 76 77 83 91 95 95 101 Chapter 4 . General Principle Variance Reengineering Reengineering Moments of Higher Order 106 107 109 116 Chapter 5 .Value of Hedging in the Delta Case 1. a) b) c) d) Definition Basic Properties Risk Attitude and Sign of the Value of Perfect Hedging PIBPfor an Uncertain Deal and Value of Perfect Hedging Joint Value of Perfect Hedging Impact of Relevance on the Value of Perfect Hedging Complete Relevance Irrelevance Incomplete Relevance Relevance-Based Dominance of one Hedge over Another vn 120 121 126 126 127 130 134 135 139 142 146 . 2.The Value of Perfect Hedging 1. 3. a) b) c) 3.

3.Impact of Relevance on the Value of Perfect Hedging Influence of the U-Curve on the Choice of a Perfect Hedge General Upper Bound on the PIBP of an Uncertain Deal Approximation of the Value of Perfect Hedging in the Delta Case 150 151 153 156 Similarities between Value of Perfect Hedging and Value of Clairvoyance 166 The Value of Perfect Hedging as a New Appraisal Tool 168 Chapter 6 . 6. Contributions Limitations Directions for Future Work 172 172 174 177 List of References Probability. Bayesian Methods and Decision Analysis: Finance and Hedging: 179 179 184 Index of Terms 188 Vlll . 5. 7.e) f) 4. 2. Summary .Conclusions & Future Work 1.

Hedging with complete relevance between X and Y.Common u-curves and some of their characteristics Figure 1.8 . X) is not monotonic in y Figure II.An influence diagram Figure 1.A decision hierarchy Table 1. 1 . 5 .Hedging as the comparison of two PIBPs Figure II. X) to y Figure 11.10 .Sensitivity to the risk-aversion coefficient Figure 1.Minimum-variance hedging for foreign currency Figure II.possible arrows and their meanings Figure 1.A tornado diagram Figure 1.3 .Hedging with partial relevance between Xand Y Figure II.Index of Tables & Figures Figure 1.Influence diagram semantics -possible nodes and their meanings Table 1. 6 — Using influence diagrams to compute the value of hedging Figure II.Best hedge for X Figure III.Sensitivity of VoH(Y \ w.9 .2 . 7 -An example for which VoHfY | w.3 — Influence diagram semantics .9 .Mnemonic for the chain rule for the value of hedging IX . 1 .3 .Computation of an upper bound on the PIBP ofY Figure III. 2 .Open loop and closed loop sensitivity analyses Figure 1.An equivalent definition of the value of hedging Figure II.Sensitivity ofVoHflX \ X) to k 2 8 13 15 16 17 18 19 21 23 26 28 36 43 44 46 52 55 56 63 63 67 79 82 90 94 98 Figure III.1 . Figure 1.Our valuation of Yean be greatly impacted by X. 5 .4 .7 — Cumulative distribution functions for two alternatives Figure 1. 3 — Hedging with partial relevance between X and Y Figure II.2 .2 .Value of hedging for two irrelevant deals Figure III.4 . Figure II.6 .1 .The six elements of decision quality Table 1.The decision analysis cycle Figure 1.5 . 8 . 4 .Hedging provided by a deal which differs from Y by a constant Figure III.

.4 .Joint perfect hedging on Oil Price and Volume Figure V.Hedging as reengineering of moments of order 3 and above Table TV.Probability mass functions ofX and (X u Y) Figure V.2 — Decomposition of certain equivalents along the first three cumulants Figure IV.The value of perfect hedging: an example 99 104 109 Ill 112 113 116 117 117 118 123 Figure V. 132 144 150 152 155 Figure V.3 .Impact of the relevance between S and S' on VoPHfS"1 \ X..Equivalent probability of clairvoyance 162 163 167 168 170 175 177 x .A chain rule example Figure 111.Hedging with negative side effects Figure VI.Applying the contraction property for the value of hedging Figure IV.l . 128 Figure V..Influence of risk-aversion on the accuracy of the approximation Figure V.Accuracy of approximation depending on the number of cumulants Figure IV.Gold Price is only relevant to the value through Oil Price Figure V.Decomposition of certain equivalents along the first two cumulants Table IV.2 .Example of variance reengineering Table IV. w) Table V.l I -Example for the use of perfect hedging as an appraisal tool Figure VI. 160 Figure V.Figure 111..6 .9 — Influence of risk-aversion on the accuracy of the approximation (2) Table V. 7 .1 .8 .2.The value of perfect hedging in the decision analysis cycle Figure V.2. 3 .5 .5 ..10..2 — Accuracy of approximation depending on the number of cumulants Figure IV.Impact of the risk tolerance on the selection of a perfect hedge Figure V. 1 .6 .4.Upper bound on the PIBPfor Y based on the value of perfect hedging. 7 -Accuracy of our value of perfect hedging approximation: an example .Decomposition of certain equivalents along the first five cumulants Figure IV.l . 1 .Comparison of value of clairvoyance and value of perfect hedging Figure V.Distribution over profit for the second oilfield. 3 .

X) The decision-maker's selling risk premium for deal Y given that he also owns wealth w and a portfolio of deals denoted by X. Variance of Y given &. since w does not have any effect on the value of certain equivalents. Xj)je[i. {A | B = b. C.two individuals might disagree as to whether two uncertainties are relevant or irrelevant given a third.. with their associated probabilities p.S~<Y | w. &} for any possible outcomes bj and bj of B. just like probability assignments. <Y | &> V Mean of Y given &. Relevance statements. A J_ B | C. we will use the notation S~(X | 0) to refer to S~(X | w). This means that in the opinion of the person making the statement. It is defined as <Y | &> .n]} The uncertain deal X comprises n prospects x. are matters of information and not matters of logic . X) RPs(Y | w. C. (Y | &> ~(Y | w.List of Notations Used {A | B. & A is irrelevant to (or some might say "probabilistically independent of) B given C and the background state of information & of the person. In the delta case. &} = {A | B = bj. &} Probability assigned to A given B and the background state of information & of the individual.. X>. The decision-maker's PISP for deal Y given that he also owns wealth w and a portfolio of deals denoted by X. XI .. X= {(pi.

~(Y | w, X)

The decision-maker's PIBP for deal Y given that he already owns wealth w and a portfolio of deals denoted by X. In the delta case, we will use the notation S~(X | 0) to refer to B~(X | w), since w does not have any impact on the value of certain equivalents and since the PIBP for any deal is equal to the PISP for the same deal.

RPB(Y

I w, X)

The decision-maker's buying risk premium for deal Y given that he already owns wealth w and a portfolio of deals denoted by X. It is defined as <Y | &> - B~(Y | w, X).

xn

Chapter 1 - Introduction

"Humanity is constantly struggling with two contradictory processes. One of these tends to promote unification, while the other aims at maintaining or re-establishing diversification. "

Claude Levi-Strauss (b. 1908), Race et Histoire

1. Dissertation Overview

In this dissertation we will study hedging through a decision analytic lens. I will first introduce a definition of hedging which is entirely grounded on the principles of personal indifferent buying and selling prices. This will also allow me to establish a method through which we can assign a monetary value to the hedging that a deal provides with respect to the decision-maker's existing portfolio. Many of the properties of the so-defined value of hedging will be presented and illustrated through practical examples. In the later parts of the dissertation, I will present a concept which provides further insights to the decision-maker: the value of perfect hedging. Given a specific portfolio, the value of perfect hedging is the amount that the decision-maker should be willing to pay for the most favorable deal that can be constructed by hedging on some particular uncertainty or set of uncertainties. The value of perfect hedging thus helps us place an upper bound on the resources that should be devoted to hedging the existing portfolio.

1

2. Motivation

In decision analysis, we often observe that our valuation of uncertain deals can be greatly affected by the existence of other deals we own. It is a common oversight to underestimate how pervasive the phenomenon actually is; many students in decision analysis, including some who have received training in the discipline for several quarters, often believe that it does not hold for decision-makers who follow the delta property. The students' intuition is that since the certain equivalents of such decision-makers for uncertain deals do not depend on their initial wealth, they should not depend on the unresolved deals which they own either. A simple example such as the one presented in the next figure is enough for those students to become aware of their mistake. In that example, the decision-maker, who follows the delta property, owns deal X and has a certain equivalent of $2,000 for it. The decision-maker is then offered deal Y for a fee. At first it might be tempting to reason that the decision-maker should be willing to pay up to $2,000 for Y, because it comprises the same probabilities of the same prospects as X.

r^—

0.5

O

$10,000

-$5,000

——

-$5,000

$10,000

Figure 1.1 — Our valuation of Y can be greatly impacted by X

However, such logic is flawed; it does not take into account the fact that deals X and Y are probabilistically relevant. In fact, by combining X and Y into the same portfolio, the decision-maker is assured of a profit of $5,000 once both deals are resolved, irrespective

2

of whether si or S2 is realized. The decision-maker should thus be willing to pay as much as $3,000 for deal Y, since it can help him transition from a situation worth $2,000 to one worth $5,000. The difference between the two possible answers, the erroneous one ($2,000) and the correct one ($3,000), is sizable. It should remind us that, just like information and control, hedging can be regarded as an alternative which might significantly affect the value of the decision-maker's portfolio. Another element which should make that alternative worthy of our consideration is its availability. Many financial instruments have been used extensively and for several decades for hedging purposes, from insurance contracts to derivatives such as forwards or swaps. Hedging instruments have even been gaining in accessibility in recent years, be it for organizations or private investors; for instance, companies such as HedgeStreet have started offering financial derivatives which are designed to give individuals more flexibility as they try to manage the risk of their portfolio. The primary ambition of this dissertation is to raise our sensitivity as decision analysts to the value that hedging can bring to decision-makers. I will strive to present enough evidence for the reader to be able to decide whether he wants to apply those views on hedging in his professional practice; but it is not one of my intentions to dissect the ideological differences between the approach to hedging presented here and that which can be found in most of the traditional finance literature. It is true that philosophical differences between the decision analytic framework and the financial framework abound, the treatment of uncertainty being one of the most notable examples; but I share the opinion of Edwin T. Jaynes [Jaynes, E.T., 1976], who argued that the true test of the merits of two competing statistical theories should consist in applying them to the same examples and deciding which one provides the most sensible results:

Let me make what, I fear, will seem to some a radical, shocking suggestion: the merits of any statistical method are not determined by the ideology which led to it. For, many different, violently opposed ideologies may all lead to the same final 'working equations' for dealing with real problems. Apparently, this phenomenon is something new in statistics; but it is so commonplace in physics that we have long since learned how to live with it. Today, when a physicist says,

3

I suggest that we apply the same criterion in statistics: the merits of any statistical method are determined by the results it gives when applied to specific problems. 'There is at least one specific application where theory A leads to a better result than theory B". and of its possible benefits and drawbacks. he means simply. he does not have in mind any ideological considerations."Theory A is better than theory B". 4 . The Court of Last Resort in statistics is simply our commonsense judgment of those results. I thus hope to provide a sufficiently ample number of practical examples throughout this dissertation for the reader to get a solid grasp of the decision analytic approach to hedging I am advocating.

and given a specific deal which he does not own but is considering buying. Research Questions The fundamental research questions which I intend to address in this dissertation are congruent with the motivation and objectives I exposed above: [1] [2] What is hedging? What is a clarity-test definition of hedging? How can I measure the value of hedging? [2.c] What remarkable properties does the value of hedging have? Does it have any special properties in the case in which the decisionmaker's u-curve satisfies the delta property? [3] Which probabilistic phenomena are at work in hedging? How can the existence of hedging be explained? [4] Given the decision-maker's portfolio. how can I help him identify the kinds of deals which best complement it? [4.3.b] Is there a way to quantify the decision-maker's willingness to pay for the ability to perform hedging on a given uncertainty or set of uncertainties? [5] How can analyses related to hedging be incorporated into the existing decision analysis process? How can decision analysts best apply those tools and methods to practical situations? 5 .a] Given the decision-maker's current portfolio.b] How can I extend the value of hedging concept to the case of a specific deal which he owns but is considering selling? [2. how can I ascribe a monetary value to the hedging that the deal provides with respect to the portfolio? [2.a] How can I detect the uncertainties on which it is most valuable to perform hedging? [4.

I will start with a short introduction to decision analysis. 6 . the engineering discipline whose principles and techniques will serve as a foundation for this dissertation. After that. I will provide a succinct account of the works on hedging which can be found in the finance literature.I will now give an overview of some of the existing research which will help us answer those questions.

its sole intent is to provide axioms and norms for how people should make decisions. and not to identify the intellectual and psychological processes which account for how people actually make decisions. as such.in other words. given his preferences. Decision analysis is a normative discipline. or Howard Raiffa [1968]. 7 . Howard [1966a] and refers to "applied decision theory". Peter C. 1966b. I recommend to the readers who are least familiar with the field that they consult the works which are cited in the list of references. Over the next few pages. 1968. 1992. Fishburn [1964]. to help him identify what is the best course of action given the information he has. Howard [1964. with an emphasis on the concepts which will be most critical to understanding this dissertation. 1965. 1966a. Elements of Decision Analysis The term "decision analysis" was coined by Ronald A. and given the alternatives that are available to him.4. in particular those of Ronald A. and not a descriptive discipline. I will provide an overview of some of the most fundamental concepts of decision analysis. 2004]. The objective of a decision analysis is to help the decisionmaker achieve clarity of action .

Reliable Information Clear Values & Trade-offs Creative..a) The Six Elements of Decision Quality It is difficult to articulate what constitutes a good decision in no more than a sentence. Doable Alternatives Logically Correct Reasoning Appropriate Frame Commitment To Action Figure 1. J. Three of the six elements of decision quality. In decision analysis. 100% indicates the point at which trying to do better on that specific dimension would yield an improvement which would not be worth the additional expense of resources required to obtain it. information and preferences of the decision-maker. we consider that there are six elements to decision quality [Matheson. D. Meaningful. Any decision or decision process can be rated along those six dimensions. E. They are enumerated on the figure below. are also collectively referred to as the "decision basis".2 .The six elements of decision quality . 1998]. from 0% to 100%. namely the alternatives. and Matheson..

B and C where A > B > C. B and C where A > B > C (">" denotes the preference order). • The order rule requires the decision-maker to order every prospect in the list from best to worst. and he may or may not choose to assign value measures to characterize the quality of all of the corresponding possible futures. if the decision-maker faces an uncertain deal in which he assigns a probability p to his receiving A versus 1 — p of his receiving C. • The equivalence rule states that for any triplet of prospects which are at different levels in the ordered list. according to his own preference. the decision-maker should be able to assign a number p. • The substitution rule states that for any triplet of prospects A. the decision-maker obtains a list of prospects. Once the probability rule has been applied. and they are commonly known as the "five rules of actional thought": • The probability rule requires the decision-maker to be able to characterize every alternative he faces by a possibility tree . a tree showing the different scenarios which might unfold following the selection of that particular alternative.b) The Five Rules ofActional Thought Like any other normative system.that is. 1992]. in other words a list of all of the possible futures he might face as a result of the decision situation. R. There are five of them [Howard. Ties are allowed: the decisionmaker might declare that he is indifferent between several prospects. The decision-maker should also be able to assign probabilities to all branches of the tree. where p is also equal to his preference probability for B in terms of A versus C. A.. comprised between 0 and 1. A. then the decisionmaker should be indifferent between keeping the uncertain deal and exchanging it forB. such that he would be just indifferent between receiving B for sure and an uncertain deal in which he would receive A with probability/) and C with probability 1 -p. decision analysis is entirely based on a few principles which serve as axioms. 9 . Such a number/? is called a preference probability.

10 . to the decision-maker who does not subscribe to at least one of the five rules.• Finally. counsel from a decision analyst is of as little use as are the theorems of Euclidian geometry to someone who rejects one of its postulates. the choice rule requires that the decision-maker choose the deal which offers the better chance of the prospect he likes better. namely A: he should select the first deal if r > s. one after the other. to a particular decision situation.s. a decision analyst can help a decision-maker infer what the best alternative available to him is. he will receive either A with probability r or B with probability \ . while in the other deal he will receive either A with a different probability s or B with a probability 1 . By successively and carefully applying the rules. and that A >B. the second if r < s. Conversely.r. let us suppose that there are two prospects A and B at different levels in the ordered list of prospects. Decision analysis can only be of help to decision-makers who choose to subscribe to the five rules of actional thought. let us also suppose that the decisionmaker needs to choose one of two uncertain deals: in the first. Then.

A. 1998]. we will call them u-values instead [Howard. We can thus lift the requirement that preference probabilities should be contained within the interval [0. All we need to do is introduce a new term to refer to those unrestricted preference probabilities. it also becomes possible to compute the decision-maker's Personal Indifferent Buying Price (PIBP) for something he does not own. jv-i] in terms of Pi and PN. u(. n]. If the value measure which the decision-maker cares about is his wealth. more formally. Once it is assessed from the decision-maker. Let us first observe that in any decision situation. A.Fortunately.. 1]. w. one would need at least N. or his Personal Indifferent Selling Price (PISP) for something he owns [Howard. one for each prospect within the list {Pi}ie[2. R. which we will call u-curve. it is possible to greatly simplify the assessment process by introducing a few more basic concepts.2 assessments. we can denote the u-curve by u(w).c) U-curves. We can then simplify the assessment process for preference probabilities by assuming that the u-values all follow a particular functional form.. Indifferent Buying and Selling Prices.AG. 1998]. which the 11 . as the analogy with a probability is lost once we allow those numbers to dwell outside of [0. and Delta Property It would be a tedious process to repeatedly apply the equivalence rule to elicit from the decision-maker a preference probability for each prospect of a large-scale decision situation: if there are JV> 3 prospects {Pi}ie[i. 1].. ie[l. the course of action which is recommended by the five rules of actional thought does not change if all preference probabilities are arbitrarily multiplied by the same positive constant.) should be an increasing function. the u-curve can be used to solve decision situations without resorting to preference probabilities anymore: it can be shown that subscribing to the five rules of actional thought is equivalent to making decisions by selecting the alternative which yields the highest expected u-value. R. Pi being the best and PN the worst. if we consider a deal X with probabilities pj and prospects x. or if any real number is added to all of them. With u-curves. The PIBP for an item is defined as the sum of money such that the decision-maker is just indifferent between not acquiring the item at all and acquiring the item at that price. If in addition the decision-maker prefers more money to less.

his u-curve is convex. ie[l. It is important to understand that nothing in the five rules of actional thought prohibits ucurves which are concave on some intervals but convex on others.m] 9 . For an uncertain deal with probabilities q* and prospects y\. and if we denote his present wealth by w and his PIBP for X by b. then: u(w + s)= 2 ie[l.000 and a 50% chance to receiving nothing is risk-averse. would want to adopt that sort of risk attitude in an actual decision situation. however. and more specifically in its concavity or convexity. A risk-averse decision-maker is defined as one whose certain equivalent for an uncertain deal is inferior to the e-value of the monetary prospects of the deal. In contrast.decision-maker is considering acquiring. A decision-maker using such a u-curve would exhibit a risk-averse behavior for some deals and a riskseeking behavior for others. once they understand what the term risk-seeking truly means in decision analysis. the PISP for an item is defined as the sum of money such that the decisionmaker is just indifferent between retaining the item and selling the item at that price. u ( w + yi) The decision-maker's risk attitude is directly reflected in the shape of his u-curve. it is not surprising if we consider that very few decision-makers. for example. We will call risk-neutral a decision-maker who assigns to an uncertain deal a certain equivalent which is exactly equal to the probability-weighted average of its monetary prospects (an amount usually referred to as "the e-value of the monetary prospects" of the deal). a decision-maker who has a certain equivalent of $450 for an uncertain deal in which he assigns a 50% chance to receiving $1.n] Similarly. 12 . the indifference statement can be translated into the following equation: u w ( ) = X PiUCw + Xj-b) ie[l. a risk-seeking decision-maker is one who assigns to an uncertain deal a certain equivalent which is greater than the e-value of the monetary prospects of the deal. Piecewise concave and convex u-curves are seldom used in practice. The PISP for an uncertain deal is also called certain equivalent. m] which the decision-maker owns and is considering selling. if we denote his PISP for Y by s. Such a decision-maker has a concave u-curve.

for a deal which differs from X by a constant 8? It is a natural n ]}. two of them. to declare that s' should be equal to s + 8. 1999]: Table 1. R. especially if they regard the magnitude of the monetary prospects involved as relatively small compared to their total wealth. A.1 — Common u-curves and some of their characteristics Among the u-curves listed above. in other words.. x 0ie[i. J.. what will be his certain equivalent s' for an uncertain deal X' = {(pi. desideratum for many decision-makers. Xj + §)ie[i.n]}. E. the linear and exponential form u-curves. If that is the case. the decision-maker's u-curve is said to satisfy the delta property. 1998]: consider a decision-maker who has a certain equivalent s for an uncertain deal X = {(p. 13 .The next table shows some of the u-curves which can be most commonly found in the literature [Bickel. possess a fascinating characteristic called the delta property [Howard..

What makes the delta property particularly remarkable is the fact that it entails many additional properties for the decision-maker: • The decision-maker's valuation of any uncertain deal remains the same whether he includes his initial wealth in his characterization of the deal's monetary prospects or not. Therefore. Therefore. it is not necessary to take initial wealth into account when computing his PIBP or PISP for a deal. • • For any uncertain deal. this also implies that the only number which needs to be assessed to determine the decision-maker's u-curve in its entirety is y. the decision-maker's PIBP and PISP for it are equal. A y of zero corresponds to a risk-neutral decision-maker. which is often called the decision-maker's risk-aversion coefficient. 14 . as mentioned earlier.at least in theory. The decision-maker's u-curve can only be of one of two forms: linear or exponential. a positive y to a risk-averse decision-maker. one question is all decision analysts need to ask in order to assess y and thereby the whole u-curve . • The value of any information gathering process can be computed as the difference between the value of the deal with the help of the additional information and the value of the deal without. Because u-curves are unique up to a positive linear transformation. and a negative y to a risk-seeking decision-maker. since in practice it is still advisable to proceed to several measurements of y in order to assess it more accurately.

• . .. Analysis ^ Probabilistic • . • .A. 15 . which are depicted below: Formulation 0. Structure .d) The Decision Analysis Cycle The decision analysis process [Howard. ..in reality. . —b. intended to guide the decision-maker towards clarity of action. Analysis Appraisal . R. the entire process can be thought of as a continuous conversation between the decision-maker and the decision analyst._ . n p r i « i n n uccisiuu .The decision analysis cycle It is another common oversight to believe that the decision analysis process merely boils down to the construction of a mathematical model and its analysis . and a mathematical model is no more than one of the recurrent and most visible constituents of that conversation. It consists of four phases.3 . 1966a] is iterative. Evaluation • • Deterministic . Appraisal . t Figure 1.

Formulation Phase The main objective of the formulation phase is to frame the decision situation: decisionmaker and decision analyst seek to distinguish the issues which should be under consideration in the analysis from those which should not. it is no simple question to answer. given the decisions which are to 16 . A decision hierarchy is a tool which helps address the issue. especially if many stakeholders are involved in the decision process.A decision hierarchy Once all decisions have been sorted into those three separate containers. The next important point to ponder is the list of the uncertainties which should be included in the analysis. Framing is more of an art than a procedure with strictly established steps and guidelines. it prompts the decision-maker to separate his decisions into three distinct categories: those that can be taken as givens. and. TAKE AS GIVEN V ANALYZE NOW y EXAMINE LATER Figure 1. we can focus our attention on the middle category. an important element of virtually every framing exercise is to determine exactly which decisions need to be made at this epoch in time.4 . those which are thought to have a small enough impact on the value for them to see their examination safely deferred until later. finally. However. those which are important enough to be the object of the current analysis. In many practical examples.

and Matheson. which are also referred to as decision diagrams in parts of the literature. A.2 . Influence diagrams. a total of four kinds of nodes and four kinds of arrows. They offer a graphical representation of the structure of the decision situation. E..be analyzed. 1981]. The semantics of influence diagrams are outlined in the following tables.Influence diagram semantics -possible nodes and their meanings 17 . can be encountered in influence diagrams: Table 1. are powerful tools which assist analyst and decisionmaker as they communicate about such matters [Howard. and of the relationships which exist between all the issues involved. and how those decisions and uncertainties all affect one another as well as the decision-maker's value. each with a specific meaning. R. J.

Arrow Functional D Deterministic node F is a function of decision D and the outcome of E Arrow The probability distribution over the D Influence Arrow degrees of C varies depending on the decision which is made at D Table 1. Informational D.3 ..Meaning A and B are probabilistically relevant given their parent nodes Decision Di and the outcome of uncertainty C are both observed before making decision D2 Relevance Arrow D. 1997]: 18 . D. R. it is based on one of the models which Ross Shachter presents in his introduction to the subject [Shachter.Influence diagram semantics -possible arrows and their meanings An example of an influence diagram for an oil exploration and drilling decision is shown in the next figure.

and to then solve it in order to identify the best alternative and its associated certain equivalent [Shachter. D. R. 1986 and 1988]. it is possible to encode probabilities and value measures into the influence diagram. 19 .Figure 1.5 — An influence diagram It should also be noted that the role of influence diagrams can be extended beyond their use as a representation of the structure of the decision situation: in fact..

