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**Decision Analysis I November 12
**

th

. 2004

Page 1 oI 10 HW #5 Solutions

Homework Assignment #5 Solutions

0

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-INF - 0 0.5 - 1 1.5 - 2 2.5 - 3 3.5 - 4 4.5 - 5 5.5 - 6 6.5 - 7 7.5 - 8 8.5 - 9 9.5 - 10

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Number of Grades within Range Cumulative

Score on HW Question (./1)

-1.00 -0.50 0.00 0.50 1.00

Question 1

10% 50%90%

Question 2

10% 50% 90%

Question 3

10% 50% 90%

Question 4

10% 50% 90%

Question 5

10% 50% 90%

Question 6

10% 50%90%