The next task for the decision analyst consists in assessing the relative importance of the uncertainties by comparing their individual effects on the value. the analyst perturbs each uncertainty. from the one triggering the greatest 20 ..in other words. J. Deterministic Analysis Naturally. the first step consists in building such a mathematical model of the decision situation. corresponding to the 10th percentile of the distribution. 1987]. • calculations showing the value which any possible scenario. It should include: • • all of the alternatives under consideration. the decision-maker is asked to provide three possible values. the value of the alternative when all uncertainties are set to their base values.Evaluation Phase During the evaluation phase. that is to say any possible selection of an alternative followed by any possible realization of the uncertainties. corresponding to the 90th percentile. Then. as framed during the formulation stage.a feature which will prove valuable on many occasions throughout the analysis. is built and analyzed in order to identify the best alternative. The results are recorded and the uncertainties are sorted. and Celona. swinging it from base to low and from base to high. For a specific alternative. and a high value. either by himself or with the help of a designated expert: a base value. as we will see later.. the analyst first computes what is called its base value . In many cases. a low value. one by one and one at a time. corresponding to the median of the probability distribution over the uncertainty. as they allow for a rapid recalculation of the value for various scenarios . it is the net present value of the scenario which is evaluated. P. all of the uncertainties listed on the influence diagram. a mathematical model of the decision situation. Such models are often built using spreadsheet programs. would yield for the decision-maker. Tornado diagrams fill that need [McNamee. for each of them.

6-A tornado diagram The analyst and the decision-maker can then read off the tornado diagram the names of the uncertainties which have the greatest potential impact on value. The whole procedure we just described is sometimes also called deterministic sensitivity analysis. 1966.0 100..0 Figure 1. A.0 150.swing in value to the one triggering the smallest. 21 . A tornado diagram such as the one shown below is built in order to display the results in a way which makes it easier to discuss and interpret them. and Howard.. Profit ($ million) -100. the analyst and the decision-maker may choose to exclude an alternative from the analysis.0 0. In addition. R. J. Uncertainties which are not selected will be modeled as deterministic quantities instead. if they observe during the deterministic sensitivity phase that it is systematically dominated by at least one of its rivals. and decide which variables they want to model probabilistically throughout the remainder of the analysis [Howard. in recognition of the fact that the probability of each possible scenario has not yet been taken into account.. 1968]. A. R. Matheson. E.0 Market Size I Revenue per jjnit Efficacy of the Drug Number of Compi rtitors Side Effects of the Drug Phase III Trial Duration Phase III Trial Cost I Production Cost per Unit New Plant Construction Cost -50.0 50.

S. S. Probability encoding is a time-consuming and complex procedure [Spetzler. and Stael von Holstein. I encourage the reader to refer to the works of Amos Tversky and Daniel Kahneman [1974] for an overview of such biases. Once the u-curve has been elicited.. for each possible realization of the value measure. 1975]. the task is considerably easier. like anyone else. Armed with those probability distributions. 22 . as mentioned earlier. the probability assigned to obtaining a result which would be inferior to that value. experts or other stakeholders in the decision-making process are often the victims of biases which cloud their judgment. and to those of Carl S. An example of two cumulative distribution functions corresponding to two different alternatives is shown on the next figure. Spetzler and Axel S.. Such a curve shows. Next. the analyst can compute the certain equivalents of all the alternatives and identify the best course of action.Probabilistic Analysis A few assessments need to be made before the analyst can proceed with the evaluation of the probabilistic model: the analyst should first elicit probability distributions for the uncertainties which were selected at the term of the deterministic phase. the analyst can assess the decision-maker's u-curve over the range of prospects involved in the decision situation. if the decision-maker is comfortable with following the delta property over that range. Stael von Holstein [1975] for an introduction to techniques which decision analysts can use to combat their influence during probability encoding. A. C. with the help of the decision-maker himself or of a designated expert. decision-makers. and it is crucial that the analyst help them discern their true belief from the distortions that those biases impose. the analyst can then plot for each alternative a cumulative distribution function over the value measure. since only one parameter needs to be assessed in that case.

23 .100% 90% 80% 70% robability 04> 60% 50% 40% "3 30% g s U 20% 10% 0% 100 -$50 $0 $50 $100 $150 $200 Net Present Value ($ Million) Figure 1. It is not a surprising conclusion when one considers that B offers a better mean profit than A. there is no dominance relationship between A and B. The situation arises in instances of: • deterministic dominance: when the worst prospect achievable under alternative A is better than the best prospect achievable under alternative B. 1998]. in such cases.. it might thus be unnecessary to assess the decision-maker's risk-aversion coefficient y with great precision.7. • or of second-order probabilistic dominance: when the integral of the difference between the cumulative distribution functions of A and B keeps a negative sign over the entire range. A. In the example shown above. R. • first-order probabilistic dominance: when the difference between the cumulative distribution functions of A and B keeps a negative sign over the entire range.Cumulative distribution functions for two alternatives It is at times possible to infer from the cumulative distribution functions of two alternatives A and B that A will be preferable to B regardless of the degree to which the decision-maker is risk-averse [Howard.

but at the cost of a substantially larger downside: to a risk-neutral decision-maker. since the mean is all that matters. B will thus appear as the better alternative. whereas to a sufficiently risk-averse decision-maker. the magnitude of B's potential downside will seem so large that A will earn his favors overall. 24 .

He follows the delta property over the entire range of prospects involved and during the assessment process for his risk-aversion coefficient. and the analyst might think that it will be indispensable to ask more questions in order to assess y more accurately. while others may trigger spectacular shifts in the decision. But that does not mark the end of the analysis.Appraisal Phase The decision analyst identified the best alternative during the evaluation phase and computed its certain equivalent. A. it might prove helpful to perform a sensitivity analysis on the decision-maker's riskaversion coefficient. a decision-maker needs to choose between four alternatives. it is helpful to answer two additional questions: • • Under what conditions should we make a different decision? Before choosing the alternative which currently appears to be the best available. C and D.11. his answers all implied values of y comprised between 0. An example follows. However. one by one and over reasonable ranges of values. that might seem to be a wide interval of possible values.. the analyst can assess the relative importance of different variables. in order to achieve complete clarity of action. At first. can the decision situation be improved by gathering further information. some may be recognized as being incapable of altering the decision-maker's choice. and by tracking the impact that such changes have on the certain equivalent of each alternative. if there is no dominance between two alternatives up to the second order. y. For instance. and its certain equivalent is 25 . B. or by exerting some influence over some of the uncertainties involved? How much should the decision-maker be willing to pay for each of those activities? Sensitivity Analysis Sensitivity analysis [Howard. At the term of the analysis. R. 1968] addresses the first of the two issues: by perturbing the variables involved in the model. inspection of the sensitivity analysis chart below reveals that alternative B is the best alternative within this entire range by a comfortable margin.07 and 0. A. the decision-maker will thus be able discern the elements which are worthy of his attention from those which are not.

012 0. This is especially important in business settings.000]. Alternative C S J= o H © = '3 aw S 4> $40 $20 $0 0.002 0.016 0.004 0.8 — Sensitivity to the risk-aversion coefficient Sensitivity analysis also helps the decision-maker understand how the best course of action might change given slightly different circumstances. As a reminder.02 Figure 1.014 0. typically.000.000 0.contained in a relatively narrow interval: [$112. since the results of a market study. $160 $140 $120 c a V3 Alternative A $100 Alternate e B $80 $60 ^«.006 0. what seemed to be an uncomfortably wide range of possible values for y appears as no more than an inconsequential annoyance. $121.018 0. an important announcement made by a competitor or a large-scale economic event often leave little time to react. All of a sudden. and it would not be to the decision-maker's advantage if he had to commission a fresh evaluation of his decision situation every time he receives a new piece of information. Sensitivity analysis is usually conducted slightly differently in the case of the uncertainties which were modeled probabilistically during the evaluation phase.010 Y 0.008 0. three values are elicited from the decision-maker for each of those 26 .

the certain equivalent of the alternative which is preferred when U = Ubase. as the analyst varies U. more specifically. and the certain equivalent of the alternative which is preferred when U = Uhigh. Those three values can then be used to perform what is called open-loop and closed-loop sensitivity analyses [Howard. 50 and 90th percentiles of the distribution. • the certain equivalent of the alternative which is preferred when U = uiow. 1968]. and it is the certain equivalent of that alternative which is recorded. the analyst computes for uncertainty U with fractiles uiow. Ubase a n d Uhigh: • the certain equivalents of A given that U = uiow. nor does any of them need to be A.uncertainties: a low. It should be noted that the open-loop curve should not surpass the closed-loop curve at any point. the alternative is not rigidly anchored on A. given that U = Ubase. a base and a high. This is called a closed-loop sensitivity analysis: this time. which respectively correspond to the 10 .This is called an open-loop sensitivity analysis: the alternative is permanently set at A. 27 . and the analyst simply computes the fluctuations in its certain equivalent as U varies. Those alternatives need not be the same. he also allows himself to change his decision in favor of a better alternative. R. A. The results of the open-loop and closed-loop sensitivity analyses can be plotted as illustrated below. and given that U = Uhigh.. if we denote by A the alternative which was shown to be the best at the term of the evaluation phase.

we should mention as a conclusion to our overview of sensitivity analysis procedures that in many decision situations. the best alternative would change if the decision-maker became sure that U = Uhigh. Conversely. 1994]. or that U = Ubase. but before that. the results they produce are remarkably compact. A is outperformed by at least one alternative by $56 million. 2 § % $200 j -* * s 1 $150 '3 e $100 '3 V.9 — Open loop and closed loop sensitivity analyses Open-loop and closed-loop sensitivity analyses are computationally intensive. G. at those two values. one for U = Ubase and one for U = UhighHowever. it can also be illuminating to evaluate the sensitivity of the decision to the relevance of various uncertainties to one another [Lowell. since six data points on a chart are enough to capture them in their entirety.. We will soon see that a few more significant insights can be extracted from the open-loop and closed-loop curves.$300 1? $250 - . and admirably powerful: in our illustrative example. D. o W $50 $0 Uiow Ubase ^high Figure 1. since they require three separate and complete reevaluations of the certain equivalent of each alternative . This helps distinguish the relevance relationships which need to be elicited and explicitly modeled as conditional probability distributions from those which can be left as marginal distributions without impairing the 28 .one reevaluation for U = uiow. the results of the open-loop and closed-loop sensitivity analyses coincide. the analyst can conclude that A would remain the best alternative even if the decision-maker were to obtain additional information which led him to believe that U = uiow with certainty. indeed.In that event.

and {uhigh | &}. 1966b] addresses the first half of the question. The value of information [Howard. A. Value of Information and Value of Control As announced earlier. we observed earlier that the value of information on some uncertainty U can be computed as the difference between the value of the deal with free and perfect information on U. be it a clinical test in a medical decision setting or market studies and R&D experiments in a major corporation. In other words. and facing the same decision situation with the help of the additional information but also with a bank account which was reduced by P. Both of those quantities can easily be calculated based on the results of the open-loop and closedloop sensitivity analyses on U: • The value of the deal with free and perfect information on U corresponds to what we might call the certain equivalent of the closed-loop curve. R. with respective probabilities {uiow | &}. Cbase and Chigh. Qow. since it is in those instances that simplifying the model in order to avoid unessential conditional probability assessments will tend to prove most valuable. as identified on the previous figure. for any information gathering scheme. or by exerting influence over some of the uncertainties involved. the value of the deal with no additional information on U corresponds to what we might call the certain equivalent of the open-loop curve. • On the other hand. 29 . a second objective of the appraisal phase is to determine whether the decision situation can be improved by gathering further information. it is the price P at which he is just indifferent between facing his present decision situation as is. and the value of the deal without any further information on U. the value of information is defined as the decision-maker's PIBP for the additional information. { i w I &}. For decision-makers who follow the delta property over the entire range of prospects involved.quality of the recommendation. it is equal to the certain equivalent of an uncertain deal in which there are three monetary prospects.. Sensitivity analysis to relevance is especially critical in decision situations with large and intricate probabilistic structures.

In the high technology and pharmaceutical sectors. and the value of the deal without any control over U. as computed during the evaluation phase. {ubase I &}. the value of control over some uncertainty U is defined as the decision-maker's PIBP for being able to choose the outcome of U [Matheson. with respective probabilities {uiow | &}. Obase and Ohigh. firms might also choose to devote more resources to a particular project or molecular compound in order to increase the likelihood of technical success. 30 . it is equal to the maximum of the values Ciow.it is equal to the certain equivalent of A. the value of control is equal to the difference between the value of the deal with free and perfect control over the outcome of U. • The value of the deal with no control over U corresponds once again to the certain equivalent of the open-loop curve. 1990].it is equal to the certain equivalent of an uncertain deal in which there are three monetary prospects. J. and {uhigh | &}. it is for example possible to try and influence a product's market share by launching a marketing campaign which will increase the product's visibility. Those two numbers can again be calculated with the help of the open-loop and closed-loop chart: • The value of the deal with free and perfect control over U corresponds to the highest point of the closed-loop curve. Just like in the case of the value of information. as well as the best alternative under those conditions. E. there exists an easy procedure to compute the value of control for decision-makers who follow the delta property over the entire range of prospects: then. Oiow. or more explicitly to the certain equivalent of A as computed during the evaluation phase. in other words. Cbase and Chigh. In a business setting. the decision-maker is free to select the outcome of U he prefers.That can be explained by the fact that this time.. It should be noted that the analyst already calculated the quantity in question earlier in the analysis . Similarly.

Conclusion of the Appraisal Phase By the end of the appraisal phase. then it should be pursued. iteratively. the appraisal step will show that the recommended alternative is so right for the decision-maker that there is no point in continuing the analysis any further. • He has identified the variables which may cause him to modify his decision if they were to change. • He knows how much he should be willing to pay for information on each one of the uncertainties involved in the decision situation.. The first three steps of the decision analysis process would then be repeated with the help of the additional information. and how much he should be willing to pay for the ability to exert control over them. the alternatives that are available to him and his current beliefs. A. and how large of an impact such an event would have on his certain equivalent. He also knows for which revised values of those variables his choice should change. Howard's words [Howard. until it eventually becomes sensible to stop the analysis and act. 1988]: At some point. 31 . If there exists an information gathering scheme whose cost would be inferior to the value of information it would provide to the decision-maker. In Ronald A. R. the decision-maker has clarity on the following issues: • He has identified the course of action which is the best given his current preferences.

indeed.. Hedging in the Financial Literature In this part of the dissertation. We will first examine conventional definitions of hedging. and the family of utility-based approaches. 1993]. D. and on issues which are almost entirely disconnected from the descriptive research. and Kothari. a large body of literature studies questions such as the extent to which hedging is used by corporations [Guay. C. 2003] or the degree to which corporate hedging is effective [Nance. and Smithson. This is not for lack of research on the subject. I will not. R. P. review the descriptive literature on hedging. R. C. however. W.. S. But this dissertation exclusively focuses on normative perspectives.. I will provide a succinct account of the views on hedging which are most commonly expressed in the financial literature. 32 . W. W..the family of mean-variance approaches..5. Smith. 1993. before moving on to an exposition of the key points of the two prevalent normative theories on hedging .

But more recently. S. For instance. which had been created in 1848. Mian. in other words the use of those derivatives.S. H. In the U. Nance and al. It is indeed with the inception of commodity futures that the concept of hedging first emerged: in late 17th century Japan. 1996]: Corporations are exposed to uncertainties regarding a variety of prices. L. The following definition by Kandice H. In that broader definition. at least in part. K. why there has been so much interest in hedging in a field such as agricultural economics. and they make an explicit distinction between "off-balance-sheet hedging". Deana R. The fact that trading derivatives and hedging have become synonyms for many in the financial community has to do with the long common history that those two ideas share. "hedging" refers to the use of financial derivatives such as futures and forwards in order to mitigate the risk that exists in another investment.. It was the first recorded instance in which such a market was created. near Osaka.. pork belly and copper futures as early as in the 1860s.. That history probably explains. hedging has referred to an activity which helps reduce or cancel out the risk imposed by another investment. derivatives trading also started with commodity futures. proposes the following definition [Mian. and more importantly why in academic circles the term has often been understood to mean the use of forwards or futures. for example. and 33 . Shehzad L. with the Chicago Board of Trade. a more inclusive definition of hedging began to surface: in the financial literature of the last two decades. Kahl [Kahl. a futures market in rice was developed at Dojima. to help suppliers protect themselves against the risks imposed by nature (poor weather) or by man (war and pillage).a) Traditional Definitions ofHedging In much of the financial literature. Hedging refers to activities undertaken by the firm in order to mitigate the impact of these uncertainties on the value of the firm. allowing investors to trade wheat. the reference to derivatives was progressively relegated to the role of mere example. 1983] illustrates that view: The traditional literature on commodity futures markets defined a hedge as a futures market position which is equal but opposite to the individual's cash market position. observe that there is more to hedging than the use of financial derivatives. more and more frequently.

"on-balance-sheet hedging" [Nance. even beyond academic circles. C. (2) selling foreign exchange futures on the foreign currency. D. it might relocate production facilities abroad or fund itself in the foreign currency. Smith. Alternatively. Hence. This exchange rate-induced volatility can be hedged by (1) selling a forward contract on the foreign currency. and options . it could employ off-balance-sheet instruments to hedge that exposure. (4) buying a put option on the foreign currency. or (5) writing a call option on the foreign currency. C.. markets from foreign manufacturers is inversely related to the value of the dollar. the firm could hedge through an on-balance-sheet strategy. W. (3) entering into a currency swap in which it receives cash flows in dollars and pays cash flows in the foreign currency. 34 .to reduce the volatility of firm value. many technical papers on the subject still focus exclusively on the pricing of derivatives. futures. W.S.forwards. But the definition of hedging we will present and defend in this dissertation has more in common with the more inclusive of the two definitions. which involves the use of more standard investment mechanisms with the intention of reducing risk: Corporate hedging refers to the use of off-balance-sheet instruments . swaps.. and Smithson. R. 1993]. It should be noted that in spite of the rising popularity of that broader definition of hedging as an activity which helps reduce the risk of an investment. if the value of an American manufacturing firm that faces competition in its U..

the approach is often called "minimum-variance hedge". 1997]. It is thus no surprise that mean-variance thinking gave rise to a normative theory of hedging. 1952 and 1959]. 1985. A U. and a popular one at that. H. Markowitz developed the first theory on portfolio allocation in which there was an explicit treatment of risk [Markowitz.. G. For that reason. but such that the price of the future contract is probabilistically relevant to that of the asset that requires hedging.. the investor should identify a future contract related to a different commodity. In what is perhaps its most basic and most radical form. Markowitz' work. for example because there exists no future contract for the asset whose value needs to be hedged.portfolios in which no added diversification could lower the portfolio's risk for a given expected return.. in U. which is loosely based on one discussed by David G. I will now illustrate the minimum-variance approach through a simple example.000 euros in a month. as measured by the mean return of the portfolio. S.. 1997]. by trading future contracts on the Japanese yen: more specifically. Harry M. firm will receive 100.S. which earned him the Nobel Prize in Economics in 1990. and a given risk level. much of financial theory remains grounded on the premise that investors should make trade-offs between a given reward level. G. L. and in which no gain in expected return could be achieved without simultaneously consenting to an increase in the risk of the portfolio.b) Mean. D. as captured by the variance of the portfolio.Variances Approaches In the 1950s. Luenberger. they decide to hedge the value of that contract. The investor can then compute the number of future contracts he should buy in order to minimize the variance of the resulting portfolio [Brown. and at a philosophical level. has had a profound and lasting influence on financial mathematics. M. The theory taught investors how to identify optimal mean-variance portfolios . the method recommends that the investor completely eliminate the variance in his investment by taking an equal and opposite position in the futures market [Luenberger. dollars. D. Portfolios which offer the highest expected return for each level of risk are still called Markowitz efficient portfolios. if it is infeasible in practice. Luenberger [1997].S. the firm will enter an 35 .

94 0.34 dollars for every euro: $/100¥ = 0.S.88-0.000 /i(0.2 $/100¥ = 0.88 $134.94 $142.88) 0. as well as the profits the company would be making from the euro contract and the yen contract under different scenarios as a function of h.4 $/100¥ = 0.94) $134.88-0.82) o.000 £(0.i $/€ = 1.88 0.000 A(0. dollars and euros is 1.21 0.88-0.82 $121.4 $/100¥ = 0.88-0.000 0.3 $/100¥ = 0.7 $/€ = 1.82) o0.1 $/100¥ = 0.34 O 0.7 Figure 1.2 $/100¥ = 0. The current exchange rate between U.88-0.88) $121.000 /i(0.88 dollar for 100 yen.10 .82) $121.Minimum-variance hedging for foreign currency The above tree shows the possible evolution of exchange rates over the coming month.88 <y $142.82 0.94) 0.3 $/€ = 1.000 6(0.3 $/100¥ = 0.88-0.3 $/100¥ = 0. Minimizing the variance of the 36 .88) $134.000 /i(0.88-0.88-0.88-0.agreement now to sell h yens in a month at an exchange rate of 0.000 /»(0.000 A(0.94 0.94) $142.42 0.82 /i(0.

While the use of such objective functions allows the investor to take into account his personal risk attitude as he makes hedging decisions. and who is given the chance to receive for free another financial instrument which.. why would they all choose the exact same hedging strategy? In order to remedy to that weakness of the minimum-variance method. . some authors from the financial literature advocate replacing as the purpose of hedging the minimization of variance by the optimization of an objective function which encodes the investor's meanvariance trade-offs [Heifner. but would also significantly improve the third central moment of his profits . D.in other words. it can sometimes be misleading to evaluate an investment opportunity based solely on the first two moments of its probability distribution over profits. it can be argued that such an approach is still not entirely satisfactory. H. Kandice H. K.750.. Kahl. the influence of the variance of the portfolio on the investor's decision's will also increase .by shifting the downside and the upside of the distribution to the right. 2000]. A is a positive number which captures the risk-aversion of the investor. where n designates profit: < T | &> . L. V <7l|&) 7 In that function. we obtain h = -8. Frechette. why would the solution not depend on the decision-maker's risk attitude? If we believe that some investors are more risk-averse than others.000 as the optimal value of h. larger values of X correspond to more risk-averse investors. and the central region of the distribution to the left. if added to his present investments. 1972 and 1973. As X increases.entire portfolio. In reality. would leave both the mean and variance unchanged. R. Kahl elects to optimize the following function. let us consider the situation of a risk-averse investor who owns a portfolio with uncertain returns.. without altering the mean or variance of his investment? 37 .A. For example. Why would a risk-averse investor necessarily dismiss such an investment opportunity as uninteresting? Would he not appreciate this opportunity to reduce the magnitude of the potential downside. For instance. G. But the answer raises some fundamental questions: for example. for example. 1983.

38 . and we will even be able to quantify their weight in the investor's hedging decisions.We will come back to that criticism of mean-variance methods much later in the dissertation: we will show that moments of order three and above can be of considerable importance.

and that explains the popularity of utility-based approaches to solve such problems [Cvitanic.... Madan. R. P.. M.c) Utility-Based Approaches In the late 1980s.. the utility function which is used is the exponential form which we already discussed in our review of decision analysis concepts.. J. 2007]. R. but their use has been more sporadic: 39 . and Zariphopoulou. M. T.. V.e . interest in another family of normative theories for the study of hedging started to surface in the financial literature. the traditional financial paradigms of portfolio replication and risk-neutral valuation are of little help to an investor who is trying to put a price tag on an option. and Strieker.. V.. which I will call utility-based approaches. H... 2001. the cash flows which an option yields cannot always be replicated by a suitable combination of other assets in the market. and Hurd. T. Panas.. Schachermayer. 2007]: U(x) = . P. Matheus R. W. 2002. In most of those papers. were originally inspired by a paper written by Stewart D. therefore. D. A. Henderson. Grandits. utility-based approaches have also been used recently to price highly sophisticated assets such as volatility derivatives [Friz. Carr. Samperi. P. 2005.. Schweizer. In such markets. 2002. Stewart D. which was soon extended to a larger class of transactional cost structures than the one it was originally developed for [Davis. in which they adapted the expected utility framework from decision theory to options pricing: essentially. The theory. Grasselli and Thomas R. Delbaen. R. 1993]. Hodges and Anthony Neuberger were computing the price at which the investor would be indifferent between having a given option in his portfolio and not having it. J. Musiela. F. became especially popular for the pricing of derivatives in what are called "incomplete markets" in the financial literature. For the same reasons. V. 2002]. and Wang. 2004]. 2005. T... and Yor. G. Geman. Hurd for example suggest [Grasselli. and Hurd. R.... Those new approaches.... H.... D. Hodges and Anthony Neuberger [1989].y x Power utility functions have also drawn some interest from the financial community [Henderson. and Zariphopoulou. and Gatheral. M. Grasselli. M. C . T. M . H. M. T. Rheinlander.

x1_R U(x) = 1-R Of all types of power utility functions. This is not surprising if we consider the fact that the financial community's utility-based approaches to hedging are built on a few principles which are similar to those of decision analysis. G. since maximizing expected utility then becomes equivalent to optimizing a function which only depends on the mean and variance of the profit distribution. D. such as indifference pricing.whereR>0 40 . 1997]. The fact that quadraticutility-function maximizers seldom use the vocabulary of indifference pricing is further proof that their thinking is more characteristic of the mean-variance school of thought rather than its utility-based counterpart. the quadratic form is one of the most commonly encountered in the literature [Luenberger.. the use of quadratic utility functions should probably be regarded as a bridge between mean-variance and utility-based approaches rather than as a utility-based approach stricto sensu. The normative theory of hedging which I will present and defend in this dissertation is much closer in its philosophy to the views developed by the proponents of utility-based approaches. However. .

The art of reasoning is nothing more than a language well-arranged. and best manner possible. most exact. in the most simple. Before we can make any serious attempt at ascribing a monetary value to hedging. 41 . Algebra. Formulating a clear definition of hedging will be our first ambition in this chapter. it is thus imperative that we define it in the most precise terms .there is little point in trying to build a solid edifice on a weak foundation. We will then see that with that definition in place. which is adapted to its purpose in every species of expression. " Antoine-Laurent de Lavoisier (1743-1794).Chapter 2 . it becomes easy and natural to ascribe a monetary value to hedging. languages are true analytical methods. Traite Elementaire de Chimie Antoine-Laurent de Lavoisier's words should remind us that employing a wellconstructed language is indispensable if we want to think clearly about an issue. is at the same time a language and an analytical method.Definition & Valuation of Hedging "We think only through the medium of words.

if we compare purchasing deal Y in the following two states: • • The decision-maker owns portfolio X and wealth w (State 1). more formally: Definition 2. we will abandon the idea of a risk reduction characterization of hedging altogether. as suggested by supporters of the mean-variance family of normative theories on hedging? As we seek to define hedging. In fact. because it leaves one important question unanswered . X) is less than B~(Y | w + S~(X | w». We will say that Y provides hedging with respect to X given w if B~(Y | w. Definition of Hedging As noted in the previous chapter. The decision-maker owns wealth w + S~(X | w). is not entirely clear. X) is greater than (Y | w + ~(X | w)).Hedging Suppose that the decision-maker has wealth w and owns an unresolved portfolio of deals X. we will say that Y provides negative hedging with respect to X given w if B ~(Y | w. 42 . but does not own X (State 2). then purchasing Y is regarded as more valuable by the decision-maker in the first state than in the second. to focus instead on the effect hedging produces on the decision-maker's preferences with respect to a specific deal: we will speak of hedging if the decision-maker finds a deal he does not own more attractive when he values it with his current portfolio in mind than when he values it without considering his existing portfolio. we should avoid relying on terms which would only add to our interlocutor's confusion. Such a definition. unfortunately. Conversely. such as "risk".1 . hedging is now commonly understood to refer to an investment "that is taken out specifically to reduce or cancel out the risk in another investment" [Wikipedia].what do we mean by "risk"? Is the word used as shorthand for "variance".1. suppose also that he is considering purchasing a deal Y. In other words.

And yet. The decision-maker is just indifferent between State 1 and State 2.. are so defined that the decision-maker is just indifferent between them.. which determines whether there is hedging or not.Hedging as the comparison of two PIBPs 43 . following the sale of portfolio X for the exact price at which the decision-maker was indifferent to parting with it.We are comparing the decision-maker's PIBP for Y under two different sets of circumstances. in the presence or absence of X but all else being equal. State 2 }S~<X|w> . but would he prefer to add Y to his portfolio in State 1 or in State 2? Figure III . S~(X | w). those two states of the world.. (1) and (2).. state (2) is nothing else than state (1). It is the possible difference in the decision-maker's valuation of Y. nothing guarantees that the decisionmaker would also be indifferent between adding Y to his portfolio in state 1. and adding Y to his portfolio in state 2. Interestingly.

already owns deal X and is thinking of acquiring deal Y as shown below: $1.000 •o -$100 0.000.Example 2. then we would also have declared that Y provides hedging with respect to X.08 B ~<Y | 0> = $138. Y does provide hedging with respect to X given w. who states that he is comfortable following the delta property within the [-$20. $20.000] range and who has a risk tolerance of $10.if we had had nothing to guide us but the vague notion that hedging qualifies an investment which reduces the risk of another investment.6 S2 $0 $300 S ~<X I 0) = $388. adding Y to X reduces the magnitude of the possible downside in the decision-maker's prospects. Indeed.07 Figure II. It is reassuring that such a conclusion is not at odds with our intuition . from $0 to 44 .Hedging with complete relevance between X and Y Then: B ~<Y | 0) = $138.61 > B~<Y | 0) In this example. 2 . by our definition.000.07 = But: B ~<Y | X) = $147.1: A decision-maker.

as in Example 2. even if they both agree on the probabilities and magnitudes of the prospects.61 ><Y|&)(=$140).X> =$147. as described by the next figure.1. Furthermore. X) > (Y | &): a risk-averse decision-maker can thus be willing to pay more for a deal Y than a risk-neutral decision-maker would pay for it. not only do we have the inequality B~(Y | w. and even if they both own the exact same portfolio X and the same wealth w. let us consider a decision-maker who has the exact same u-curve as in our first example.000 to $900. X) > B~(Y | w + S~(X | w)>.02 But the PIBP for Y when we take the existing portfolio X into account is larger: B ~(Y | X) = $87.71 > B~(Y | 0 ) 45 . he is contemplating acquiring a different deal Y. and owns the same unresolved deal X. We now have: B ~(Y | 0> = $82. from $1. but it sometimes even turns out that B~(Y | w. this time. Here: B ~(Y|w.2: Hedging does not only arise in situations in which the monetary prospects of the deals under consideration are determined by the exact same set of uncertainties. this example shows that in situations of hedging. J Example 2.$300. at the cost of a slight reduction in the magnitude of the possible upside. In order to demonstrate it.

just as in our first example.000 •o 0.1 $300 s'2 -0 S'l 0. that conclusion matches our intuition's predictions.S'l 0. since Y is structured in such a way that it is more likely than not to compensate for some of the potential losses imposed by X. 3 .7 ~sV b $300 ~<X | 0 ) = $388.4 $1.3 -$100 06 . 3 46 .02 Figure II. Also. s2 $0 •o 0.9 Si -$100 0.Hedging with partial relevance between Xand Y In spite of the fact that the monetary prospects of X and Y are determined by different uncertainties.08 B ~(Y | 0> = $82. Y provides hedging with respect to X given w.

why compare B~(Y | w. The decision-maker owns wealth w + S~(X | w). an increase in wealth tends to cause an increase in their PIBP for an uncertain deal. and yet yield the exact same result? Sadly. but does not own X (State 2). but does not own X (State 2'). Consider an existing portfolio X which is deterministic and offers a sure profit equal to x: one might conclude from applying that erroneous definition of hedging that since the decision-maker's PIBPs for Y in states 1 and 2' are different. problems with that second possible definition of hedging would arise for u-curves which do not satisfy the delta property. instead of comparing it to B~(Y | w)? Would the latter not be more convenient. And yet. With that in mind. instead of comparing the decision-maker's PIBPs for Y in the following states 1 and 2': • • The decision-maker owns portfolio X and wealth w (State 1). The discrepancy has to do with a phenomenon which. 47 . it seems absurd to think that one can hedge a portfolio which involves no uncertainty. For such u-curves. X) to B~(Y | w + S~(X | w)). The decision-maker owns wealth w +J^P^i*w7. it may seem puzzling that we chose to define it by comparing the decision-maker's PIBPs for Y in states 1 and 2: • • The decision-maker owns portfolio X and wealth w (State 1). Y provides hedging or negative hedging with respect to X given w. In more formal terms. in decision analysis. let us come back to the comparison between states 1 and 2' as a possible definition of hedging. has often been called the "wealth effect": for a risk-averse individual. B~(Y | w + S~(X | w)> is not necessarily equal to B~(Y | w).To the first time reader of our definition of hedging. The next example demonstrates the same point numerically.

000 as his initial wealth. that applying the correct definition of hedging which we proposed earlier in this chapter would lead to the intuitively acceptable conclusion that there is no hedging provided by Y with respect to X: f I B ~(Y | w.93 The two PIBPs for Y are different.1.. X) and B~(Y | w) we would then infer that there is hedging in this example. it seems preposterous to argue that Y compensates for any of X's risk. Let us suppose that the decision-maker can choose to purchase deal Y from Example 2.3 B 48 .16.Example 2. owns w = $1. where w denotes his initial wealth . however.000.000.000 (i. namely.16 L B~(Y | w> = $119. equal to $1. Yet. in our example. Finally.X) = $130. is not as much of a concern to a decisionmaker who has an initial wealth of $2. It should be noted.e.X) = $130. X) and B~(Y | w) with wealth effects. so if we were to define hedging based on a comparison of B~(Y | w. We can explain that the difference between B~(Y | w. Then: f B ~(Y | w. we will suppose that his u-curve is encoded by u(x) = ln(w + x).so that the decision-maker does not follow the delta property for the range of prospects under consideration. the potential negative consequence of acquiring Y. In our example. the possibility of losing $100. as well as an unresolved deal X which has an assured outcome.000 as well as deal X) as it is for a decision-maker who simply has an initial wealth of $1.16 ~(Y|w + s~(X | w» = $130.3: A decision-maker owns $1.

• The value of hedging would also allow us to compare several deals based on how well or how poorly they complement the existing portfolio Having a common monetary scale on which we can measure the hedging that each of those deals provides enables us to sort them. 49 . We will come back to that point in greater detail later. Definition of the Value of H e d g i n g Now that we have a better understanding of what constitutes hedging. outside of the original list. but Y is found out to provide a positive value of hedging with respect to the existing portfolio. from the best complement of the portfolio to the worst.2. which would also possess the characteristics we identified. we are ready to move on to the question of how to ascribe a monetary value to it. • Using such an ordered list. and the merits of the deal in terms of the hedging it provides. we can then attempt to identify some common characteristics that the best hedges might share If we succeed in recognizing such patterns. Some of those deals might prove even more valuable as additions to the portfolio than any of the acquisitions which we had considered prior to that. the notion of value of hedging will have helped the decision-maker understand why Y should be of any interest to him. There are three reasons why we should be keen on defining a value of hedging: • The value of hedging concept would add to our understanding of the possible merits of a deal which the decision-maker is considering acquiring The value of hedging would help us distinguish between what we might call the intrinsic value of the deal. here is an example to ponder: if the PIBP for Y without taking the existing portfolio into account is equal to zero. but in the meantime. we can start looking for other deals. as measured by the value of hedging. as measured by the decision-maker's PIBP for it without taking his existing portfolio into account.

07 = $9. But it is still substantial enough that a decisionmaker who omits the value of hedging in his valuation of Y might end up declining to buy the deal even though it was in his interest to do so. Y provides hedging with respect to X given w if and only if VoH(Y | w.54. X) < 0. as the difference of two PIBPs: VoH(Y | w. Example 2.4: Coming back to Example 2.1 gives us the answer .since Y is said to provide hedging with respect to X given w if B~(Y | w. the value of hedging appears to be relatively small compared to the intrinsic value of Y.2 — Value of Hedging of an Uncertain Deal Y We will define the value of hedging provided by Y given w and X. this would arise for instance if the price at which the decision-maker can purchase Y was $140. X) . which we will denote by VoH(Y | w. X) is greater than B~(Y | w + S~(X | w».B~(Y | w + S~<X | w » [2.1] Consequently. X) > 0.1: VoH(Y | X) = B~(Y | X> . X).a) The Value of Hedging as a Difference of Two PIBPs How can we quantify the value that a deal provides through hedging.B~(Y | 0> = $147. B~(Y | 0 ) .• 50 . X) = B~(Y | w.61-$138. and negative hedging if and only if VoH(Y | w. In this example. though? The very form of Definition 2. we could simply define the value of hedging as the difference between those two quantities: Definition 2.

For convenience. B~(Y | w.n] ie[l. whose prospects are a function of another set of state variables 5".m] We can already see that the value of hedging is intimately connected with the decisionmaker's u-curve and. X) and B~(Y | w + S~(X | w)) are the quantities which satisfy the following two equations: f x Pi u(w+xs) = x Pi Z % u ( w + x i+yj . thereby. x ^ i . yOie[i.m]}. We will come back to this point later on in order to determine the exact nature of that relationship between hedging and risk attitude. let us first introduce more explicit probabilistic notations: suppose the decision-maker has wealth w and owns an unresolved portfolio of deals X = {(pi. To show that. Then. He is considering purchasing a deal Y = {(qi.As a reminder.n] je[l.3] u(w + S~<X | w» = X Qj u ( w + S~<x I w> + Yj" B~<Y I w + S~(X | w») je[l. with his risk attitude. we will denote by q^ the conditional probability that the decision-maker assigns to s'j given Sj. n]} whose outcomes are determined by the set of state variables S. 51 .B~<Y Iw' x » ie[l.m] i2-2] [2. B~(Y | w. X) and (Y | w + ~(X | w» can both be computed using equations involving the decision-maker's u-curve.

and I will show how in this part of the dissertation.4] Indifference Figure II. Then it turns out that the value of hedging that Y provides with respect to w and X is equal to the decision-maker's PIBP for Y': B~/ VoH(Y | w. Y' = {(qis y'i)ie[i. and that it is not necessarily possible to express it as the PIBP of just one deal.b) The Value of Hedging as the PIBP of a Translated Deal Equation [2. In reality. . So how can we define the value of hedging as the decision-maker's PIBP for one deal? All we need to do is define a deal Y' by subtracting ~(Y | w + ~(X | w» from all prospects of Y. This will provide another perspective on the value of hedging concept. m] }.1] may give the misleading impression that the value of hedging provided by Y with respect to w and X can only defined as the difference between two PIBPs.B~<Y | w + S~(X | w») iG[1 .m]} = {(qit y. X) [2. this is quite feasible. which will prove especially useful in deriving some of the results we will encounter later in this chapter of the dissertation. X) = B~(Y' | w.4 — An equivalent definition of the value of hedging 52 .

1 — PIBP for a Deal Translated by an Amount S Let us consider a decision-maker with wealth w and an existing portfolio of unresolved deals X. X) . For any deal Z and any amount 8 (positive or negative).To use a mathematical metaphor.B ~< Y i w + s ~< x i w » . denoting by (pOiefi.V o H ( Y i w ' x ) ) ie[l.n] ie[l.n] P.B ~<Z'|w» = Z ie[l.s] ^uCw + Xi+z'k-^Z'lw)) r k|l u(w + x i + (z k +S). [2.4] equivalent? Why is B~(Y' | w.B~(Y | w + S~(X | w»? The equality follows from a much more general result: Lemma 2.u(w + X i ) = Z ie[l. S] the conditional probability distribution over the prospects of Z' given those of X: X p. Z ke[l. Z ke[l. we could say that the value of hedging provided by Y is equal to the PIBP for a deal which is the result of translating Y by an amount .B ~(Y | w + S ~<X|w». augmented by 8: B ~(Z' | w. his PIBP for a deal Z' in which all prospects of Z were augmented by the same amount 8 is equal to his PIBP for Z. X) + 8 The result holds whether the decision-maker's u-curve satisfies the delta property or not.m] But why are expressions [2.n] PiUCw + x.1] and [2.) [2A. X) equal to B~(Y | w.s] 53 .} = S Pi Z % u ( w + x i + y > .n] je[l.4] can also be written in terms of u-values as: £ i*. Proof: We start by writing the definition of the decision-maker's PIBP for Z'.n] P. X) = B~(Z | w. and by (rk|i)ke[i. n] the probability distribution over the prospects of the existing portfolio X.

We observe that the two quantities are equal.B~<Y | 0) = $87.n] Pi u(w + X i )= X Pi Z ie[l.B ~ < z l w » Comparing the last two equations.69 Finally. this time by definition of the PIBP for Z: 2 ie[l. with 8 = . many of the proofs in this dissertation will be based on the former rather than the latter.02. we can conclude that [2.5: We will reuse Example 2.1].s] r k|i u ( w + x i + z k . We first transform deal Y into Y' by translating it by . D 54 .69. let us compare that PIBP to the value of hedging for Y. and we obtain the deal which is represented in the next figure.2 in order to illustrate our alternative definition of the value of hedging as the PIBP for just one deal through a practical situation.02 from all of its prospects.n] ke[l. The PIBP for this new deal Y' given X is equal to: B ~(Y' | X) = $5. we previously computed B~(Y | 0) to be equal to $82. Example 2.02 = $5. X) than [2.71-$82. [2. In fact.B~<Y | w + S~<X | w».B~(Y | 0): we subtract $82.1] and [2. X) = B~(Z | w.4] occasionally turns out to be more convenient to use as a definition of VoH(Y | w.We also have.D If we then apply this lemma to the particular case of deals Y and Y' as defined earlier. As a reminder. as expected: VoH(Y | X) = B~(Y | X) . we can conclude that B~(Z' | w.4] are indeed equivalent. X) + 8.

02 0.000 ) -0 0.1 S'2 $217.S'l 0.98 -0 S'l -$182.Hedging with partial relevance between Xand Y 55 .02 0.7 ~<X | 0 ) = $388.6 S2 $0 •o 0.4 $1.3 $217.08 Figure II.98 0. 5.9 Si -$182.

and we will see that the value of hedging can be computed by means of an influence diagram evaluation. 56 . the decision-maker also owns initial wealth w and an uncertain portfolio X. whereas in the second. 6 .Using influence diagrams to compute the value of hedging In both diagrams. Influence Diagram Representation I have already mentioned in the first chapter that influence diagrams are among the most effective communication tools available to a decision analyst. the decision-maker would like to decide whether he should buy deal Y or not. given its cost. and that it is even possible to encode probabilities and value measures into them in order to solve them and identify the best course of action and its associated certain equivalent. Those features of influence diagrams are the reason I would now like to present an influence diagram representation of the value of hedging computation. the value of hedging can be computed by evaluating and comparing the two influence diagrams shown below: Influence Diagram 1 Influence Diagram 2 Figure II. but does not own X. he owns initial wealth w + S~(X | w). This will help consolidate our understanding of hedging as defined in this dissertation. The difference between the two situations lies in the fact that in the first.3. More specifically.

X).B~(Y | w + S~(X | w».The value of hedging can then be computed using the following algorithm: Step 1: Adjust the value of the node "Cost of Y" in Influence Diagram 1 until the decision-maker is indifferent between the two alternatives available at the decision node. X). then return ymax as the approximate value of B~(Y | w. i. For example. Step 3: The value of hedging is equal to the difference between the results obtained at the end of steps 1 and 2 of the algorithm: VoH(Y | w. In practice. X) . Step 2: Similarly. a binary search would allow for a fast and efficient evaluation of B~(Y | w. adjust the value of the node "Cost ofY" in Influence Diagram 2 until the decision-maker is indifferent between buying Y and not buying Y in that second diagram as well. buying Y and not buying Y. Otherwise.e. Once that is achieved. we know that the value of the node "Cost ofY" is exactly ~(Y | w. If the difference between the certain equivalents of the "Buy Y" and the "Do Not Buy Y" alternatives is less than the desired level of accuracy e. X) = B~<Y | w. for a chosen level of accuracy e: Step 1-a: Solve Influence Diagram 1 when "Cost of Y" is set to the highest dollar prospect achievable in deal Y. Once that is achieved. X) and B~(Y | w + S~(X | w)) in steps 1 and 2. we know that the value of the node "Cost ofY" is exactly B~<Y | w + S~<X | w». 57 . here is a detailed view of a possible evaluation procedure for step 1. which we will call ymax. proceed to Step 1-b. We start from there because ymax constitutes a natural upper bound on the decision-maker's PIBPforY.

In the last possible case. If the difference between the certain equivalents of the "Buy Y" and the "Do Not Buy Y" alternatives is less than 8. and go back to Step 1-c with those new values of A and B. keep B as is. it implies that we need to increase the cost of Y for the decision-maker to be indifferent between buying it or not: B~(Y | w. If the difference between the certain equivalents of the "Buy Y" and the "Do Not Buy Y" alternatives is less than s in that case. X). set B to C. 58 . X). We should then set A to C. X) is thus larger than C. X) is less than C. Otherwise. Otherwise. we can infer from it that B~(Y | w. if the best decision is to "Not Buy Y". then return C as the approximate value of B~(Y | w. which we will call ymin. Step 1-c: Solve Influence Diagram 1 again when "Cost ofY" is set to C = lA (A+B). and go on to Step 1-c again with those new values of A and B. create two variables A and B and initialize them with values ymjn and ymax respectively.n as the approximate value of B~(Y | w. and proceed to Step 1-c.Step 1-b: Solve Influence Diagram 1 when "Cost of Y" is set to the lowest dollar prospect achievable in deal Y. We know that ymin constitutes a lower bound on the decision-maker's PIBP for Y. we should then keep A as is. then return ym. if the best decision is to "Buy Y".

irrespective of how risk-averse the decision-maker is. as encoded for instance in the probabilities he assigns to the prospects of all the deals involved in his decision situation. for instance. since his risk preference will have a direct effect on the calculation of PfflPs B~<Y | w. hedging considerations are simply irrelevant: 59 .the solution we would arrive at would invariably be the same. irrespective of whether he has taken his existing portfolio X into account or not. we will realize that the decision-maker would ascribe the same value to deal Y. An interesting risk preference case to examine is that of a decision-maker who is riskneutral within the range of prospects involved: if we consider Example 2.4. the value of hedging will be equal to zero. In fact. Basic Properties of the Value of Hedging a) Hedging in the Risk-neutral Case We observed during our review of the minimum-variance approach that one of the most common criticisms against the theory is the fact that it leaves us with no possibility to take into account the decision-maker's risk attitude . • and the decision-maker's preferences. Hence. which are the two quantities we need to compute in order to form the value of hedging. X) and B~<Y | w + S~<X | w».1.to a risk-neutral decision-maker. equal to the e-value of its prospects ($140). The result actually turns out to be true in general . the value of hedging for a deal depends upon two elements of the decision basis: • the decision-maker's information. a conclusion which appears quite sensible given that a risk-neutral decision-maker will not see any value in the fact that Y compensates for some of the potential downside imposed byX. The definition of hedging we have formulated and studied does not suffer from that flaw.

4]. X) = 0 for a risk-neutral decision-maker. X) = <Y'|&> = <Y. for the particular case of a risk-neutral u-curve: VoH(Y | w.Property 2. no matter what deals X.1 . Proof: Let us start from equation [2.«Y | &> | &> = <Y|&>-<Y|&> = 0. X) = B~(Y' | w.B ~(Y|w + s ~<X|w»|&> = <Y-(Y|&)|&) = <Y | &> .Value of Hedging and Risk-neutrality VoH(Y | w. D 60 . Y and wealth w are.

and the one that the decision-maker is contemplating acquiring. our risk-averse decision-maker would be increasing his exposure to risk. if we were to omit the existence of the first deal. Property 2. by adding the second copy of deal X to the one he already possesses. X) can in some cases be negative.6: Let us suppose that the decision-maker who already owns deal X (as in Example 2.46. U 61 . Example 2.Sign of the Value of Hedging It is important to note that VoH(Y | w. for other deals it can be detrimental to acquire them because they would only add to the risk. If we do take it into account. then the PIBP is equal to $364.b) Existence of Negative Hedging I will continue this overview of some of the elementary properties of hedging with an important reminder . would be $388.08. Therefore.2. This should come as no surprise: when adding a second deal X to the current portfolio. the best outcome occurs for si for both the deal that is already owned. It implies that the value of hedging provided by the second copy of X is negative: it is equal to -$23.62. The PIBP for this new deal. Just as it can be valuable for some deals to incorporate them into our portfolio in order to mitigate some of its risk.1) needs to decide whether he should buy a second copy of the very same deal. the monetary prospects involved in both deals reveal a bias in the same direction.our definition of hedging allows for the existence of situations in which the value of hedging is negative. instead of neutralizing some of it.

the answer to both questions is no.1 drew our attention to the fact that hedging considerations can never be of any use to a risk-neutral decision-maker. Here is a simple example which will help us convince ourselves of it.e"yx.c) Sign and Monotonicity of the Value ofHedging in the Risk-Averse Case Property 2. A valid ucurve for such a decision-maker is u(x) = 1 . although the conclusions we will reach can be extended beyond the delta case. because the value of hedging is always equal to zero for such a choice of u-curve. does the value of hedging provided by Y with respect to X retain the same sign for all possible values of the risk-aversion coefficient y? In other words. It is only for other types of risk attitude that the value of hedging can take on non-zero values. does the value of hedging have the same sign for all such decision-makers. we will assume that the decision-maker whose situation we are discussing is risk-averse and follows the delta property over the entire range of prospects involved. irrespective of the degree to which they are risk-averse? • Is the value of hedging provided by Y a monotonic function of y? Even in as simple a situation as the delta case. 62 . For simplicity. This insight can lead us to investigate a few related and interesting questions. Then: • For two given investment opportunities X and Y.

3 S2 $100.000 -$12.4 S3 $40. He owns some deal X.000] range. $1. X) for different values of y.X)toy 63 .00001 0. The results of that sensitivity analysis are displayed below: 0.000 $18.000.000 03 .000 Figure II. both are shown on the next figure: Sl 0. 8 .0001 0.000 -$2.01 0.Sensitivity of VoH(Y \w.000 •o0. -$20. 7 -An example for which VoH(Y \ w.001 0.000.1 y (for Deals Expressed in $ Thousand) Figure II. and is considering acquiring Y.Example 2.000. X) is not monotonic in y What we will do here is plot VoH(Y | w.7: A decision-maker wishes to follow the delta property over the [-$1.

X) does not keep a constant sign in the risk-averse range. How can that be explained? We will see in chapter IV that the value of hedging essentially corresponds to the value which can be derived from reengineering the moments of the original portfolio X. when choosing to add a deal Y to a portfolio X. but it also has the advantage of increasing the value of the third central moment. secondly in reducing its variance. For some values of y the positive effects will outweigh the negative.The chart shows unequivocally that VoH(Y | w. and thirdly in enhancing its third moment. and that it is not monotonic either. a decision-maker will first and foremost be interested in augmenting the mean of X. while for other values of y the negative effects will outweigh the positive. starting with the low-order moments. Y has the undesirable effect of increasing the variance. H 64 . More explicitly. so that overall Y will provide positive hedging with respect to X. X) we can observe in the present example is that adding Y to the decision-maker's portfolio has contradicting effects on its moments. The reason for the peculiar change of sign in VoH(Y | w.

Zi)je[i> m]} whose prospects are also fully determined by S'. y'i)ie[i. then: VoH(Y | w. if we define deal Z' by subtracting B~(Z | w + S~(X | w)> from all prospects of Z: Z' = {(qi. m]} whose prospects are fully determined by a set of uncertainties 5'. X) = VoH(Y | w. then: VoH(Z | w. and not just for those which satisfy the delta property. Then. X) Similarly.. Theorem 2.. or a deal Z = {(q. since the constant by which they differ can neither mitigate nor add to the risk of the existing portfolio. m] }. y. The result is intuitive: after all.B~<Y | w + S~(X | w») ie[ . z'i)i6[1. VoH(Z | w.m]} = {(qi. X) 65 .4].1 — Hedging Provided by Two Deals Which Only Differ by a Constant Suppose that the decision-maker is considering purchasing a deal Y = {(q. then we are assured that the two deals provide the exact same value of hedging. X) = B~<Y' | w. What is perhaps most surprising about this insight is the fact that it holds for any possible u-curve. m] }.B~(Z | w + S~<X | w») je[ i. Zi . yi)i<=[i.d) Value of Hedging for Two Deals Which Differ by a Constant Another important feature of the value of hedging is the fact that if we look at two deals whose prospects are determined by the same set of uncertainties but differ by a constant. two such deals should offer the same benefits or dangers from a hedging perspective. X) Proof: By virtue of [2. suppose that the prospects of Y and Z only differ by a constant 8: Zj = yj + 5 for all values of i. .. X) = B~(Z' | w. if we define deal Y' by subtracting B~(Y | w + S~(X | w» from all prospects of Y: Y' = {(qi. Furthermore.m]} = {(qi.

Y provides hedging with respect to X. where w = $2. We have: B ~(Y | w + S~(X | w» = B~(Y | w + $259. X) = B~<Z' | w.94 Let us now consider Z.8: Let us go back to Example 2.B~<Y | w + S~(X | w» = y'i (by virtue of Lemma 2.30 But the PIBP for Y when we take portfolio X into account is larger: B ~<Y | w.24 > B~<Y | w + S~<X | w» Therefore. X). X) = $97. we will analyze the situation from the point of view of a decision-maker whose u-curve is ln(w + x).(B~<Y | w + S~(X | w» + 8) = yi . + 8 .B~(Z | w + S~<X | w» = (y.82) = $75.X) =$21. n Example 2.But: z'i = Zi . We will first compute the value of hedging provided by Y. this time.000 denotes his present wealth. + 8) . however. which differs from Y only by a positive constant of $100: 66 .1) It follows that B~(Y' | w.2. X) and therefore that VoH(Y | w. of a value equal to: VoH(Y|w.B~(Z | w + S~(X | w» = y. X) = VoH(Z | w.

S'l 0.9 Si $0 0.9.30 =$197.82 B ~(Z | w + S~(X | w » = $175. S2 $0 0.X) =$175.24 Therefore: VoH(Z|w.30 Figure II. S'l $400 -0 S'l $0 06 .94 The values of hedging provided by Y and Z are indeed equal.X) =$21.000 ) -0 01 .3 ) 0.Hedging provided by a deal which differs from Y by a constant We repeat the same calculations for Z: B B ~<Z | w + S~(X | w » ~(Z|w. • 67 .7 "sV S $400 ~<X | w) = $259.4 $1.

Such reasoning can be of practical use if we have access to an approximation of the value of hedging provided by Y. an upper bound on the value of hedging can be computed based on the risk premiums of the current portfolio and of the new deal Y. In the case of [2. B~(Y | w + S~(X | w)>. the first. X) and B~<Y | w + S~(X | w » in order to obtain the value of hedging. in which the total energy of a system is the result of a combination of the effects of some variables which are inherently related to the system itself.5]. is an interaction term which captures the reciprocal effects of Y and X on each other.3 .instead of computing PIBPs B~(Y | w. as well as of other variables which capture the interaction of the system with its environment.PIBP for an Uncertain Deal and Value of Hedging As a direct consequence of Definition 2. measures the intrinsic worth of Y. if we can easily detect that Y is inferior to another deal Z for hedging purposes.5] In its philosophy [2. and if we have already computed the value of hedging provided by Z.e) PIBPfor an Uncertain Deal and Value of Hedging In some situations. That property will also be useful in the next chapter of this dissertation: we will then see that when the decisionmaker's u-curve satisfies the delta property. X> = B~(Y | w + S~<X | w » + VoH(Y | w. X) from the value of the other PIBP and from the value of hedging that Y provides.2. or to an upper bound on it. we decomposed the PIBP for a deal Y into the sum of two terms. This might arise. X). Property 2. it is helpful to reverse the chain of inference implied by our definition of the value of hedging . 68 . a convenient relationship links the decisionmaker's PIBP for deal Y to the value of hedging provided by deal Y: B ~<Y | w. we might want to infer the value of B~(Y | w. for example. X) [2. while the second.5] resembles some of the laws of physics. VoH(Y | w.

X. Extension of the Value of Hedging Concept to the Sale of Deals Ever since we introduced our definitions of hedging and of its value. Loss of hedging should certainly be part of their preoccupations as they contemplate selling one of their stocks. 69 .an elementary transformation allows us to regard any selling decision situation as an equivalent buying situation: Theorem 2. or of a conglomerate with activities that are thought by the management to compensate for each other's possible downturns. in which he is wondering whether he should sell a deal he currently owns.5. Can our approach to hedging be extended to selling situations? Fortunately. Let us think of an investor who owns a diversified portfolio of stocks. bearing in mind what the rest of his portfolio is. which the decision-maker is considering selling. or ceding one of their business activities. it seems that hedging should play just as large of a role in selling situations as in purchasing situations. if we only regard the sale of Y as equivalent to buying -Y. including stocks of oil companies and stocks of airline companies. it can . a portfolio X and a deal Y. Yet. Then.X) = -B~<-Y|w.Y> This implies that all of our definitions and results on the value of hedging are applicable to the case in which a decision-maker is contemplating selling an asset. which he believes to mitigate each other's risks. we have been focusing on situations in which the decision-maker is contemplating acquiring a new deal which he could incorporate into his existing portfolio.2 -Extension of our Results to Selling Deals Suppose that the decision-maker owns wealth w. This might give the impression that we have neglected to address the symmetric issue. s ~<Y|w.

n] je[l. • Example 2. We have: S ~(Y | 0) = $82. X) satisfies the following equation: Z p i u(w + x i + s ~(Y|w.m] qjii u ( w + x i+yj) After simplification of the left-hand side. selling Y would leave the decision-maker more exposed to risk.Y l w > x > Y » = Z Pi Z ie[l.n] ie[l. however.n] je[l. in other words. X. X. The decision-maker's u-curve satisfies the delta property within the [-$20.m] This proves that S~<Y | w.m] is[l. that Y provides hedging with respect to X. Both deals are shown on the next page as a reminder.02 We should recall. + y ^ ie[l.Y» = Z ^ Z qjiiUCw + x . this time in the case in which the decision-maker starts from a situation in which he owns both deal X and deal Y and is considering selling Y.X. $20. S~(Y | w.n] Ml.y r B ~ < . It hence seems sensible that the decision-maker should actually place a higher value on Y than (Y | 0) initially seemed to suggest.2. what remains is: Z is[l.m] As for B~( -Y | w.000. Y).000] range.n] je[l.Proof: By definition.000.n] P l u(w + x. Y).71 70 . with a risk tolerance of $10.9: We will take yet another look at Example 2.B ~<-Y|w. it satisfies: Z Pi Z q j i i u ( w + x i + y j .X»= X Pi S qjiiUCw + Xi+Yj) is[l. The actual computation of (Y | X) confirms this prognosis: S ~(Y | X) = $87. X) = B~< -Y | w.

9 Sl -$100 0.4 $1.3 -$100 0.1 s'2 $300 S'l 0.7 S'2 $300 ~<X I 0> = $388.08 ~(Y | 0) = $82. it is also interesting to remark that the numeric values of S~(Y | X) and B~(Y | X) (which we computed in Example 2.6 S2 $0 •O 0. • S'l 0.02 71 .2) match. this is due to the fact that the decision-maker's u-curve satisfies the delta property.This example thus illustrates our observation that hedging can be just as important a consideration when selling a deal as it is when acquiring a deal. On a side note.000 -0 0.

due to the fact that the decision-maker's initial wealth does not impact his valuation of uncertain deals in the delta case. We will also write VoH(Y | X) as a shorthand for VoH(Y | w. The opportunity for simplification is very encouraging. 72 . Throughout this part of the dissertation. One of its most notable implications is the fact that the value of any information gathering process is easier to compute for a decision-maker whose u-curve satisfies the delta property than for one who does not. The sign of y indicates that the decision-maker is risk-averse. In this chapter we will see that the same can be said of the value of hedging.Value of Hedging in the Delta Case "All through history. because in all examples that come to mind the simple and elegant systems tend to be easier and faster to design and get right. and we will investigate many of the special properties it exhibits in the delta case. simplifications have had a much greater longrange scientific impact than individual feats of ingenuity. and much more reliable than the more contrived contraptions that have to be debugged into some degree of acceptability. more efficient in execution. X). we will work with a u-curve of the form: u(x)=l-e-yx.Chapter 3 . " Edsger Dijkstra (1930-2002) The delta property often leads to considerable simplifications in a decision analysis. where y > 0 denotes the decision-maker's risk-aversion coefficient.

4]. then we have: VoH(Y | X) = S~(X.1. the above indifference statement implies that: 73 .S~<Y | 0 ) [3. Y | 0> . VoH(Y | X) is the dollar amount which makes the decision-maker indifferent between the following two states: By definition of the certain equivalent for deal X. the value of hedging provided by Y with respect to X is equal to the difference between the certain equivalent of the portfolio (X u Y) and the sum of the certain equivalents of X and Y when considered individually: Theorem 3.1 -Hedging as the Comparison of Joint and Individual Certain Equivalents in the Delta Case: If the decision-maker follows the delta property over the entire range of prospects involved.S~(X | 0 ) . A Simpler Formula to Compute the Value of Hedging In the delta case.1] Proof: Starting from [2.

S~(Y | 0 ) VoH(Y | X) By definition of the certain equivalent for deals X and Y together. Y | 0 ) Due to the fact that the decision-maker follows the delta property. to both sides of this indifference statement: Finally.S~<Y | 0 ) .1].VoH(Y | X). . the indifference statement above remains valid if we add a constant.DealX s~(X | 0 ) + Deal Y . we also have: s~< X . • 74 . we can conclude from the second and fourth indifference statements we have derived that: s~'<X | 0> This completes the proof of [3.

69 This matches the result we had obtained in Example 2. X).S~(X | 0) . Y | &) = (X.79 . at a time when all we could use to compute the value of hedging was its original definition as B~(Y | w.2.1] to the case of Example 2. • 75 .$388.B ~(Y|w + s ~<X|w».S~(Y | 0) and: Cov(X . Y | 0) .2.Like many of the relationships we discussed in the second chapter.1: We can apply [3. the fact that the formula for computing the value of hedging can be greatly simplified in the delta case makes for another striking resemblance. We will see over the course of this dissertation that the two concepts actually have many more features in common.$82. Y | &) . there is indeed a perceptible similitude between: VoH(Y | X) = S~(X. Y | 0) . [3. Y.1] illustrates the fact that the value of hedging measures the direction and magnitude of the interaction that exists between the portfolio of deals X and the deal which the decision-maker is considering acquiring. since the decision-maker follows the delta property: VoH(Y | X) = S~(X.02 = $5. Example 3. we could say that the value of hedging bears the same relationship to the interaction of two monetary deals X and Y as does the covariance to the relevance of two random variables.S~(X | 0) . this time between value of hedging and value of clairvoyance.08 .(X | &> (Y | &) Also.S~(Y | 0) = $475. In a sense.

1] is symmetric in X and Y. In the delta case it would thus be more adequate to speak of the value of hedging between two deals. 76 .2] Proof: Relationship [3. Theorem 3. Special Properties of the Value of Hedging in the Delta Case a) Symmetry The value of hedging provided by Y to a decision-maker who already owns X is the same as that which is provided by X if he already owns Y. rather than of the value of hedging provided by one deal with respect to the other.2 . • Many will find such a conclusion intuitively pleasing. provided by his u-curve satisfies the delta property.2. after all. we defined the value of hedging with the intention of quantifying the interaction between two portfolios. consequently. VoH(X | Y) = VoH(Y | X) when the decision-maker's u-curve satisfies the delta property.Symmetry of the Value of Hedging in the Delta Case: The value of hedging is symmetric when the decision-maker follows the delta property: VoH(Y | X) = VoH(X | Y) [3. and it only seems fitting that the interaction would be symmetric at least in some situations.

3 77 .3] Proof: From [3.S~<Y | 0> Since the decision-maker is risk-averse.3 -.1]: VoH(Y | X) = S~(X.S~(Y | 0 » < RP(X | 0) + RP(Y | 0).Uvper Bound on the Value of Hedging in the Delta Case: If the decision-maker follows the delta property over the entire range of prospects involved and is risk-averse.S~(Y | 0) < «X | &) . we also know that: S ~(X.S~<X | 0> .S~(X | 0 » + «Y | &> . then we have: VoH(Y | X) < RP(X | 0) + RP(Y 0 ) [3. Y | 0> < (X + Y | &) Combining these two results: VoH(Y | X) < <X + Y | &> .S~(X | 0> . Y | 0) .b) Upper Bound on the Value of Hedging The value of hedging between two deals is dominated by the sum of the risk premiums of the two deals: Theorem 3.

S~<Y. let us consider the deal X which was common to Examples 2. In that instance the difference between the upper bound and the actual result is thus reasonable. We can find in the probabilistic structures of Yi and Y2 the reason why the upper bound yields a better answer in the case of the former than in the case of the latter: Yi and Y2 are similar in some respects (the magnitude of their monetary prospects is the same).2: We will see that the tightness of the upper bound on the value of hedging depends on the specific probabilities and monetary prospects of the deals involved.can the upper bound from [3.$388.69.2. That observation leads us to another question .3] yields: VoH(Yi | X) < RP(X | 0) + RP(Y. | 0) < ((X | &) . For that purpose.S~(X I 0 » + «Y2 I &> . but due to the better relevance between Yi and X compared to the one between Y2 and X.3] be achieved? In other words.S~<X | 0 » + «Y! | &) .54. | 0 » < ($400 .S~<Y2 I 0 » < ($400 .90 This time the comparison is less impressive.02) < $13.$82. Yi and X will compensate for more of each other's risk than Y2 and X will.$138.Example 3. we computed earlier the exact value of hedging to be equal to $9.1.2: VoH(Y2 I X) < RP(X I 0) + RP(Y2 | 0) < ((X I &) . is there a deal Y* such that the value of hedging 78 .$388.08) + ($84 .84 As a reminder. As for deal Y2 which was combined with X in Example 2. since the actual value of hedging between Y2 and X is $5. with deal Yi which was regarded as a potential addition to X in Example 2.08) + ($140 . upper bound [3.07) < $13.1 and 2.

$388. 79 . we might think that what we need to discover is the best possible complement to deal X.S~<Y* | 0) = $1000-$388.4 O $1.between it and X will be equal to.92) < $23.99 Interestingly.92 = $23. but not surprisingly.S~<X | 0 » + «Y* | &> .S~(X | 0) . the sum of the risk premiums of the two deals? The answer is yes.l — Best hedge for X Then: VoH(Y* | X) < RP(X | 0) + RP(Y* | 0) < «X | &> .08-$587.$587. which we define as follows: r^ 0.08 B $1000 ~<Y* | 0) = $587.99. the actual value of hedging provided by Y* is equal to that same number: VoH(Y* | X) = S~<X. and not less than.08) + ($600 .S~(Y* | 0 » < ($400 .000 $0 1 0-6 S2 S $0 ~<X | 0> = $388. and what better hedge is there than one which completely eliminates uncertainty from the portfolio? We thus examine the interaction between X and Y . Y* | 0) .92 Figure III. Intuitively.

by virtue of Theorem 2. that the value of hedging would * have turned out to be identical for any deal which differs from Y by a constant for example. -$1. or {-$2.000}. X).5] and we had announced that the property would prove especially valuable in the delta case.4.Upper Bound on the PIBP for any Deal Y: If the decision-maker follows the delta property over the entire range of prospects involved and is risk-averse. It is now time to fulfill that promise: we will combine [2.000. we had observed that: B ~(Y | w. then for any deal Y which he does not own: B ~(Y | X) < RP(X | 0) + (Y | &) [3. This means that there exists an infinity of deals Y such that VoH(Y | X) = RP(X | 0) + RP(Y | 0). $500}. X) = B~<Y | w + S~<X | w» + VoH(Y | w.5] with the results of the theorem we just discussed to obtain a general upper bound on the decision-maker's PIBP for any deal which he does not already own: Theorem 3.It should also be noted. if the monetary prospects of Y corresponding to s\ and S2 had respectively been {-$500. J In chapter II.1. [2.4] 80 . because we would then have an upper bound on the term which corresponds to the value of hedging. we introduced the idea that the value of hedging concept can also be used to infer the value of the decision-maker's PIBP for a deal which he does not own.

1 and 2. and compare the sum to the price of the investment.Proof: We first rewrite [2. all we have to do is add to the risk premium number the mean of the new investment. the associated risk premium is: RP(X|0) =$11. that knowledge will be sufficient to quickly rule out a potential investment as being unworthy of our attention.2 only holds deal X in his current portfolio. for a price of$260: 81 . the second term of the sum is dominated by RP(X | 0) + RP(Y | 0): B ~(Y | X) < B~<Y | 0) + (RP(X | 0) + RP(Y | 0)) < RP(X | 0) + (B~<Y | 0) + RP(Y | 0)) < RP(X | 0) + <Y | &). If the price exceeds RP(X | 0) + (Y | &).3.92 The decision-maker is contemplating acquiring deal Y shown below. no further analysis is required and we should walk away from the investment opportunity.5] for a decision-maker whose u-curve satisfies the delta property: B ~(Y | X) = B~(Y | 0) + VoH(Y | X) By virtue of Theorem 3. we would be well-advised to write down on a piece of paper the value of the risk premium of our present portfolio and carry it with us: occasionally. It shows that as decision-makers. Example 3. which is a simple task compared to the full computation of a certain equivalent. 3 A decision-maker should thus never pay more for a deal than the sum of the risk premium of his existing portfolio and the mean of the possible acquisition.3: The decision-maker from Examples 2.

000 ^ ~ $ 6 5 0 S' &— 0.S'l $1.i S -$500 ~(X I 0) = $388.92 Assessing a complete conditional probability distribution over the prospects of Y given those of X would thus be a waste of time: the decision-maker is already assured that he should reject the offer to buy Y at a price of $260. this will be enough to compute an upper bound on his willingness to pay for Y: B ~(Y | X) < RP(X | 0) + <Y | &> < $11.2 $100 fj o.000 0. 2 . • 82 .Computation of an upper bound on the PIBP ofY No conditional probability distribution over the prospects of Y given those of X has been assessed yet.92+ $240 < $251. all we have elicited from the decision-maker is a marginal distribution.4].6 S2 $200 $0 ^ 0.00 Figure III.1 Sl 0. based on [3. Still.4 0.08 <Y | &) = $240.4 $1.

9] Proof We will prove that VoH(X | X) < 0 for simplicity. but the same reasoning can be extended to the general case of VoH(A.n] are determined by the same set of uncertainties as the prospects {xi}ie[i>n] of X. we will denote by AX the deal whose monetary prospects {x'i}ie[i.5] In particular: f VoH(X | X) = S~(2X | 0 ) .7] Equivalently.2 S~<X | 0 ) < 0 \ VoH(-X | X) = .S~(-X | 0 ) > 0 [3.p chance to receiving 0: 83 . What is the value of hedging between two deals which are multiples of each other? We have already encountered an instance in which VoH(X | X) was negative (Example 2. [3. We will call such deals multiples of X. and such that x'j = XXJ for all values of i.S~(X | 0 ) . VoH(A.RP(2X | 0 ) < 0 [3.8] L VoH(-X | X) = RP(X | 0 ) + RP(-X | 0 ) > 0 [3.c) Value of Hedging for Multiples of a Deal with Respect to Itself In this part.5 -. for any deal X. in terms of risk premium: f VoH(X | X) = 2 RP(X | 0 ) . but is that true in general? Theorem 3.6] [3.X X) is of the opposite sign of X.Hedging of a Deal With Respect to Itself: If the decision-maker follows the delta property over the emtire range of prospects involved and if he is risk-averse.X | X): • Proof that VoH(X | X) < 0 for binary deals X where the decision-maker assigns p chance to receiving x and 1 .6). then we have: For any scalar X .

p + pe-2yx We see that the sign of the difference depends on the sign of (1-p + pa)2 .e"yz for all z as a u-curve.For now. or equivalently x = 0.2 S~<X | 0): s ~(2X|0)-2 ~<X|0>=-ln Y s f 1. we have: u( s ~<X|0» = pu(x) + (l-p)u(O) u(s~(2X | 0 » = p u(2x) + (1 . where a = e"7*. in fact.p + pa 2 ).1].p + pe"2l.. Consequently. f a .x) Forming the difference S~(2X | 0) . By virtue of [3.2 S~<X | 0> Also.p) u(0) Let us choose u(z) = 1 .( 1 .ln(l . then u(0) = 0 and: u( s ~<X|0» = pu(x) u(s~<2X | 0 » = p u(2x) This leads to: s ~ ( X | 0 > = .p + pe-yx) s ~ (2X10) = —. by definition of the certain equivalent.l n ( l . That function of a is always less than or equal to 0.2 S~<X | 0> < 0 for such a deal X. VoH(X | X) = S~(2X | 0) . 84 . we are only considering deals of the form detailed above. to simplify those equations.p + pe"^)2^ 1 . we know that: VoH(X | X) = S~<2X | 0) . the only case in which it is not negative but equal to zero is the case in which a = 1.

• Proof that VoH(X | X) < 0 for any binary deal X: Let us now examine VoH(X | X) for deals X where the decision-maker assigns p chance to receiving x and 1 . by virtue of the delta property. S ~(2X | 0) .2 (S~(X' | 0) + y) = S~<2X' | 0) .p chance to receiving y: I $x o 1 1-p t $y We define deal X' as follows: r— o $x-y Then.2 S~<X | 0) = (S~<2X' | 0) + 2y) .2 S~<X' | 0) <0 The last inequality is a mere application of the result we proved earlier for deals where the decision-maker assigns p chance to receiving some amount x and 1 .p chance to receiving 0. 85 . We have thus shown that VoH(X | X) < 0 holds for any binary deal X.

For that. -0 Pn-l $ x n-l Pn $Xn Equivalently. the last two branches of deal X can be rearranged as follows: 86 . and we will call pi.. We will label them X]. It is by applying the result derived above successively to all of those binary deals that we will demonstrate that VoH(X | X) < 0 holds for any deal X. as shown earlier. it may also be interesting to note that Pi is true. we will consider a deal X with exactly n different monetary prospects.. As a side note. Then: • P2 is true. pn their associated probabilities: Pi $x. since VoH(X | X) = 0 in that case. P2... Let Pn be the following proposition: "For any deal X with exactly n different monetary prospects. However. . More formally. VoH(X\X) <0".. .. we will show that this implies that Pn is true as well. • Let us suppose that for some value n. the validity of Pi is not significant for the rest of this proof. we will reason by induction...Proof that VoH(X | X) < 0 for any deal X: Any deal can be regarded as a combination of binary deals. Pn-i are all true. .. xn.

Then | 0 ) is equal to the certain equivalent of the following deal: (2X Pi $2x. Pn-l + Pn 2X„.Pi $Xj We will call Xn_i the subdeal which consists of the two branches of the tree which were highlighted above. that in turn is equal to the certain equivalent of the deal shown below: 87 . By the substitution rule. •0 Pn-2 3> 2 x n .

S~(2X | 0) is less than the certain equivalent of: Pi $2xi -0 Pn-2 j> 2x n _ Pn-l + Pn 2 s~<Xn. | 0 ) The deal shown above now comprises exactly n-1 branches. therefore. which allows us to make use of Pn_i. we observe that the certain equivalent of the deal shown above is equal to the certain 88 .Pi $2x..i | 0). to complete the proof. > Pn-l + Pn "<2 X n . ~<X„-. •o Pn-2 q 2x n ..i | 0) < 2 s~(X„. its certain equivalent will be less than twice the certain equivalent of: Pi $Xi 0 Pn-2 $ xn. | 0> By P2. s~<2Xn. I 0 ) Pn-l + Pn Finally.

X | X) for different values of X (see next figure): 89 . It demonstrates that s (2X | 0) < 2 S~(X | 0). and therefore that Pn is valid if P2.000 O 0. no matter how many monetary prospects are involved in it. .000] range and has a risk tolerance of $10.. $20. : We have successively proved that P2 is true. who wishes to follow the delta property within the [-$20.equivalent of X.4: A decision-maker.3 We can then plot VoH(A.. holds deal X shown below: Sl 0. Pn-i are valid.000 $0 -$2. 3 Example 3. and that the validity of Pn is hereditary: VoH(X | X) < 0 thus holds for any deal X.000.000.3 S2 $3.4 S3 0..

DJD *M $1. 3 .000 X Figure III. it also appears to be a monotonic decreasing function of X over the range which we studied. D 90 .5.Sensitivity of VoH(XX \X) to X Two insights can be derived from that sensitivity analysis: • • the value of hedging has the sign predicted by Theorem 3.

d) Value of Hedging and Irrelevance We already observed. in a manner of speaking. we will now see that the absence of probabilistic relevance between two deals produces an effect which we could have easily foretold: the value of hedging then becomes equal to zero. But what about uncertain deals whose prospects are not all distinct? In their case. probabilistic relevance is a concept which qualifies the relationship of two uncertainties. But before we show and discuss this result in greater detail. that the impact of risk attitude on the value of hedging can be hard to predict and can pose a challenge to our intuition. yi)ie[i. would be probabilistically equivalent to it.n]}5 whose prospects are all distinct. Stricto sensu. in order to extend its applicability to the latter. we would be well inspired to find a way to associate with any given deal an uncertainty which.1 .. even in situations in which the decision-maker's u-curve satisfies the delta property (see Example 2. But all we need to do is collapse Y by successively recombining every pair of equal prospects (y. in the previous chapter.) Another way to think about this is to notice that minimal underlying uncertainties satisfy {Y = yj | S = sh &} = 1 as well as {S = s. because it would make us create an uncertainty with several degrees which in fact all correspond to one same monetary prospect of Y. The solution is evident as long as the uncertain deal under consideration has prospects which are all distinct: Definition 3. n]. &} = 1 for all values of i.. and not of monetary deals.7). In contrast. we should first precisely define what it means for two monetary deals to be relevant or irrelevant.Minimal Underlying Uncertainty Associated with an Uncertain Deal: Given an uncertain monetary deal Y = {(p. o S = s. we will call "minimal underlying uncertainty associated with Y" an uncertainty S with n degrees st such that: For all i e [ l .•• \ Y = ys. yj) into 91 . we cannot apply the above definition directly. (Y = y.

Irrelevance and Value of Hedging: If the decision-maker follows the delta property over the entire range of prospects involved. With this foundation in place. + S~<Y|X»= X p. the value of hedging between two deals which are irrelevant given & is equal to zero: Theorem 3.n] 92 . Z qjU(x i+yj ) ie[l. it then becomes possible to examine the important result which we had announced earlier .n] ie[l.m] qjiUCxj+yj) We then make use of the irrelevance between X and Y: X ie[l.m] Since the decision-maker follows the delta property.n] je[l. and if X and Y are irrelevant given &. u(x. then: VoH(Y | X) = 0 Proof: We will start with an alternate form of equation [3.6.n] P i u(x i + S ~<Y|X»= X Pi Z ie[l. whose probability will be equal to the sum pi + p.n] Piu(x1 + S ~<Y|X»= S P.n] je[l..a single prospect. + S ~<Y|0» ie[l.S~(Y | 0) By definition of certain equivalent S~(Y | X): X ie[l.1 to the uncertain deal which is produced by that transformation. we will thus say that two uncertain deals are probabilistically relevant given a specific state of information if their respective minimal underlying uncertainties are themselves probabilistically relevant given that state of information. and we can then apply Definition 3. the right hand side can be simplified as follows: X Pi u(x.in the delta case. From this point on.1]: VoH(Y | X) = S~<Y | X) .

and through wealth effects: even if there is no probabilistic relevance between X and Y. let us remember that the value of hedging is an entity by which we place a monetary value on the interaction between X and Y. therefore. Only in the delta case is it guaranteed that such wealth effects need not be considered. its presence in the portfolio and its possible outcomes can still influence the decision-maker's valuation of Y. At a more fundamental level. for a decision-maker who does not follow the delta property. • Why is this result not necessarily true outside of the delta case? In order to understand that. the value which he places on deal Y might be affected by the change in wealth triggered by receiving some reward or penalty Xj from deal X.We can then conclude that S~(Y | X) = S~<Y | 0>. There are only two ways in which that interaction can manifest itself: • • if there exists a probabilistic relevance between X and Y. it is only in the delta case that the absence of probabilistic relevance between X and Y necessarily implies that the value of hedging between them will be equal to 0. we could say that because X has yet to be resolved. and therefore that VoH(Y | X) = 0. 93 .

31 Figure III.3 94 .S~(Y | 0> = $566.Value of hedging for two irrelevant deals We can then verify that the value of hedging between X and Y is indeed equal to zero: VoH(Y | X) = S~<X.40 .7 s2 ' S $300 ~<X | 0) = $388.S~(X | 0) .000 -0 07 .08 -$178.$388. who is contemplating buying a deal Y which is irrelevant to the unresolved portfolio X he already owns: S'l 03 .4 .31 = $0. $1.3 -$100 06 . s2 ' S'l $300 -0 0.Example 3.2. Y | 0) .08 B ~(Y | 0) = $178. S2 $0 -0 0.5: Let us examine the situation of the same decision-maker as in Example 2. Sl -$100 04 .

) i=l In this equation. Here is what might seem the most evident conjecture: VoH(Y. A. such a chain rule exists in the case of the value of clairvoyance. we will discuss some tempting but incorrect guesses at what the chain rule might be before we present the correct answer.but what can be said of the value of hedging which two deals Y and Z jointly provide with respect to X? Is the joint value of hedging. related in some way to the individual values of hedging VoH(Y | X) and VoH(Z | X)? The idea that there might exist a chain rule connecting those entities is not incongruous. VoC(B | a. VoH(Y. indeed. andB: VoC(A. this next attempt would certainly seem a more fitting candidate: 95 .) stands for what we might call the conditional value of clairvoyance on B given a\: it is. Bearing that objection in mind. However. Z | X) = VoH(Y | X) + VoH(Z | X). B) = VoC(A) + ]T {a. we can dismiss the conjecture as highly unlikely to be correct. there is much to be learnt from the reasons why those guesses are incorrect. Indeed.n].3. We will now see that a chain rule which is similar in its spirit can be derived for the value of hedging. with degrees {ai}ie[i. Z | X). who is facing a decision situation with two uncertainties. since the sum VoH(Y | X) + VoH(Z | X) completely ignores any information pertaining to the relevance or irrelevance of Y and Z given X. The Chain Rule for the Value of Hedging and its Implications a) Chain Rule So far we have examined many important properties of the value of hedging which a single deal Y provides with respect to the decision-maker's existing portfolio X . for a risk-neutral decision-maker. the decision-maker's personal indifferent buying price for perfect information on B once he has already acquired the certainty that A = aj. | &} VoC(B | a. But we have seen that the relevance relationships between the distinctions involved in the decision situation can have a great impact on the value of hedging.

This time. in fact. and the deal formed by the union of Y and Z on the other. VoH(Y. Interestingly. 96 . This is the root of the issue with our second conjecture. But the latter should not have any influence on the value of the number we ultimately seek to evaluate. Y) thus captures the interaction between Z on the one hand. Y) The structure of that equation echoes that of the chain rule for the value of clairvoyance. the actual chain rule for the value of hedging is nothing other than a version of our second conjecture in which that same issue was rectified. Y). To put it in another way. VoH(Z | X. Z | X) = VoH(Y | X) + VoH(Z | X. Let us recall the interaction metaphor we have used many times as a guide for our intuition for two deals A and B. which should solely depend upon the interaction between X on the one hand.but it still does not hold in the general case. and thus their interaction does not need to be accounted for anymore. that second conjecture even turns out to be true in a number of cases . Z | X). Y) will occasionally be affected by the nature of the interaction between Y and Z. Y). and deals X and Y on the other. Y and Z are already regarded as a bundle. in the expression VoH(Y. The term VoH(Z | X.VoH(Y. the mere fact that Y and Z are now dissociated and sitting on opposite sides of the vertical bar makes their interaction germane to the value of the right-hand side VoH(Y | X) + VoH(Z | X. Z | X). VoH(A | B) captures the interaction between those two deals. Incidentally. but in the term VoH(Z | X. the intuitive explanation for the invalidity of our conjecture is more subtle.

S~(Y. Z | X) using [3. Y. Y) .VoH(Z | Y) [3. Y) . Z | 0) Finally. Z | X) can be decomposed into a sum of other terms involving the values of hedging provided by Y and Z individually: VoH(Y. U 97 .S~<Z | 0) When we then form VoH(Y | X) + VoH(Z | X.1] to each one of the three terms in that expression: r VoH(Y | X) < VoH(Z | X. VoH(Y. we can recognize in the right-hand side of the above equation the decomposition of VoH(Y.S~(Y | 0> = S~(X.S~(X | 0) . Z | X) = S~<X. Z | 0) Therefore.VoH(Y | Z) [3. Y | 0) .S~(Y | 0) . Z | X) = VoH(Y | X) + VoH(Z | X.S~(Y. Z) .S~(X. Y.S~(X | 0> . Y) .7' .VoH(Z | Y).VoH(Y | Z) = S~(X. Z) . Y.10] Naturally. Z | 0) . we can observe that many terms cancel out. Z | X) = VoH(Z | X) + VoH(Y | X. Y) . all we are left with is: VoH(Z | X) + VoH(Y | X. Y | 0) . then VoH(Y.VoH(Z | Y).S~<X | 0) . Z | 0> . Z | 0) . Z | X) = VoH(Y | X) + VoH(Z | X.1]: VoH(Y.VoH(Z | Y) by first applying [3.Chain Rule for the Value of Hedging: If the decision-maker follows the delta property over the entire range of prospects involved. it is also possible to start the chain rule decomposition with VoH(Z | X) instead: VoH(Y. Z | 0) .S~<Z | 0> = S~<Y.11] Proof: We will evaluate VoH(Y | X) + VoH(Z | X. Y) VoH(Z | Y) = S~(X.Theorem 3.

for any deals A and B. Y) = 1 + _ VoH(Z | Y) = 1 + + VoH(Y. and see which kinds of practical insights it allows us to derive. Z) in order to compensate for the problem we had detected in that conjecture. one interprets VoH(A | B) as jl(A fl B). 5 . our second guess was not far off the mark . the area of A fl B: VoH(Y | X) = n* + + VoH(Z | X. 98 . and if.all we needed to do was to subtract the term VoH(Y | Z) from the sum VoH(Z | X) + VoH(Y | X. Y and Z are represented by three intersecting circles.As announced ahead of Theorem 3.7. It is also interesting to note that it becomes even easier to remember [3.Mnemonic for the chain rule for the value of hedging We will now study a concrete example in which the chain rule can be applied.10] if one draws a Venn diagram in which X. Z | X) + + Figure III.

6 0.10] first and [3.3 '0.52 = $5. owns deal X and is contemplating acquiring deals Y and Z as described below: 0. Z | X) using [3.50 (X ~<Y | 0) = $119.6.000] with a risk tolerance of $2.21 =$10. $5.i -00.3 -$200 0.53 ~(Z | 0) = $55.000.000 •0 0.11] afterwards: VoH(Y|X) + VoH(Z|X.6 $0 -O 0.9 $600 -$100 $600 -$100 $600 -$100 $600 -$100 $1.7 -0 0.0. Z | X) =$39.Y) -VoH(Z|Y) VoH(Y. I 0) = $342.000.8 0.A chain rule example We will decompose VoH(Y.94 Figure III.08 $54.3 •0.2 $500 0.4 -$200 o.7 s~.6: A decision-maker.7 $500 0. who wishes to follow the delta property within the monetary range [-$5.82 99 .4 •O 0.Example 3.

Here is the second application of the chain rule to VoH(Y, Z j X): VoH(Z|X) + VoH(Y | X, Z) -VoH(Y|Z) VoH(Y, Z | X) • =$13.64 = $36.09 = $5.08 = $54.82

There are a few conclusions that we can draw from this analysis: The decision-maker should have a positive PIBP for Y and Z taken individually, and for Y and Z when they are regarded as a bundle: B~(Y | X) = $158.74; B~<Z | X) = $69.59; B~<Y, Z | X) = $225.21. • Also, both Y and Z provide hedging with respect to the current portfolio X, and that again is true whether Y and Z are considered in isolation or jointly: VoH(Y | X) > 0; VoH(Z | X) > 0; VoH(Y, Z | X) > 0. • However, it is also important to realize that Z provides less value than Y in itself, B~(Z | 0) < ~(Y | 0), and it also provides less value than Y through hedging with respect to X. In fact, a significant portion of VoH(Y, Z | X) is attributable to deal Y alone. Those remarks should help the decision-maker realize that, while Y and Z both constitute valuable additions to his portfolio, Y is the stronger choice of the two. Perhaps it would be worthwhile for the decision-maker to look for a better acquisition than Z. •

100

b)

Toward an Irrelevance-Based Value of Hedging A Igebra

We mentioned earlier that VoH(Y, Z | X) = VoH(Y | X) + VoH(Z | X, Y) actually turns out to be true in some situations; for that, all we need is for VoH(Z | Y) to be equal to zero. Our earlier discussion of the effect of irrelevance on the value of hedging (see Theorem 3.6) showed us when such a situation might arise:

Theorem 3.8- Chain rule for the Value fHedsins when Y' J.Z &: c If the decision-maker follows the delta property over the entire range of prospects involved, and if Y and Z are irrelevant given &, then: VoH(Y, Z | X) = VoH(Y X) + VoH(Z X,Y) [3.12]

Proof: The general chain rule for the value of hedging was given by equation [3.10]: VoH(Y, Z | X) = VoH(Y | X) + VoH(Z | X, Y) - VoH(Z | Y) By Theorem 3.6, the fact that Y and Z are irrelevant given & implies that VoH(Z | Y) = 0. The chain rule thus simplifies into: VoH(Y, Z | X) = VoH(Y | X) + VoH(Z | X, Y). •

Theorem 3.8 gives us a first glimpse of the analytical power that we get access to once we start combining the irrelevance properties of a decision situation with the chain rule. As the decision-maker contemplates a new acquisition, applying the chain rule in a way

that will let him exploit the irrelevance structure of the resulting portfolio can help him

compute the value of hedging much faster. Such thinking will be of greatest value to decision-makers who own particularly complex portfolios of unresolved deals. In a way, we can speak of an irrelevance-based algebra for the value of hedging, an algebra in which the theorems of probability on irrelevance are transposed into sister 101

rules on the value of hedging. Another example follows, in which we start from a classic rule from probability called the contraction property to derive more results on hedging:

Theorem 3.9 - Contraction Property for the Value of Hedging: If the decision-maker follows the delta property over the entire range of prospects involved, and if he believes that X L Y | & and that X _ Z | Y, &, then: L f 1 VoH(Y, Z | X) = 0 VoH(Z | X, Y) = VoH(Z | Y)

Proof: Let us first write the contraction property from probability in its most general form for any uncertainties or sets of uncertainties A, B, C and D, if A J. C | B, D, & and A 1 B | D, &, then A 1 B, C | D, &. We will apply this result to the particular case in which A = X, B = Y, C = Z and D = &; since the decision-maker believes that X 1 Y | & and that X 1 Z | Y, &, he should also believe that X 1 Y, Z | &. By Theorem 3.6, X 1Y |& X I Y, Z | & implies that implies that VoH(Y | X) = 0 VoH(Y, Z | X) = 0

This already proves the first clause of the conclusion of Theorem 3.9. For the second part, let us recall the chain rule for the value of hedging given by equation [3.10]: VoH(Y, Z | X) = VoH(Y | X) + VoH(Z | X, Y) - VoH(Z | Y) Two terms in the equation are equal to zero; therefore, it simplifies into: VoH(Z | X, Y) = VoH(Z | Y). This proves the second clause of Theorem 3.9. D 102

We will now study a practical illustration of the contraction property for the value of hedging in order to show how useful it can be:

Example 3.7: The same decision-maker as in Example 3.6 owns two uncertain deals, X and Y, which he believes to be probabilistically irrelevant given &. He is contemplating acquiring a third deal Z, which is irrelevant to X given Y and & but relevant to Y given X and &. For instance, some investors might well have such beliefs about a portfolio in which X was the stock of a pharmaceutical company, Y the stock of an oil company, and Z that of an airline company. All three assets are shown on the figure below. Let us help the decision-maker compute his PIBP for deal Z, given that he presently owns X and Y. There are two ways in which we can do this: • First, we could compute B~(Z | X, Y) directly. This would require that we take into account the full probabilistic structure of the problem. With this approach, we obtain:

B

~(Z | X, Y) = $408.96

•

Secondly, we could also choose to exploit the irrelevance properties of the portfolio. We can start by applying Property 2.3:

B

~<Z | X, Y) = B~<Z | 0> + VoH(Z | X, Y)

Next we can invoke the contraction property for the value of hedging and observe that: VoH(Z | X, Y) = VoH(Z | Y) Combining the two results:

B

~<Z | X, Y)

= B~<Z | 0 ) + VoH(Z | Y)

103

7 — Applying the contraction property for the value of hedging What is particularly interesting about this second approach is that it enables us to derive the result much more rapidly and efficiently than the first.96 S ~(X | 0> = $342. Y ny degrees and Z n z degrees.10 Figure III. if X has n x degrees. 104 .47 S ~(Z | 0) = $378.= $378.50 S ~(Y|0> =-$14. As for the second approach.86 = $408. it requires two evaluations: one of a tree of size nz (to compute B~(Z | 0)) and one of a tree of size ny x nz (to compute VoH(Z | Y)). In general.10+ $30. the first approach requires that we evaluate a tree of size nx x ny x nz.

• 105 . the contraction property for the value of hedging eliminates altogether the need to take the irrelevant component X of our portfolio into account. The gain in efficiency will be all the larger as X is more complex.In other words.

Circles The question I will address in this chapter of the dissertation is perhaps more fundamental and theoretical than any of the other issues we have examined so far . In this entire chapter.Chapter 4 . We will denote his riskaversion coefficient by y.e-yx 106 .what probabilistic phenomena lie at the source of hedging? My ambition is to identify some universal characteristics of the situations in which hedging arises. A possible u-curve for him is thus given by: u(x) = 1 .Hedging as Moment Reengineering "Cause and effect are two sides of one fact. we will again assume that the decision-maker is risk-averse and follows the delta property over the range of prospects involved. in order to be able to detect hedging more easily. " Ralph Waldo Emerson (1803-1882).

R.2] The approximation turns out to be exact if the probability distribution over Z is normal. a convenient decomposition of their certain equivalent for a deal involving prospects within that range is given by: "<Z|0) = X ^^Yn-1K„ n! [4.< Z | & » 3 | & > (first cumulant) (second cumulant) (third cumulant) By truncating the series in [4. For example. we obtain: 107 .1] where K„ denotes the nl cumulant of the distribution {Z | &} [Howard. A.E k-1 Kk IV: k=l In particular: Ki=<Z|&> K2 = V (Z | &) K3 = < ( Z . one of the most commonly used approximations of the certain equivalent in decision analysis is: s ~<Z|0)«<Z|&)-ly v (Z|&) [4. it will be all the more precise as: V (Z|&)«^ y If we instead consider the first three terms of [4. it is sufficient for the purposes of our discussion to know that the values of those cumulants can be computed recursively based on the values of the moments of equal or lower order: K n-1 n = U n . we can then obtain approximations of the certain equivalent which will be more or less precise depending on the term at which we stopped. 1971].1].. General Principle Ronald A. For the reader who is not familiar with the concept of cumulants. for people who follow the delta property over some range. Otherwise.1]. Howard showed that.1.

we should reject the offer.2] to assess our certain equivalent for it. then we should ask about the mean and variance of the deal. We will now examine some concrete examples in order to demonstrate that such a process is exactly what hedging is about . if we own a deal and wish to make it more valuable. etc. some deal Y has a positive value of hedging with respect to a deal X which we already own if and only if Y helps us reengineer the cumulants of X of order 2 and above in a helpful manner. Such decompositions of the certain equivalent should remind us that if we are offered an uncertain deal of which we know nothing. if it is negative. and if we are allowed to ask one question and only one about the moments of the deal in question. If we are allowed to ask two questions.in other words.3] which implies that if two deals have the same mean and variance. a risk-averse decision-maker who follows the delta property will tend to prefer that deal over the other. but one of them is more skewed toward the right. then at increasing the value of its third central moment. Likewise. so that we can use approximation [4. our best efforts should be aimed at increasing its mean. 108 .s ~<Z|0>*<Z|&>-^y v <Z|&> + V<(Z-<Z|&>) 3 |&>. we should inquire about its mean. then at decreasing its variance. 2 o [4.

l . In this part we will for once also focus entirely on the variance. because in those cases a large part of the value that hedging provides comes from a variance reduction effect.2. Variance Reengineering We saw in the first chapter that the idea that hedging can be used to reduce the variance of an existing deal is already widespread in the financial literature. The two deals are shown below: Sl 0. to the point that hedging and variance reduction have often been regarded as complete synonyms.1: The same decision-maker as in Example 2.000 -$300 O 1 0. we will see that in many situations the certain equivalent approximation s ~(Z|0>*(Z|&>-iy v (Z|&> can help us compute an approximate PIBP for any deal with a respectable accuracy. Example 4.Example of variance reengineering 109 .4 $1.6 $0 $200 Figure IV.1 owns some unresolved deal X and is considering buying deal Y.

Y | 0) . S~(Y | 0) = -$3.94.93. indeed. so that the terms corresponding to first moments are separated from those which correspond to second moments: s ~(Y|X> = (<X.1]: VoH(Y | X) = S~(X. which is not surprising since the decision-maker is risk-averse and since Y has a mean of 0.Y|&>.S~(X | 0) We will decompose that difference along the first two cumulants as in [4. Y | 0) . However.Y|&>-<X|&>)-i Y ( v <X.2]: s ~(Y|X) = (<X. it might be tempting to dismiss Y as a bad investment opportunity. closer examination reveals that VoH(Y | X) = $11.S~<Y | 0) Let us also recall [2.01 < 0. (X u Y): 110 .Y|&) ]-( <X|&)-^y V (X|&) 2 V ) \ 2 ) Rearranging the terms.Y|&>-i Y V (X. and of the portfolio in which X and Y are combined.S~<X | 0) . let us recall [3.As with some of our earlier examples. X. which more than compensates for the low value of ~(Y | 0) and suffices to make Y worth buying for a price of up to B~<Y | X) = $8.5]: S ~<Y | X) = S~<Y | 0) + VoH(Y | X) Therefore: S ~<Y | X) = S~<X.v <X|&)) The following table shows the values of the first and second moments of the original portfolio. Where does the positive value of hedging come from? In order to understand it a little better. at first sight.

as shown below: 111 .000. even when truncated after only two moments. is accurate enough to help us compute the decision-maker's PIBP for Y with an error of less than 1%.2] to be precise: V ( X | & > « .! T 3) The approximation would have been even more accurate if we had stopped the decomposition after three cumulants instead of two. all have variances small enough for [4. In other words.Decomposition of certain equivalents along the first two cumulants Several interesting observations can be made based on those results: 1) The main reason why S~(X. X. it might be worth acquiring because it helps us reduce its variance.000 for the original deal X. Y | 0 ) is greater than S~(X | 0 ) is the fact that Y helps reduce some of the variance of X. be it the original one.Table IV.Y| & > « . The variance of deals X and Y combined is 60. even though Y does not add to the e-value of the monetary prospects of our portfolio. 2) Our approximation of the difference (X. or the one resulting from the combination of X and Y. That can be explained by the fact that the portfolios we are examining here. Y | 0 ) (X | 0 ) .l .^ and Y V <X. versus 240.

the two-cumulant decomposition was already so good that it is doubtful that the slight increase in accuracy obtained as a result of using a three-cumulant decomposition instead of a two-cumulant decomposition really warrants the extra computational effort. Y | 0 ) . as one takes into account more and more cumulants in summation [4.2 .Decomposition of certain equivalents along the first three cumulants This time the error is of less than a cent. The next chart represents the evolution of the certain equivalents of the original and new portfolio.1]. As shown by that study. D 112 . S~(X | 0 ) and S~(X.Table IV. the fourth and fifth cumulants have even less of an impact on the accuracy of our approximation than the third. However.

Let us consider the case of a firm..2 . which currently owns a single business division. and they state that the company is comfortable using an exponential u-curve with a risktolerance of $200 million for this particular decision situation.00 S-KHUMI .Accuracy of approximation depending on the number of cumulants Example 4.2: As mentioned in the first part of this chapter.!§-. The profits generated by X are modeled as a normal distribution.0o\ $400. X. The company's management also believe that the probabilistic relevance between X and Y is best captured as a correlation coefficient rXy = -0-5..oo S400. Y | 0) sw.« \ $390.00 $395...„_„.00 $405.2] is exact that is when the probability distribution over the deal Z whose certain equivalent we wish to evaluate is normal..00 $380. and is contemplating acquiring a division Y from another company. 113 .S~(X.00 $385. with a mean of $200 million and a standard deviation of $100 million.• .00 " :""" "'""'' i i 1 Cumulant 3 Cumulants 5 Cumulants 2 Cumulants 4 Cumulants Figure IV. whereas those of Y are modeled as another normal distribution.$410.00 ^^---B- • -8 „„.00 i * PIBP(Y | X) ($8..S~(X | 0) -m.93) A A $388. there is one situation in which the certain equivalent approximation based on only two cumulants [4. with mean $50 million and standard deviation $20 million.

V ( X | & > ) S ~<Y|X) = ( Y | & ) .V ( X | & ) ) s ~(Y|X) = (Y|&)-^ Y (^Y+2r X Y a x a Y ) s ~<Y|X>=50--0.x 0. and directly apply [4. because Y would mitigate some of the risk associated with X and reduce the variance of the whole portfolio.S~<X | 0} As in the previous example. Y | & ) .| Y ( V ( X .< X | & > ) .y v (Y|&) s ~<Y 10) . Y | & > .What is the most that the firm should be willing to pay for Y? If we neglect the probabilistic relevance between the two business divisions.5 0 . It is not the first time in this dissertation that we encounter a situation in which hedging 114 .005 (400-2x0. Y | & > .| Y ( V < X .2] to Y.005x400 2 s ~ <Y 10)= $49 million The situation looks quite different once we take into account the fact that the company already owns X and that Y would compensate for some of its risk: S ~<Y | X) = S~<X.5x20x100) Finally: s ~ <Y | X>= $54 million The company should thus be willing to pay more for the new business division Y than the mean of the profits it would generate. we will decompose that difference along the first two cumulants: S ~(Y|X) = ( ( X .. we obtain: s ~(Y|0) = ( Y | & ) .. Y | 0) .

1.effects justify that a risk-averse decision-maker value an uncertain deal at more than its mean: we had already observed the same phenomenon in Example 2. H 115 .

3 S2 $1.52 -$217.3: The decision-maker's risk tolerance is assessed as being equal to $1. Y.3. preserves its mean as well as its variance. his current portfolio X and the deal he is considering acquiring. Y does provide hedging with respect 116 . Example 4.000 $400 -$200 s~(X | 0) = $294. there are still many more cumulants on which we can have a valuable effect. In spite of that.Hedging as reengineering of moments of order 3 and above It turns out that Y. Reengineering Moments of Higher Order In spite of the accuracy of the results we obtained on our first example with a twocumulant decomposition. Here is an example which will demonstrate the potential importance of those higher order cumulants. if acquired and used as an adjunct to the portfolio. [4.71 $190.3 .63 -O0.1] should remind us that even if we do not have any way to enhance the e-value of the monetary prospects. follow: si 0. nor any way to reduce the variance.49 $99.3 Figure IV.000.7 ~(Y|0) =-$16. it would be a mistake to systematically associate hedging with variance reduction.4 S3 0.

00 $0. but in a graphical manner: MOU.02 $11.00 " S400.59 $0. Y | 0 ) $400. a closer examination of the first five cumulants of deal X.00 1 PIBP(Y | X) ($11. versus those of deals X and Y when considered together. Y | 0 ) .ov(Ki $300.0o\ $380. shows why: S ~(X | 0> S ~(X.to X.00 " $320.45 -$1.00 $0.00 " $360.00 -$108.Accuracy of approximation depending on the number of cumulants 117 .00 I « \ > S292.00 $280.S~(X | 0 ) $0.00 $2.43 ^(\.00 -$0.00 -$108.00 $2.59 Table IV.84) 1 Cumulant 3 Cumulants 5 Cumulants 2 Cumulants 4 Cumulants Figure IV.00 " $340.84 $400.IMI $400.00 $13.00 " s.14 -$1.00 $13.4 .00 H i V ' W (10 S292.00 $294. 3 .Decomposition of certain equivalents along thefirstJive cumulants The next figure presents the exact same information as the table.02 $306.

48. Here.3i 0.0.2 I I i i 0.25 '0.35 *0. it provides a welcome boost to its skewness. It is approximately equal to $11. turns out to be positive.00 $0. Y would be a valuable addition to the decision-maker's portfolio.000.84. 5 .84 . with the skewness shifting into the positive realm. we plot the probability mass function for deal X considered individually (dotted lines) and then for deals X and Y combined into one portfolio (solid lines): | 9r4§- 0.00 $1. Therefore.1 O.4 0. most of the value of hedging seems to be attributable to the fact that adding Y to X has a beneficial impact on the third moment of the portfolio. S~(Y | X). despite the fact that it does not affect its first two moments in any way. perhaps slightly more graphic way to look at the effect of Y on the third moment of the portfolio is shown below.05 L^_ -$500.00 $500.63) = $28.while preserving its mean and variance.15 . Another.00 Figure IV. but we have successfully limited its downside 118 .The decision-maker's PIBP for Y.500.(-$16. which means that the value of hedging provided by Y is in the region of $11.Probability mass functions ofX and (X uY) The chart confirms the favorable effect that Y has on the decision-maker's portfolio .00 $1. The resulting portfolio has the same center of gravity and the same spread as the original portfolio.

000. This example should remind us of the limitations of the two-cumulant approximation of the certain equivalent. which is not far from the result we obtain with five cumulants ($11. Here the square of the decision-maker's risk tolerance is equal to 1. we would have obtained S~(Y | X) = $13.while improving its upside. the approximation will only yield satisfactory results if the variance of the deal is negligible compared to the square of the decision-maker's risk tolerance.84) and not far either from the actual value of S~<Y | X) ($11. The key to analyzing this second example correctly was to include the third cumulant in our study. Both changes will be of great interest to our riskaverse decision-maker. we would have made a grave mistake if we had only analyzed the effects of Y on the mean and variance of the portfolio: we would have rejected a proposition which in reality was quite attractive given the decision-maker's risk attitude and current assets. If we had assessed S~(Y | X) = S~(X. Y | 0) .99).000.S~(X | 0> based on a three-cumulant decomposition of the two certain equivalents on the right hand side.00. Conversely.000: the risk involved in those portfolios is so close to the decisionmaker's risk tolerance that it is not safe to truncate the decomposition of the certain equivalent after the mean and variance. whereas the variances of X and (X u Y) are equal to 216. • 119 .

we discussed how we can think of hedging in the context of a specific deal Y with respect to a portfolio of unresolved deals which the decision-maker owns. " Leonardo Da Vinci (1803-1882) In earlier parts of this dissertation.The Value of Perfect Hedging "To not plan ahead is to whimper already. he just does not have the time and resources to analyze and evaluate the merits of the myriad of financial deals which are available to him on the markets. We will now examine a different but related situation: suppose that the decision-maker owns a portfolio of unresolved deals which is fairly complex. He would like to take a proactive stance and identify deals which might help him hedge his portfolio .however. X. How can he determine which uncertainties are most worthy of his attention? For which uncertainties should he seek hedging opportunities. and how much of his resources should he devote to that research? 120 .Chapter 5 .

.m] qjiiu(w+xi+yj-^) 121 .1 — Value of Perfect Hedging Suppose the decision-maker has wealth w and owns an unresolved portfolio of deals X = {(Pi> Xj)ie[i> n]}. f Y is chosen so that S' is a minimal underlying uncertainty for it and (Y | &) = 0 | L Z p i u(w+x i )= X Pi Z ie[l. we will call perfect hedge on S' given X and w the deal Y = {(q. X) is defined as follows: VoPH(S'|w. We will define the value of perfect hedging on S' given w and X as the decision-maker's PIBP for that choice of Y. more explicitly: VoPH(S' | w.2] s.n] je[l. Definition The value of perfect hedging is the concept which will help us answer those questions: Definition 5. VoPH(5" | w. X).n] ie[l. m]} which has the highest PIBP of all the deals which satisfy the following two conditions: • Its prospects are solely determined by the outcomes of S' (in the sense that S' is a minimal underlying uncertainty for that deal Y).X) = max Y s.1. X) = max <p [5. X) [5.t. for which S is a minimal underlying uncertainty. More formally.1] Or. yi)iG[i. (Y | &> = 0 Y determined by S' B ~<Y | w.t. We will denote it by VoPH(S' | w. For any uncertainty or set of uncertainties S'. • <Y | &> = 0.

his existing portfolio of unresolved deals and a pre-identified potential adjunct to his portfolio. In previous chapters.It is important to understand that our perspective has undergone a radical change compared to what it was when we were studying the value of hedging concept. and the price at which they will be able to sell the oil. the goal of our analysis was to quantify the interaction between the existing portfolio and that possible adjunct. They believe the two uncertainties to be irrelevant given &. and those were the only alternatives he was considering. We will denote by X the deal that they own at present: 122 . The following figure provides an overview of their current decision situation and certain equivalent. Example 5. the inputs to the value of perfect hedging are current wealth.the volume of oil that they will be able to extract. In other words. the inputs to our problem were the decision-maker's current wealth. our approach will be more proactive and open-ended: it is not an external stimulus which has triggered our decision to look for valuable additions to the decision-maker's portfolio. the existing portfolio of unresolved deals. X. the first situation was one in which our behavior was reactive: the decision-maker had been given a choice of a deal or several which he could add to his portfolio. and their risk tolerance is assessed to be $500 million. and a set of uncertainties S' which will serve as a support to build new deals. and to place a monetary value on it. Finally. From now on. In contrast.1: An oil company is just about to start operating an oil field which it recently acquired. but our own resolve to improve it. the board also state that they are comfortable following the delta property for the range of prospects involved. the goal of our investigation is to identify the value provided by the best possible hedging deal of mean zero which one can construct based on that support 5". They believe that their profit will be entirely determined by two uncertainties . all monetary prospects are expressed in millions of dollars.

f a = b c=d .6 0. in order to help the company ascertain the variable on which it is most important that they seek hedging.7 $300 M $50 M $a $b Low Volume -0 High Volume 0.6c = 0 123 .4 a + . which implies that a = b and c = d on the picture shown above.t.4a + .High Volume High Price 0. we need to identify the best hedge such that its prospects are only determined by oil price. which implies that . We thus need to solve the following optimization problem: max S~(Y | X) s.99 M $c $d •o Low Price 0.4 0.l — The value of perfect hedging: an example We can then compute the value of perfect hedging on the oil price uncertainty and on the volume uncertainty.6 c = 0.3 ) 0.7 Low Volume Figure V. and such that the mean of its monetary prospects is equal to 0.3 $120 M -$50 M ~<X | 0 ) = $38. To compute the value of perfect hedging on oil price.

55 M c = d = $47.The solution we obtain is: a = b =-$70. but is probabilistically relevant to at least one of them. the perfect hedge is a deal which provides a benefit if the situation which is least favorable to the oil company arises (low oil prices).8 probability to a high gold price and . It is also possible to look for a perfect hedge which is determined by none of the uncertainties which are directly involved in the existing portfolio.t. the solution to that second optimization problem is: a = c =-$137. r Y's prospects are solely determined by the gold price uncertainty L <Y|&) = 0 124 .77 M b = d = $59. but instead they could hedge based on the price of another commodity. but relevant to oil price. We then solve: max S ~(Y|X) s.04 M VoPU(Volume | X) = $7.2 to a low gold price. Given a high oil price.9 probability to a low gold price and . We then compute the value of perfect hedging on the volume uncertainty by a similar process. Let us suppose for example that it is not possible for the company to hedge directly on oil price.68 M The analysis thus shows that perfect hedging on volume is more valuable to the oil company than perfect hedging on price.03 M V6PH(Oil Price | X) = $3. and given a low oil price. but leads to a loss if the situation which is most favorable arises (high oil prices). they assign a . 1 to a high gold price. they assign a . They believe gold price to be irrelevant to the volume of oil they will extract from their field given &.26 M As was to be expected. gold.

The best hedge entails a profit of $31.68 million if gold prices are low, and a loss of $51.69 million if they are high; furthermore, Vo?U(Gold Price | X) = $1.61 million. Interestingly, the value of perfect hedging on gold price is lower than that on the uncertainty to which it is relevant and which is directly involved in the determination of the monetary prospects of X, namely the oil price. Also, in spite of the strong relevance between the two uncertainties Oil Price and Gold Price, the difference between the values of perfect hedging that they provide is considerable: one is twice as much as the other. G

125

2. Basic Properties

a)

Risk Attitude and Sign of the Value ofPerfect Hedging

We will soon discuss the behavior of VoPH(5" | w, X) as a function of various characteristics of S'. But before that, it is worth spending a few minutes on some of the most basic properties of the value of perfect hedging - for example, the relation between its sign and the decision-maker's risk attitude. The first clause of Property 5.1, which states that the value of perfect hedging is always equal to zero for a risk-neutral decisionmaker and can therefore never be a useful consideration to him, echoes a similar observation we made earlier about the value of hedging.

Property 5.1 - Sign of the Value of Perfect Hedging and Risk Attitude For a risk-neutral decision-maker, VoPH(5" | w, X) is always equal to zero. For a risk-averse decision-maker, VoPH(5" | w, X) is always greater than or equal to zero.

Proof: For a risk-neutral decision-maker, B~(Y | w, X) = (Y | &) for any deal Y. Since the value of perfect hedging is computed as the maximum ofB~<Y|w,X> over the set of deals Y which have a mean of zero, VoPH(5" | w, X) = 0. For a risk-averse decision-maker, all we need to do is notice that the deal Y° whose prospects are all determined by S' and are all equal to 0 belongs to the set of deals over which we maximize B~(Y | w, X) in [5.1]. Consequently, VoPH(S" | w, X) >

B

~(Y° | w, X) = 0. 3

126

b)

PIBPfor an Uncertain Deal and Value of Perfect Hedging

Now that we know of situations in which the value of perfect hedging is not an illuminating concept, let us turn to those in which it is and ask ourselves what makes it helpful. Why should we ever be interested in computing VoPH(5" | w, X)? What can it add to our understanding of a decision situation? The following theorem presents one of the most persuasive reasons:

Theorem 5.1 — PIBPfor an Uncertain Deal and Value of Perfect Hedging The value of perfect hedging allows us to calculate an upper bound on our PIBP for any deal Y whose outcomes are solely determined by some set of uncertainties iS":

B

~<Y | w, X) < (Y | &) + VoPH(S' | w, X)

[5.3]

Proof: Let us construct a deal Y' which is the exact copy of Y up to a constant: more specifically, we will define Y' so that y'j = yj - (Y | &) for all values of j . Let us recall that for any deal Z, any wealth w and any amount 8, the PIBP for a deal Z' in which all prospects of Z were changed by the same amount 8 is equal to the sum of the PIBP for Z, augmented by 8 (Lemma 2.1); in particular, that result implies that:

B

~<Y | w, X) = (Y | &} + B~(Y' | w, X)

**But by virtue of Definition 5.1, we also have:
**

B

~(Y' | w, X) < VoPH(5' | w, X)

Therefore:

B

~(Y | w, X> < <Y | &) + VoPH(S' | w, X). •

[5.3] is a remarkable relationship because it provides us with an upper bound on B~(Y | w, X), a quantity which, in general, is not easy to compute, especially if the probabilistic 127

structure of the current portfolio of deals X is elaborate. The upper bound consists of the sum of (Y | &>, which is easy to evaluate and does not depend at all on the decisionmaker's existing portfolio X or even on his exact risk preference, and VoPH(5" | w, X), which is a more obscure notion at this point of our story but for which we will soon be able to derive some upper bounds and approximations.

Example 5.2: Let us go back to Example 5.1, and consider deal Y which is defined as follows and whose prospects are determined by the Gold Price uncertainty:

High Gold Price 0.38

-$50 M

**0.62 Low Gold Price
**

B

$100 M

~(Y | 0) = $37.59 M

Figure V.2- Upper bound on the PIBPfor Y based on the value of perfect hedging

**We directly apply [5.3] in order to compute an upper bound on the decisionmaker's PIBP for Y:
**

B

~<Y | w, X)

< <Y | &) + VoPU(Gold Price | w, X) < $43.00 M +$1.61 M < $44.61 M

128

00 M +$1.X> =-$3.61 million. X) = $43. It should also be noted that in this example.65M The bound gives disappointing results in the case of Y'. X) < <Y' | &) + VoPH(GoldPrice | w. the oil company already knows that it should not buy deal Y if its price exceeds $44.56 M The difference between upper bound and actual value is small. then the upper bound gives: B ~(Y' | w. • 129 . Y' provides negative hedging with respect to X explains it.61 M <$8. X) < $7. and call the resulting deal Y'.61M The actual value of the PIBP is: B ~(Y'|w. If we swap the two monetary prospects of the deal Y we have just studied.Based on that simple analysis. the actual value of the oil company's PfflP for Y is: B ~(Y | w. but we should be aware that the tightness of the bound can vary considerably from example to example. the fact that unlike Y.

having perfect information on both 5" and S" is at least as valuable as having perfect information on S' alone. X) > max (VoPH(S' | w. S" | w. VoC(5")) In other words. the joint value of perfect hedging on S' and S" is greater than or equal to the higher of the two individual values of perfect hedging on S' and S": VoPH(S'. and at least as valuable as having perfect information on S" alone.t. X) = VoPH(S' | w. X).4] Proof: We will first prove that VoPH(S'. let us denote by Y the deal which helps achieve perfect hedging on 5": Y* = argmax Y s.2 -Joint Value of Perfect Hedging For two sets of uncertainties S' and S". X) > VoPH(S' | w. We will now see that the same can be said of the value of perfect hedging: Theorem 5. X)) [5. For that. VoPH(S" | w. X> Y determined by S' It implies that: B ~(Y* | w. S") > max (VoC(S'). X) 130 . In reality. and in others it is lower. S" | w. all that can be said with certainty is that: VoC(5".c) Joint Value of Perfect Hedging It is a tempting mistake for many new students of decision analysis to believe that there is a general rule connecting the joint value of clairvoyance on two uncertainties S' and S" to the sum of the individual values of clairvoyance on S' and S". (Y | &> = 0 B ~(Y | w. it turns out that in some situations the joint value of clairvoyance is greater than the sum of the individual values of clairvoyance. X).

We will compute the value of perfect hedging on S. That is precisely the set of deals over which we maximize ~(Y | w. X). X) >VoPH(S'|w. S" | w. S " | w. X)).t. X) > VoPH(5"' | w.S"|w.We can remark that a fortiori.1 to designate the monetary prospects of the perfect hedge Y we wish to construct. X) Y s.S" Therefore: VoPH(S'.3: We will again refer to Example 5. X) > B~<Y* | w. S" | w.1. Using the same notation {a. d} as in Example 5. and whose mean is equal to 0. which we already computed. S" | w. we can prove that VoPH(5". the set S of the uncertainties which completely determine the monetary prospects of X comprises two elements: Oil Price and Volume. c. X) when we wish to compute VoPH(S'. (Y | &> = 0 Y determined by S'.X)= max B ~(Y | w.X) By the same reasoning. and then compare it to the individual values of perfect hedging on Oil Price and Volume. b.I! Example 5. X) > max (VoPH(S' | w. in that situation. we start by solving the optimization problem shown below: 131 . We thus conclude that VoPH(S'. Y* also belongs to the set of deals Y whose monetary prospects are solely determined by S' and 5"'. VoPH(S" | w. X): VoPH(S'. X).

2 8 b + .7 $300 M + -$249.61M For clarity.60 M $50.7 $120 M + -$100 M + -$69. X and its perfect hedge Y are represented below: High Volume High Price 0.99 M Figure V.18c + .3 ) 0.60 M $50.40 M b = $0.60 M { c = -$69.60 M Low Volume s~(X | 0 ) = $38.t.4 0. VoPH(5|X) = $11.42d The solution we obtain is: C a =-$249. 1 2 a + .60 M .4 M $50 M + $0.max S~<Y | X> s.6 •0 Low Price l 0.3 0. 0 = <Y|&> = .3 — Joint perfect hedging on Oil Price and Volume 132 .40 M d = $100.60 M $50.60 M $50.40 M $100.60 M Low Volume -o High Volume 0.

S" | X) > max (VoPH(S' | X).68 M It proves that VoPH(S'. Now we know that the same can be said of the value of perfect hedging. as announced by Theorem 5.60 million (as shown by the previous figure). The value of clairvoyance on two uncertainties is not necessarily equal to the sums of the value of clairvoyance on the individual uncertainties. We will soon determine that none of this happened by coincidence. VoPH(S" | X)).60 million happens to be precisely equal to the mean of the decision-maker's original portfolio. even when the uncertainties are irrelevant.26 M Vom(Volume | X) = $7. Incidentally.2.We then compare the joint value of perfect hedging to the values of perfect hedging on Oil Price and Volume: f VoPH(S|X) = $11. 3 133 .68 M = $10.61M VoPH(CW Price | X) = $3. let us also make a note of the fact that the value of perfect hedging on S in this example is less than the sum of the values of perfect hedging on the individual uncertainties which compose S: VoPH(0/7 Price | X) + Vo?H(Volume | X) = $3. It is also thought-provoking that the perfect hedge which we constructed on Oil Price and Volume simultaneously would transform the oil company's uncertain portfolio into a deterministic one.94 M < VoPH(S | X) It illustrates the interesting parallel between the value of perfect hedging and the value of perfect information which we mentioned previously. A point of further interest is that $50.26 M + $7. whose monetary prospects are all equal to $50.

Incomplete relevance: S and S' are relevant.Sj. 5" | &. We will examine the following three cases separately: • Complete relevance: S and S' are identical. we remarked that it is equal to zero for two deals which are irrelevant given &. • • Complete irrelevance: S A. or S and S' are deterministic given each other. In other words.3. &} as well as {S' | S . for example. &} only consist of ones and zeros. Impact of Relevance on the Value of Perfect Hedging In the course of our investigation of hedging. we have already gathered a few clues here and there as to the nature of its connection with probabilistic relevance. As we studied the special properties of the value of hedging in the delta case. but not to the extent that S is deterministic given S'. we will see that the value of perfect hedging on any uncertainty S' is determined to a large extent by the relevance relationship between S' and the set S of the uncertainties which completely determine the monetary prospects of the existing portfolio. 134 . the probability distributions {S | S' = s ) . We will examine the connection between relevance and hedging more systematically and more in depth over the next few pages.

3 . equality of B~(Y | w. we know that: £ ie[l.a) Complete Relevance Theorem 5. X) > B~(Y | w. X ) ) ie[l. X). By definition of the PIBP. define y.B ~<Y|w.n] Combining the last two equations.n] P i u(w + x.x.m] X ie[l.n] Let us now remember what the definition of the certain equivalent S~(X | w) for X is: X p i u(w + x i ) = u(w+ s ~(X|&» ie[l.J ] ie[l. [5. X » ie[l.^ Y I w . X) is achieved if and only if Y is the deal which transforms every single prospect of X into (X | &). X) and VoPH^ | w.Value of Perfect Hedging when S' = S VoPH(.n] je[l. X) > RPS(X | w): For each prospect Xj of X. Z qj|iU(w + x i + y j . Proof: Proof that VoPH(£ | w.X» Y. Then (Y | &> = 0 and by definition of the value of perfect hedging.n] P i u(w + <X|&). X) = RPS(X | w).B .S | w.B ~(Y|w.m] X PiUCw + x ^ . X) = RPS(X | w).. we obtain: 135 . = (X | &> .X» i £ [l.n] je[l.n] P i u(w + X i )= X P. we have VoPH(5' | w.< Y | w .)= X Pi Z qjiUCw + x ^ X I & ^ x J . p i u(w + x i ) = u(w + (X|&). Let us compute B~(Y | w. The result also holds for an uncertainty S' such that S and S' are deterministic given each other: then again.5] Furthermore. X) for that particular choice of Y. VoPH(5" | w.n] ie[l.

X). we also have: £ ie[1.S~(X | w) ~(Y | w.B~(Y | w. The mean of those dollar prospects is equal to w + (X | &) . we obtain: u(w + S~<X | w» < u(w + (X | &) .B~(Y | w. X) ~(Y | w. as well as X and Y which are still unresolved.X» The left-hand side of that inequality can be rewritten as u(w + S~(X | w)) by definition of the PISP for deal X. X)) < u(w + (X | &) .B~(Y | w. we have: £ ie[l. X). X» u(w + (X | &) .B~(Y | w. X). X ) ) Therefore: £ ie[l. . We will show that we necessarily have B~(Y | w.B~(Y | w. • Proof that VoPH(S | w. He then owns w . X» By definition of PIBP B~(Y | w.^ Y I w .B~(Y | w.n] p i u(w + x i )<u(w + <X|&). since Y itself has a mean of zero.B~(Y | w. Consider the situation in which the decision-maker has acquired deal Y for exactly B~(Y | w.n] PiUCw + X i + y i . X) < RPS(X | w): Let us now prove that VoPH(S | w.b ~<X I w) = (X ] &) . For that let us consider any hedging deal Y whose outcomes are solely determined by S and for which (Y | &> = 0.B~<Y|w. X).n] Pi u(w + x. + y. X> = <X | &> . X) < RPS(X | w).n] PiU(w + X i )= £ ie[l. X) > RPS(X | w). doing so.RPS(X | w)) < u(w + (X | &> . Since the decision-maker is risk-averse. X) = RPS(X | w) B B This proves that VoPH(5 | w. X) < RPS(X | w). X» 136 .

and vice versa: In Theorem 5. Adding Y to the current portfolio thus 137 . X) = RPS(X | w) if S' is an uncertainty such that S is deterministic given S'. i.5.n] Pi u(w + x. X) > RPs(X | w) if 5" is an uncertainty such that S is deterministic given 5" and vice versa. It should also be noted that for a strictly concave u-curve. As for proving the reverse inequality. • Proof that VoPH(5" | w.e. VoPH(5 | w. X» < u(w + (X | & . X) > B~(Y | w. = (X | &) .B~(Y | w. X) < RPs(X | w) would then also have become a strict inequality. X» > VoPH(. X) < RPS(X | w).Xj in the first part of the proof also belongs to the set of uncertain deals which have prospects which are solely determined by S' and which have a mean of 0. VoPH(5" | w. . we can simply notice that the deal Y which we defined by taking y. X) < RPS(X | w). X) < RPs(X | w) becomes strict: £ ie[l. and since it is true for any deal Y whose prospects are solely determined by S and for which (Y | &> = 0. plus a constant equal to (X | &>. We already computed the PIBP for that deal Y as being equal to the selling risk premium of X. Therefore.xi.3 shows exactly what becomes of deal X once it is perfectly hedged based on distinction S: to perfectly hedge X.S | w. the concavity inequality we based ourselves upon to prove that VoPH(5' | w. VoPH(S' | w. we will show that for a general uncertainty S'. = (X | &) . we use a new deal Y which is defined as the exact opposite of X. VoPH(5" | w.That in turn shows that B~(Y | w. and for a hedging deal Y which is not defined by y. J Theorem 5. X) = RPS(X | w).B~(Y | w. X) < RPs(X | w). + y.

transforms every single one of its monetary prospects into (X | &), thus removing any uncertainty from it. As a result, the portfolio will gain RPs(X | w) in value because its risk, which was initially captured by RPs(X | w), is now entirely compensated for by the addition of deal Y. In light of that explanation, not only does Theorem 5.3 appear as remarkably simple in its conclusions, but it also seems quite intuitive.

Example 5.4: Here we will take another look at perfect hedging on the set S = {Oil Price, Volume}. We have already naively computed the value of perfect hedging on S in the previous example, by solving an optimization problem as we have always done it so far; we will now compare that answer to the predictions of our theorem on perfect hedging when S = S'. The first clause of Theorem 5.3 announces that the perfect hedge should transform the oil company's uncertain portfolio into a deterministic one, by making all of its monetary prospects equal to $50.60 million, which is the mean of the oil company's original portfolio. If we examine Figure V.4, we will see that it is indeed the result we had reached when we naively computed the value of perfect hedging on S. Next, let us verify the second clause of the theorem; it states that the value of perfect hedging on S should be equal to the risk premium of the original portfolio: RPs(X | 0) = (X | &) - S~(X | 0) = $50.60 M-$38.99 M = $11.61M The risk premium matches the value of perfect hedging on S we had computed in the previous example: RPs(X | 0) = VoPH^ | X) is verified. H

138

b)

Irrelevance

We continue our investigation of the connection between value of perfect hedging and relevance with the second case in our nomenclature - the case in which S and S' are irrelevant given &:

Theorem 5.4- Value of Perfect Hedging on S' when S J. S' | & For any set of state variables 5" which is irrelevant to S given &: VoPH(S' | w, X) = 0. [5.6]

Furthermore, equality of B~(Y | w, X) and VoPH(5" | w, X) is achieved if and only if Y is the deal which has all of its prospects set to be equal to 0.

Proof: Proof that VoPH(S' | w, X) > 0: We already proved in Property 5.1 that the value of perfect hedging is non-negative for a risk-averse decision-maker. Proof that VoPH(S' | w, X) < 0: Let us now prove that VoPH^ | w, X) < 0. For that let us consider any hedging deal Y whose outcomes are determined by S'. We will show that we necessarily have B~(Y | w, X) < 0. By definition of B~(Y | w, X): £

ie[l,n]

P i u(w

+ X i )= X Pi Z qjii u ( w + x i + yj- B ~< Y l w > x »

ie[l,n] je[l,m]

**Exploiting the irrelevance between S and S': ^
**

ie[l,n]

p i u(w + x i )= Z Pi Z q j u(w + x i +y j - B ^<Y|w,X»

ie[l,n] je[l,m]

139

We can now use the fact that the decision-maker is risk-averse to transform the summation over index j on the right hand side: X

ie[l,n]

P i u(w

+ X l )< X p1u(w + x 1 +(Y|s i ,&>- B ~<Y|w,X»

is[l,n]

**Due to the irrelevance of S and 5", (Y | Sj, &) = (Y | &) = 0 for all values of i: £
**

ie[l,n]

PiUCw + x,)^ X

ie[l,n]

P i u(w

+ X i - B ~<Y|w,X»

We can finally conclude that B~(Y | w, X) < 0. Also, using the same series of arguments as in the end of the proof of Theorem 5.3, we can notice that the inequality VoPH^ | w, X) < 0 would have been strict for any choice of Y other than the deal whose prospects yj were equal to zero for all values ofj.D

This theorem shows that it is pointless to hope to hedge a portfolio X based on a set of uncertainties S' which is probabilistically irrelevant to it: the acquisition of any deal Y with a mean of zero and at least one non-zero payoff would then have no chance to compensate for any of X's risk, and could only add to the overall level of risk of the portfolio. The theorem should also remind us of an analogous result, which we encountered when we studied the properties of the value of hedging: we had seen that VoH(X | Y) = 0 if the decision-maker's u-curve satisfies the delta property and if X and Y are irrelevant given &. There is an important difference between the two theorems, though: the claims of the first result were restricted to the delta case, whereas those of the one we just derived are not.

140

Example 5.5: We return to our oil field hedging example, but this time, the oil company wishes to hedge based on Copper Price. They believe Copper Price to be irrelevant to both Oil Price and Volume given &. More specifically, they assign a probability of 0.6 to a high copper price and a probability of 0.4 to a low copper price, irrespective of the outcomes of Oil Price and Volume. In order to compute the value of perfect hedging on Copper Price, we need to solve the following maximization problem: max S~<Y | X> s.t. r Y's prospects are solely determined by the copper price uncertainty

1 (Y|&> = 0

The solution we obtain is the one we expected based on Theorem 5.4: it is impossible to create a hedge Y with a mean of zero but a positive certain equivalent. The best we can do is to set all of the monetary prospects of Y to zero, which yields a certain equivalent of zero: Vo?U(Copper Price | X) = 0. J

141

5 . we have: Z P. X) < PvPs(X | w).Value of Perfect Hedging on S' in the General Case For any set of state variables S\ 0 < VoPH^' | w. X) > 0: We can again refer to Property 5. X) < RPS(X | w): We will slightly adapt to the case of a general S' the second part of the proof we wrote for Theorem 5.B ~ < Y | w . we obtain: 142 .c) Incomplete Relevance When the decision-maker believes S and 5" to be relevant given &.B ~<Y|w. Let us prove that VoPH(5" | w.&) . Since the decision-maker is risk-averse. [5.m] qjpu(w + x i + y j . X) < RPS(X | w). We will show that we necessarily have B~(Y | w.X» ie[l.1 to find the proof of that result. but higher than or equal to what it would have been in the case of irrelevance: Theorem 5.n] je[l. the value of perfect hedging can be proved to be less than or equal to what it would have been in the case of complete relevance. but not completely. • Proof that VoPH(S' | w. X) < RPS(X | w). For that let us consider any hedging deal Y whose outcomes are solely determined by S' and for which (Y | &) = 0. £ ie[l. X » < X p i u(w + x i +(Y|s i .n] Applying one more concavity inequality to the right hand side.3.7] Proof: • Proof that VoPH(S' | w.

n] p.X)) <u(w + <X|&) + « Y | S i . X » < u ( w + <X|&> . Consequently.B~(Y | w.n] Pi Z je[l.X» Let us now recall the definition of ~(Y | w. & ) | & ) .B ~ < Y | w . X) < RPS(X | w). we find that: Z ie[l.X)) If we combine this equation with the previous inequality. we should observe that our concavity inequalities and our final inequality VoPH(5" | w.n] Pi Z je[l.u(w + x i )<u(w + <X|&> . X) < RPs(X | &). Since it is true for any deal Y whose outcomes are solely determined by S' and for which (Y | &) = 0.m] q j | i u(w + x 1 + y J . X » Since «Y | si? &) | &) = <Y | &) = 0: Z ie[l.B ~ ( Y | w .B~<Y | w. we have: u(w + S~<X | w » < u(w + <X | &> . VoPH(S' | w. X) < RPS(X | w) all become strict when S and S' are not completely relevant.n] Pi ^qi]iu(VJ M'.B ~ ( Y | w . 3 143 . X » But the left-hand side of that inequality is also equal to u(w + definition of the PISP for deal X. X » (X | w)) by This in turn shows that B~(Y | w. Finally.m] qji^w + Xi+yj-^YIw. X): Z ie[l.n] p i u(w + x i ) = Z ie[l.RPS(X | w)) < u(w + (X | &) .I ie[l. ] m + xi+yJ-B~(Y\w. X)) u(w + (X | &) .B ~<Y|w.

6: In Example 5. Volume}.61M We can thus observe that the value of perfect hedging on gold price is indeed comprised between zero and the risk premium of the original portfolio.26 million).Gold Price is only relevant to the value through Oil Price The probabilistic relevance between the Gold Price uncertainty and the original portfolio X is entirely channeled through the set S = {Oil Price. an uncertainty which was believed by the firm to be relevant to the set S = {Oil Price. we computed the value of perfect hedging on Gold Price. Volume} given &. However. as predicted by Theorem 5.Example 5. that value of perfect hedging is much lower than the total risk premium of X. We had then computed that: V6PH(Gold Price | X) = $1. which is captured by the influence diagram below: Figure V. and yet not completely relevant to it. more precisely through Oil Price. It is not surprising once we consider the probabilistic structure of the problem.5. it 144 . which is also the one of the two uncertainties in S on which the value of perfect hedging is the lowest ($3.1. Therefore.61 M More recently. we established that: VoPH(S|X) =RPs(X|0) = $11.4.

The next theorem expresses the same result in greater generality.seems intuitive that there should be at most as much to be gained from perfect hedging on Gold Price as there is to be gained from perfect hedging on Oil Price. D 145 .

and such that (Y | &) = 0. X)) Here we will aim at proving that S" 1 S | S'. S' and S".S\S\ 1fS"±S\S'. VoPH(5" | w. to put it differently. X) [5. combined with the inequality on the joint value of perfect hedging stated above. X). Is there any way to determine that the value of perfect hedging on one uncertainty will be greater than the value of perfect hedging on the other. B~(Y | w. X) > max (VoPH(S' | w. S" | w. & implies that VoPH(5". X). can we exploit the relevance structure of a decision situation in such a way as to infer that some value of perfect hedging will necessarily dominate another? The following theorem shows that it is possible indeed: Theorem 5.Value of Perfect Hedging on S" z/S" J.8] Proof: We know from Theorem 5. &: &. S" \w. would allow us to conclude that VoPH(5"' | w. then the value of perfect hedging provided by S" is less than the value of perfect hed ging provided by S': VoPH(S" | w. Both S' and 5"' are incompletely relevant to S given &.2 that for two sets of uncertainties S' and S". because that result. We will thus consider a deal Y whose prospects are solely determined by the uncertainties S' and S". X) < VoPH(S' | w. X) 146 . X) < VoPH(5'|w.X).d) Relevance-Based Dominance of one Hedge over Another Let us suppose that our decision-maker needs to choose to hedge based on only one of two uncertainties.X)< VoPH(5" | w. the joint value of perfect hedging on S' and 5"' is greater than or equal to the higher of the two individual values of perfect hedging on S' and S": VoPH(S'. If for any such deal Y.6-. without explicitly computing those two quantities? Or.

B ~<Y|w.n] je[l.n] P i u(w + X i )< S P. X).x». the equation above then simplifies into: £ ie[l.n] je[l. Since S" J_ S \ S\ &. X) < B~<a | w.n] je[l.)^ X P.k. S" | w.l] where qj|j denotes the conditional probability distribution over S' given S and &.^ Y I w .n] je[l. where each a was defined as the conditional mean of Y given S' = s'j and &: Oj = <Y | S" = s'j.J u ( w+x i + y J . we decompose each one of the prospects y^ of deal Y as follows: yj* = «j + pj.+y J .B ~<Y|w. X).)= X Pi Z % Z ie[l. Z qjpuCw + Xi+oij-^YIw. X).k.B ~( Y lw.l] Since the decision-maker is risk-averse: £ iefl. Z qj|lu(w + x i + a J + < p | y = s' j . &> We substitute aj + Pjk for y^ in the definition of B~(Y | w.&).m] The inequality above implies that: B ~<Y | w.n] ie[l.X» Next. X ) ) ie[l.m] ke[l. rk|ij = rky. By definition of B~(Y | w. it satisfies the following equation involving the decision-maker's u-curve: £ ie[l. and rk|ij the conditional probability distribution over S" given S.X)) ie[l. ie[l.m] ke[l. S' and &.k.n] je[l. as desired. X) < VoPH(S' | w.l] r k|j u ( w + x .n] P i u(w + x.n] p i u(w + x i )= Z Pi Z Ijli Z rkij^w + X i + O j + p ^ .< VoPH(S' | w.n] P i u(w+ X i )= X Pi Z % Z r k| 1 .X» ie[l. then we will have proved that VoPH(S'. X) 147 .m] Because of the way we defined the a's.m] ks[l. X) and obtain: £ ie[l. the conditional mean of p given S' = s'j and & is equal to 0: £ PiUCw + x.

X> < VoPH(S' | w. In more formal and more mathematical terms.We can then remark that a is a deal whose mean is equal to 0. X) This proves that B~(Y | w. therefore. as desired. X) < VoPH(S' | w. and whose prospects are solely determined by 5". the decision-maker's PIBP for that deal is less than his value of perfect hedging on 5": B ~(Y | w. we could say that the partial ordering of uncertainties based on the conditional irrelevance of one of them with respect to S given the other and & induces an equivalent partial ordering of the same uncertainties based on the value of perfect hedging that they provide. his preference should go to the perfect information on S'. 3 Theorem 5.6 is yet another result which highlights the strong resemblance between value of perfect hedging and value of clairvoyance: for the value of clairvoyance as well. 148 . X). if a decision-maker has a choice between free and perfect information on 5" and 5"' when S" ± S | S\ &. X) < B~(a | w.

Example 5. it is irrelevant to S= {Oil Price. This is also illustrated by Figure V. and more specifically to the Gold Price uncertainty: by its very definition. we have: Vo?U(Gold Price | X) = $1.1. And indeed. Volume} given Oil Price and &.6. the value of perfect hedging on Gold Price should thus be lower than or equal to the value of perfect hedging on Oil Price.26 M. By Theorem 5.7: Again we will refer to Example 5. • 149 .61 M VoPH(Oz7Price | X) = $3.4.

all we can be assured of prior to computing an exact value is that the value of perfect hedging is comprised between zero and the selling risk premium of X.e) Summary .Impact of Relevance on the Value of Perfect Hedging The following figure offers a qualitative graphical summary of the results we have just derived on the impact of the relevance relationship between S and S' on the value of perfect hedging: RP.X i = PM o > S"±S\S'. 150 .& SIS' Dependence between S and S' \ X.5. w) S=S' Figure V. = <X|&).Impact of the relevance between S and S' on VoPH^ The diffuse area between the two extreme cases S 1 S' and S = S' should remind us that in order to determine the exact value of perfect hedging when S and S' are relevant given & but not identical.g(X | w)' Best hedging deal: y. we first need to assess all the probability distributions and monetary prospects involved.

4 and 5. For the risk tolerance figure of $500 million which we have been using so far.3) or complete irrelevance (Theorem 5. regardless of his u-curve. then the selection of a perfect hedge might be affected by the decision-maker's u-curve.2 .4) do not depend on the decision-maker's u-curve. so the event is certainly worth remembering. Example 5.3. Here is an example which will demonstrate it.8: We will study the behavior of the value of perfect hedging on Gold Price as a function of the oil company's risk tolerance. 5.Perfect Hedging Strategies and U-Curves The deals Y which allow us to achieve perfect hedging in the case of complete relevance between S and 5" (Theorem 5. In other words. if there is incomplete relevance between S and S'. only the value of perfect hedging depends on the decision-maker's ucurve in those cases.5: Property 5.f) Influence of the U-Curve on the Choice of a Perfect Hedge There is another remarkable observation that we can make based on Theorems 5. his choice of a preferred hedging strategy does not. Very rarely do we come across recommendations in a decision analysis which are so universal that they would be equally valid for any decision-maker. On the other hand. we already know what the perfect hedge and the value of perfect hedging are: 151 .

61 M -$53.38 M p = $500 M $31.61 M We then repeat the analysis for two other values of the risk tolerance. This is no surprise since Also. In addition.68 M -$51.33 M -$47. and the other being lower (p = $200 million).86 M Table V. we see here that a more risk-averse decision-maker will tend to select a perfect hedge with a narrower spread between its monetary prospects.YHigh Gold Price ~ $ 3 1 . The results are shown in the next table. one being higher than the value we have used so far (p = $1 billion).21 M $0.61 M p = $1 B $32. it seems that the value of perfect hedging increases with risk-aversion over the range of risk tolerance values we have considered. in this example at least. with the first two rows indicating what the prospects of the best hedge are for each possible value of the risk tolerance. 6 8 M J YLow Gold Price = "$51 69 M \- Vo?H(GoldPrice | X) = $1.l -Impact of the risk tolerance on the selection of a perfect hedge We can thus remark that the decision-maker's risk attitude has an influence on his choice of a perfect hedge on Gold Price. • 152 .69 M $1.86 M $3. and the last row indicating what the corresponding value of perfect hedging is: p = $200 M $29.

and the second. Indeed. (Y | &). General Upper Bound on the PIBP of an Uncertain Deal We mentioned earlier.1.4. RPs(X | w). Proof: This is a direct consequence of combining Theorems 5. • The result. Since we also proved that the value of perfect hedging on 5" is itself less than or equal to the risk premium of the existing portfolio. 153 .7 . there is absolutely no need to elicit a conditional probability distribution over Y given X from the decision-maker. can be assessed without so much as assessing the relevance relationship between the potential acquisition Y and the existing portfolio. can be computed ahead of time by the decision-maker. further demonstrates the importance to a decision-maker of knowing the value of the risk premium of his existing portfolio. that the decision-maker's PIBP for any uncertain deal whose monetary prospects are solely determined by a set of uncertainties S' will be less than or equal to the sum of the mean of the deal and the value of perfect hedging on 5". in order to compute (Y | &). which is similar to Theorem 3. what is particularly appealing about this upper bound is that it relies on two quantities of which one. which could be a daunting task if the existing portfolio was complex. As mentioned in our discussion of Theorem 3.5.4. assessing a marginal probability distribution over Y is enough. we can conclude that: Theorem 5.4 except for the fact that it is valid beyond the delta case. in Theorem 5.1 and 5.Upper Bound on the PIBP for an Uncertain Deal (Y | &) + RPs(X | w) gives us an easy to compute upper bound on the decision-maker's PIBP for any deal Y.

at a price of $25 million. naturally.Example 5. if the first location allows them to pump out a high volume of oil. they believe that the two fields would connect to the same reservoir. it probably means that the additional amount of oil that can be extracted from the second location will be low. The next tree shows the distribution over profits for the second oilfield. there is some relevance between the volume of oil that they would be able to extract from one and what they would be able to extract from the other. the company's beliefs as to oil prices are the same as in Example 5. and vice versa.1: 154 . The management of the company believes that since the two oilfields are adjacent.9: Let us suppose that one of the oilfields bordering the one that the oil company presently owns is available for sale. More specifically. However. and they are not ready yet to assess a conditional probability distribution over it given the volume they will extract from the field they already own: they believe that they would need to consult experts in the geology of the area before they can think about such a distribution with clarity. at present the management are only comfortable assessing a marginal probability distribution over the volume of oil for the second field.

8 Low Volume $70 M -$40M <Y|&> = $10M Figure V. • 155 .Distribution over profit for the second oilfield.2 0.High Volume High Price 0.61 M < $21. $25 million is too high a price for that second oilfield.4 -6 High Volume 0.6.6 -0i Low Price 0.2 -6) $140 M $30 M 0.61 M In this example. we can compute an upper bound on their PIBP for Y as: B ~(Y | X) < <Y | &> + RPS(X | 0) < $10. we can thus spare the company the cost and the trouble of having to make any conditional probability assessments: the marginal distribution over the profits generated by Y was enough to establish that to them.8 Low Volume 0. Even though the company has not yet fully assessed the relevance that they believe exists between this new opportunity Y and their existing portfolio X.00 M +$11.

Approximation of the Value of Perfect Hedging in the Delta Case The upper bound on the value of perfect hedging which we just discussed has one flaw nothing guarantees that it will be tight. we need to solve the optimization problem VoPH(S' | w. X). In fact. <Y | &> = 0 Y determined by S' B ~<Y | w.t. we should also bear in mind that in order to compute the exact value of perfect hedging on S'. And yet. which can be a challenging and computationally intensive task if the probabilistic structure of the decision situation is complex. unlike that of the risk premium upper bound we have already derived. we might suspect that the risk premium of the existing portfolio might make for a poor approximation of the actual value of perfect hedging.5. would be assured at least as long as some reasonable conditions are met. Fortunately. in the general case in which S' is relevant to S given & but not completely. it would be of considerable practical importance to have access to an approximation of the value of perfect hedging whose accuracy. such an approximation exists if the decisionmaker's u-curve satisfies the delta property: 156 . If instead the relevance between S and S' is weak. X) = max Y s. Hence. our earlier inspection of the effects of relevance on hedging has taught us that the value of perfect hedging on 5" can only be equal to the risk premium of the existing portfolio if S' is completely relevant to S given &.

as long as deal Z has a small enough variance compared to the square of the decision-maker's risk tolerance: V (Z|&)«^ Y Consequently. where X is a deal whose prospects are determined by 157 . his certain equivalent for a deal Z can be approximated by: s ~(Z|0)»(Z|&)-iyv(Z|&).2] stated that for a decision-maker who follows the delta property. B~(Y* | X) where Y is defined such that y j = (X | &) . More precisely. the better the approximation will be. let us consider the problem of the minimization of the variance of X and Y. Finally. &) is an approximation of VoPH(5" ] X). [4.2] reminded us that for small enough values of the risk-aversion coefficient y. unlike the first part of this theorem.(X | S' = s'j. The approximation is an underestimate of the actual value of perfect hedging. Proof: • Proof that y*j = (X | &> .8 . we should devote our best efforts to minimizing the variance of the combined portfolio made of X and Y together before we focus on optimizing any of the higher order moments of that portfolio. &) yields an approximation of VoPH(5" | X) in the general case: [4. the higher the square of the risk tolerance (p2) is compared to the variance of the deals involved. Also.Approximation for the Value of Perfect Hedging For a risk-averse decision-maker who follows the delta property.Theorem 5. it should be noted that the approximation happens to give an exact answer when S and iS" are completely relevant or when S and S' are irrelevant given &.(X | s'j. that last result holds no matter what u-curve the decision-maker has.

m] je[l. &) is indeed the solution to our variance minimization problem.^) 2 -*! IP.n] je[l.n] J =0 This leads to: 2 Z P u ^ + yJ-X Z Pu=0. y k = (X | &) .n] and to the value of the monetary prospect yk: Z yk _ _ ^ _ ie[l.t. We can first notice that the problem is equivalent to the following: Min £ / £ p u (x.(X | s'k.J ie[l.n] Pu x i P i "2" S ie[l.m] l^ietl.n] We can then find the value of X by substituting those values of the prospects yk into our original constraint. we can form the Lagrangian and set its derivatives to 0 .for all values of k in [1. ie[l. S' = s'j | &}.n] je[l. where we denoted by pij the joint probability {S = Sj.the outcomes of S and Y another deal whose prospects are determined on the outcomes of S': Min ~(X.m] V. 158 .n] je[l. +yj) 2 \ ie[l. <Y|&> = 0.+yj) V' 6 ! 1 '"] M 1 .m] ^ Z SPM J yj =o je[l. we have: d dyk Z IM*. (Y | &) = 0: ^= 2 f Z je[l. Therefore.Y|&)=X Z p ^ x .Z ie[l.m] Vie[l.m] v 2 ( V Ep^x.n] In order to find the minimum.ie[l. 1 "] s. + y j ) . x \ It shows that X = 2 (X | &). n].n] Z PiJ i .n] is[l.

(X\S'= s'j. This is the same hedging deal as the one defined in Theorem 5.3 to achieve perfect hedging if 5 and 5" are completely relevant. • Proof that the approximation always gives an underestimate of VoPH(5" | X): One simply needs to notice that the deal Y we defined belongs to the set of deals such that <Y | &) = 0. or when S15": When S = S'. which yields y*j = (X | &) . The approximation is thus exact when S and 5" are completely relevant. &) = (X | &). When S1 S\ (X | S' = s'j.XJ. or when S and S' are irrelevant given &. &) = Xj. Therefore. which yields y*j = 0.4 to achieve perfect hedging if S IS'. This is the same hedging deal as the one defined in Theorem 5. X) = VoPHCS' | X) when S and S' are completely relevant. by definition of VoPH(S' | X). 3 159 .• Proof that B~< Y* | w. we have VoPH(S" | X) > B~(Y* | X).

among all possible deals that have 0 as their mean. It would require building 160 . let us consider the approximation we would obtain based on Theorem 5. The decision-maker is interested in knowing which choice of deal Y.Example 5.6 S2 $0 -0 0. but not identical.8 Sl $yi 0. constitutes the best match for his current portfolio X . Before we look for the exact answer to that question.7 -Accuracy of our value of perfect hedging approximation: an example A decision-maker currently owns deal X.10: We will demonstrate how good the approximation is based on a simple example: S'l 0. whose monetary prospects are determined based on the outcomes of a distinction iS" which is relevant. He is considering acquiring a deal Y.2 S'l $y2 -o S'l 0.4 $100.3 $yi 0. to the S distinction. which has a mean of $40.7 S2 $y2 Figure V.8.000. which deal Y provides the highest PIBP B~(Y | X).more specifically.000 -0 0.

000 respectively. again for each of the six values of y. for six different values of the risk-aversion coefficient y. since we want (Y | &) to be equal to zero.001. &). = -$20. For example.a hedging deal Y* such that y*j = (X | &} . B~(Y | X) is maximized for yi ~ -$23. we can compute those two prospects as being y \ = -$24. any choice of yi imposes that we choose -yi as y2. and for y.01.2 does not stand any longer once we consider cases in which we have neither complete relevance or irrelevance between S' and S: the selection of a best hedging deal Y does depend on risk attitude apart from those extreme cases. let us first notice that Y is fully specified by the choice of yi. For that. Several insights can be derived from a careful examination of this figure: • As noted earlier. The curves on the following figure show B~(Y | w.(X | S' = s'j.500 when y = 0. 161 . X) as a function of yi. The large dots mark the value of yi for which the maximum value of B~( Y | w. indeed.000 and y 2 = $24. X) is attained. Property 5.500 when y = 0. Let us now numerically solve the problem of selecting the best possible complement Y to the current portfolio X for different values of y.

000 $0 -$1.000 $1.000 ^ Value of y given by approximation k^jm^ --442 $50 -$46 'v=0.Influence of risk-aversion on the accuracy of the approximation The approximation suggested in Theorem 5.8. hedging will not be as valuable an alternative to someone whose risk attitude is close to risk-neutral. That being said. in a sense.8.02 Figure V.000 -$4.000 $3. because on the other hand.000 -$3.000 -$2.000 -$6. as shown by the following figure: 162 .000 -$5.$4. this is potentially problematic. seems to yield more accurate results for low values of y. as predicted.000 $2. the approximation appears to be quite reliable for values of y up to 0.01 -$38 -254 -$30 -$261 -$22 -$18 -$14 -$>6 -$6 -$2 yi $ Thousand) I y=0.02.

whereas the second is a negative side effect from hedging with the variance-minimizing deal Y .000 -$10.02 Why does the accuracy of the approximation break down as risk-aversion increases? Consider the hedging deal Y suggested by Theorem 5. risk-averse decisionmakers will grow increasingly concerned about the second effect.005 0.000 -$12.000 Figure V.8.000 -$4.000 -$14.$4.001 -$2.01 0. o It also increases the size of the range of prospects the decision-maker will be facing. for higher values of y. The first effect is desirable from the point of view of a risk-averse decisionmaker.000 $0 0. 163 .000 $2. incorporating it into the decision-maker's portfolio will have two effects: o It does provide value by reducing the variance of the combined portfolio of deals X and Y to its minimum.Influence of risk-aversion on the accuracy of the approximation (2) i VoPH Estimated Using Our Approximation I Actual VoPH 0.000 -$8. and as a result it has a detrimental impact on some of the higher order moments of the portfolio (such as decreasing the third central moment).9 .000 -$6.

For that value of y. and thereby gain access to both an upper and a lower bound on the value of perfect hedging. the optimal choice of yi is yi ~ -$16.650. which we already knew to be equal to 0 for risk-neutral decision-makers.8. In our example.8.it consists in choosing a lower value of yi than the one suggested by Theorem 5. and at worst. We can thus use that PIBP in conjunction with the risk premium of the original portfolio.8. The next example will illustrate that approach. the value of yi for which the value of perfect hedging is achieved increases with y. this can turn out to be a wiser decision than blindly choosing deal Y as defined in Theorem 5. 164 . a decision-maker renounces to part of the benefits of the variance reduction effect. an underestimate for it. is also equal to 0 for extremely risk-averse decision-makers. a natural solution exists in order to somewhat immunize oneself against that second effect . that maximum is reached for y ~ 0. On the whole. The value of perfect hedging also seems to reach a maximum for some specific value of y. This explains why. while curbing the negative impact of the second effect more drastically.02. and the value of perfect hedging is roughly equal to $2. By doing so.000.However. at best. on Figure 5. • VoPH(5" | X). an accurate approximation of the value of perfect hedging. • The PIBP for the deal Y which minimizes the variance of the portfolio gives us.

00 M = $33.1).8 is not quite as robust as it could be otherwise. We first need to compute the values of the monetary prospects which will help minimize the variance of the decision-maker's portfolio.8 tells us that: f y*Low Gold Price = (X | &> . &) L y*High Gold Price = <X | &> . the oil company is not risk-averse enough for the approximation from Theorem 5. since even with a risk tolerance of $150 million.8 to lead to very inaccurate conclusions.42 M = -$54.82 M We can then compute the PIBP for deal Y as we defined it: B ~(Y* | X) = $3.60 M . so that the approximation from Theorem 5.60 M . we compute the risk premium of the existing portfolio: RPs(X | 0 ) = $32.99 million and $32.09 M From that we can infer that the value of perfect hedging on Gold Price is comprised between $3.99 M Next.(X | Low Gold Price.$105.<X | High Gold Price. The exact value of perfect hedging is equal to $4. Theorem 5. &) Therefore: f y*Low Gold Price = $50.6 M \ y*High Gold Price = $50.$17.15 million.09 million.Example 5. to make matters more interesting we will consider that the oil company's risk tolerance is equal to $150 million (instead of the $500 million from Example 5. • 165 . which is much closer to the lower bound than to the upper bound of our interval.11: We return to our Gold Price hedging example.

The last row of the table. the value of information on some uncertainty is positive if and only if the decision-maker's preferred alternative changes for at least one possible report on the value of the uncertainty. The following table presents some of the most striking resemblances.in a decision situation.6. Similarities between Value of Perfect Hedging and Value of Clairvoyance As a summary of our study of the value of perfect hedging and its properties. should remind us that in disciplines such as probability or decision analysis. all of them are supported by various theorems and examples shown throughout this chapter. 166 . I will enumerate the similarities it shares with one of the best known and most useful concepts of traditional decision analysis: the value of clairvoyance. Conversely. hedging only made his portfolio more valuable in his eyes by limiting its risk. the value of perfect hedging on an uncertainty can be positive even if the best alternative remains the same with or without hedging. There is an important difference between the properties of the value of information and those of the value of perfect hedging . which discusses the impact of risk attitude on the value of clairvoyance and on the value of perfect hedging. many of the conjectures which might initially to our intuition as tempting to believe in are in fact often wrong. The examples we have discussed throughout this chapter demonstrates this well: the value of perfect hedging was positive even though the availability of hedging did not modify the decision-maker's choices in any way.

& => VoPH(5" | w. VoPH(5")) No general rule between joint VoPH and sum of individual VoPHs = 0ifS"±S|& Increases with relevance otherwise in the sense that S" 1S | S'. Sign >0 1) Provides an upper bound on the value of any experiment Usefulness 2) Helps prioritize uncertainties based on how valuable it is to gather additional information on them Joint value of clairvoyance or of perfect hedging VoCOS". & => VoC(5") < VoC(S"). it is not necessarily true that the most risk-averse person of the two will be willing to pay more for clairvoyance on 5". for a deal whose prospects are determined solely by 5' and whose mean is equal to 0. it is not necessarily true that the most risk-averse person of the two will be willing to pay more for perfect hedging on S'. then. 5") > max (VoPH(5"). then. VoC(S")) No general rule between joint VoC and sum of individual VoCs = Impact of relevance 0ifS'±S\& >0 1) Provides an upper bound on our PIBP for any deal we do not own 2) Helps prioritize uncertainties based on how valuable it is to hedge on them VoPH(5". Increases with relevance otherwise in the sense that S" 1S | S'. until it reaches VoC on S when S' = 5 Consider two risk-averse decisionmakers who each own a deal X in which they believe they face the exact Impact of risk attitude same chances of the same prospects. X) < VoPH(5' | w. S") > max (VoC(S").Comparison of value of clairvoyance and value of perfect hedging 167 .VALUE OF CLAIRVOYANCE ON S' VALUE OF PERFECT HEDGING ON S' The most we should be willing to pay Definition The most we should be willing to pay for the clairvoyant's services. Table V.2 . X). until it reaches RPs(X w) when S' = S Consider two risk-averse decisionmakers who each own a deal X in which they believe they face the exact same chances of the same prospects.

Just as the value of clairvoyance will help the decision-maker focus his information gathering activities in the next iteration of the cycle on the uncertainties which matter the most. Analysis Appraisal . Structure • p. with the formulation phase. . Appraisal . which uncertainties he should seek to hedge on. the step in which the decision analyst has the most freedom in choosing how to conduct the process.10 . the value of perfect hedging will help him decide whether he should pursue any hedging opportunities. Formulation c. • Deterministic Analysis . it is in the appraisal phase that some of the analyst's choices will most significantly affect the quality of his final recommendation to the decision-maker. . ngpjeJQri t • • • • Sensitivity analysis Value of information Value of control Value of perfect hedging Figure V.The value of perfect hedging in the decision analysis cycle 168 . As a result. What we will advocate in this part of the dissertation is that one more tool be added to that critical part of the decision analysis cycle . The Value of Perfect Hedging as a New Appraisal Tool Of all the steps of the decision analysis cycle. . Probabilistic • . the appraisal phase is probably. Evaluation . .the calculation of the value of perfect hedging. and if so.7.

and its profitability will be greatly enhanced. a possible alternative consists in bringing in another individual and possible investor in this deal. to the extent that he may eventually prefer A to B. and a fraction 1 .In some cases. Perfect hedging might then enable the decision-maker to redeem more of the risk premium of A than of the risk premium of B. A small study conducted in a European university was recently published. In that respect. A. and forces him to settle for an alternative B with a lower mean. Zeta's management would like to convince the Food and Drug Administration (FDA) of granting them an official neuroprotection claim on the label of Nemesis: if they succeed. Zeta.12: The following example shows the impact that the value of perfect hedging can have on the final recommendation of a decision analysis. showing that the compound might have a neuroprotective quality which no one had suspected up to that point. the concept of the value of perfect hedging fills the same need as what is sometimes called risk-sharing in the decision analysis literature: if an uncertain deal has a positive mean. Generally speaking. who assigns the same probabilities as the first individual to the monetary prospects of the deal. we then split the uncertain deal between the two of them by giving a fraction f of every prospect to the first investor. Nemesis will become the first drug with such a claim. the availability of hedging can greatly affect the final recommendation of an analysis by causing a reversal in the preference order between two alternatives. Several years ago. but a narrower risk profile and a higher certain equivalent overall. a small biotechnology company. it will be possible to find a value of f such that both decision-makers have a positive certain equivalent for the portion of the deal that they are left with. Zeta's board believes that 169 . Unfortunately. Example 5. If the second decision-maker's risk tolerance is sufficiently high. launched a drug for the treatment of Parkinson's disease called Nemesis. hedging is most likely to have such an effect in situations in which the decision-maker's risk-aversion prevents him from selecting the alternative with the highest mean. but the decision-maker's certain equivalent for it is negative because of the risk the deal carries.f to the other.

Zeta is thus considering funding a phase IV study.6 $3. Neuroprotection Endpoint 1 0. 170 . due to the small scale of the experiment. the best decision for Zeta is to renounce to the phase IV study: conducting the study yields a negative certain equivalent of -$4 million. with the hope that it will provide enough evidence to persuade the FDA. We observe that at present.3 0. with a risk tolerance of $1.05 $3.4 B •0 0.1 00.6 0 0.ll — Example for the use of perfect hedging as an appraisal tool The figure above captures the most important elements of Zeta's decision situation.the data from the European study would be insufficient to convince the FDA.4 B -$200 M Phase IV Study CE: -$4 M Mean: $286M Endpoint 2 0.4 B -$200 M No Neuroprotection Neuroprotection Endpoint 3 0.15 0.95 -$200 M No Neuroprotection No Phase IV Study $0 Figure V. The company's board also states that they wish to follow the delta property for the range of prospects involved.85 $3.4 No Neuroprotection Neuroprotection 0.5 billion.

We will denote this uncertainty by NP < 2010. the board would assign a 20% chance to NP < 2010. this could take the form of an insurance contract. the company's board states that it might be possible to hedge based on whether or not any drug at all will receive the FDA's approval for a neuroprotection claim before 2010. With perfect hedging. if Nemesis itself were to conduct a phase IV study and receive the FDA's approval. When asked about possible hedges. and a profit of $235 million to No NP < 2010. the company would have needed to have a risk tolerance of about $1.However. Concretely. That remark should prompt us to investigate the effect of the value of perfect hedging on the final recommendation. The corresponding value of perfect hedging for the Phase IV Study alternative is: VoPH(JVP < 2010 | X) = $39 million Hence.5 billion. and an 80% chance to No NP < 2010. in the absence of any hedging. Naturally. In a sense. on the other hand. We can then compute VoPH(JVP < 2010 | X): in doing so. then NP < 2010 would automatically be true.95 billion instead of $1. • 171 . perfect hedging on NP < 2010 can thus be said to be equivalent to a $450 million increase in the company's risk tolerance for the purposes of this decision. which implies that the only reason why it is not the best course of action is that it currently involves too much risk for the company's taste. if Nemesis were to be denied the claim. we can also notice that the mean of the alternative is $286 million. we can conclude that perfect hedging on NP < 2010 is indeed susceptible of altering the final recommendation in favor of performing a phase IV study. we identify as the perfect hedge on that uncertainty a deal which associates a loss of $528 million to NP < 2010. We can also note that in order to obtain the same certain equivalent of $35 million for the basic decision situation of Figure V.l 1. the certain equivalent of the study increases to $35 million.

I have argued in favor of adding a study of possible hedging alternatives to the appraisal phase of the decision analysis cycle. Quite the opposite. under the protection of Cox's theorems. That value of hedging then 172 . I have also shown how a decision analysis of hedging can be conducted in practice. Probability Theory: the Logic of Science 1. it should act as our compass when we do not know where to start and which uncertainties to hedge on. The concept of the value of perfect hedging helps us identify the uncertainties on which it is most valuable to seek hedging.Chapter 6 . we have avoided the inconsistencies and absurdities which are generated inevitably by those who try to deal with the problems of scientific inference by inventing ad hoc devices instead of applying the rules of probability theory. Contributions Over the course of this dissertation. At the same time. hedging can be of considerable value to a decision-maker. " Edwin Thompson Jaynes (1922-1998). we have learnt to compute or approximate the value of hedging which an uncertain deal provides with respect to the existing portfolio. we have thought of probability distributions as carriers of information. As for situations in which the decisionmaker needs to choose from an already established shortlist of available hedging alternatives. We have observed on many examples that like additional information.Conclusions & Future Work "It was our use of probability theory as logic that has enabled us to do so easily what was impossible for those who thought of probability as a physical phenomenon associated with 'randomness'.

whose profession requires that he should always be keen on learning new ways of identifying valuable alternatives for his client. and yet precise enough for it to pass the clarity test. It is probable that our findings on that front are further removed from the practical concerns of most decision-makers than are some of the other concepts we discussed.helps us determine the decision-maker's personal indifferent buying price for the uncertain deal in question. We have thus addressed all the research questions which I had originally listed in the first chapter and which I proposed to examine. we have also proposed a new definition of hedging: we have spoken of hedging in situations in which the decision-maker's valuation of a deal differs depending on whether he owns his present wealth w and his current portfolio X. we have covered the topic of the probabilistic origins of hedging and shown that hedging boils down to moment reengineering. still. or his present wealth w augmented by his certain equivalent for X. such as the value of perfect hedging. 173 . This new definition has the merit of being broad enough that it does not restrict our characterization of hedging to the use of financial derivatives. In this dissertation. In addition. knowledge of the probabilistic origins of hedging might appear as quite useful to a practicing decision analyst.

be it because those investors also believe that there is a great upside to gold prices. where some companies are proud to announce that they do not hedge their gold production at all. their stock would lose some of its appeal to shareholders.com. The second argument which gold companies offer to explain why they do not hedge is more atypical: they believe that many of the shareholders who invest in their company do in fact desire to be exposed to evolution of the price of gold1. hedging can have side effects.2. gold-mining companies believe that if they began to hedge their gold positions. Limitations The research presented in this thesis has an important fundamental limitation: in all of our findings and illustrative examples. 1 See for example a 2006 interview of Peter Marrone. by Bill Mann: http://www.fool. Some of the best examples can be found in the gold-mining industry. It thus remains a relatively modest weakness of this research that its scope is limited to uncertain deals whose prospects can be evaluated with a monetary measure./investing/small-cap/2006/09/13/a-brazilian-gold-mine. and that hedging might lead them to agree to prices which would be inferior to the actual future price of gold. By that I mean that it can entail consequences for the decision-maker which the monetary prospects of the existing portfolio and of the hedging deal would not suffice to explain. But those are perhaps also the decision situations in which it is hardest to think of alternatives which would provide hedging with respect to the decision-maker's current situation. We should bear in mind that there are decision situations in which it is not natural to do so . there is one situation which we have not explicitly addressed: occasionally. CEO of Yamana Gold. we have only considered situations in which the decision-maker's preferences could be expressed in monetary units.most notably in medical settings. In either case.aspx 174 . A second limitation of the thesis is that in spite of our efforts to study hedging in its largest generality. There are several reasons for their behavior. and more infrequently in engineering settings. The first is that many of those mining companies appear to be convinced that there is a tremendous upside to gold prices in the current economic environment. or because they regard gold as a safe haven in the event of a major economic crisis.

Those adjustments are best illustrated by an influence diagram such as the one below. when applied to other industries than gold-mining. they also make their stock more attractive to certain kinds of shareholders. The result is an influence diagram with a richer and more complex probabilistic structure.6. While it is true that I have not explicitly addressed issues of side effects to hedging in the dissertation.6. can work in the opposite direction. that is. if it believes that there would be a negative side effect attached to hedging: Figure VI. Loss of Safe Haven Status. 1 . we should also realize that we only need to make a few modifications to the framework we have proposed before it can lend itself to the successful study of those situations as well. in favor of hedging.It would be fascinating to see whether the same argument. it captures the sort of dilemma which a gold-mining company might face. because they believe that by hedging. we can see that there is only one important difference: we added a new uncertainty. but with the same overall philosophy as the diagram from Figure II. We can then use this 175 . and a new path leading through it from the decision to buy the hedge to the value node. Perhaps some companies attach a greater value to hedging practices than our concept of the value of hedging would detect.Hedging with negative side effects If we compare the influence diagram above with the general influence diagram for hedging which we presented in Figure II.

176 .representation of the decision situation to determine the gold-mining company's PIBP for the hedge as the price at which they would just be indifferent between buying the hedge and not buying it.

however. Just like the value of hedging. The equivalent probability of clairvoyance is defined as the probability p such that the decision maker would be just indifferent between using the information gathering scheme in question. R. can help us reason on the merits of an information gathering scheme in the absence of a monetary value measure. but we have not yet discussed any possible solutions to the framework's inadequacy to cope with instances in which preferences are not captured by a monetary value measure. Directions for Future Work The two limitations of the thesis which we mentioned can also be envisaged as promising research opportunities. and receiving either full clairvoyance on his decision situation with probability/' or no additional information at all with probability l—p: Receive full clairvoyance Information gathering scheme ^^^ 6 Receive no further information 1-P Figure VI. In that respect. called "probability of knowing" or "equivalent probability of clairvoyance" [Howard.]. the value of information can only be computed if the prospects are measured in monetary units. a related concept. the similarities we have so often detected between value of information and value of hedging can give us an idea which might be worth investigating.2 — Equivalent probability of clairvoyance 111 .3. A. We have already given a few hints as to how our hedging framework can be adapted to the study of situations in which hedging has side effects.

by defining a concept of equivalent probability of hedging. Perhaps it is possible to accomplish the same thing for hedging alternatives. I would finally like to suggest the search for additional evaluation methods. it is probable that we can do much more to complete our arsenal of hedging valuation techniques. and it might be worthwhile to look for further results in that direction. 178 . for the value of hedging as well as for the value of perfect hedging. But it is the situations in which the decision maker's u-curve does not satisfy the delta property that we are least equipped to handle: only a small number of the approximations and bounds we have identified are valid in that case. and it would be of great practical use to have access to a few more results for at least the most commonly used u-functions. We have often remarked throughout this dissertation that the computation of those quantities can be an intensive task. which is why we have so frequently stressed the significance of the approximations and bounds we were able to derive.It is then possible to sort information gathering schemes from most valuable to least valuable by comparing their respective equivalent probabilities of clairvoyance. For cases in which the decision-maker's u-curve satisfies the delta property. However. as a third direction for future work on hedging. such as the logarithmic and power u-curves. we have just laid out the foundations of an irrelevance-based algebra for the value of hedging.

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Index of Terms Certain equivalent Chain rule Chain rule for the value of hedging Chain rule for the value of information Clarity of action Contraction property from probability Cumulant Cumulative distribution function (CDF) Decision analysis Decision analysis cycle Appraisal phase Evaluation phase Formulation phase Decision diagram Decision hierarchy Delta property Deterministic analysis Deterministic dominance Elements of decision quality Equivalent probability of clairvoyance Five rules of actional thought Choice rule Equivalence rule Order rule Probability rule Substitution rule Framing HedgeStreet Hedging 188 xi. 12 95 95 7 102 107 22 7 15 25 20 16 See Influence diagram 16 13 20 23 8 See Probability of knowing 9 10 9 9 9 9 16 3 33.42 .

11 xi. 11 9 22 23 23 22 177 xii xi 12 .Minimum-variance hedge Negative hedging Side effects of hedging Incomplete markets Influence diagram Decision node Deterministic node Functional arrow Influence arrow Influence diagram for hedging Informational arrow Relevance arrow Uncertainty node Value node Irrelevance Judgmental bias Mean-variance approaches Minimal underlying uncertainty associated with an uncertain deal Multiple of a deal Normative discipline PIBP PISP Preference probability Probabilistic analysis Probabilistic dominance First order probabilistic dominance Second order probabilistic dominance Probability encoding Probability of knowing Risk premium Buying risk premium Selling risk premium Risk-averse 189 35 61 174 39 17 17 17 18 18 56 18 18 17 17 xi 22 35 91 83 7 xii.

Risk-seeking Risk-sharing Sensitivity analysis Open loop / closed loop sensitivity analysis Tornado diagram U-curve Utility-based approaches U-value Value of control Value of hedging Value of hedging in the delta case Value of perfect hedging Dominance for the value of perfect hedging Joint value of perfect hedging Value of perfect information Venn diagram Wealth effect 12 169 25 27 20 11 39 11 30 73 121 146 130 29 98 47 190 .

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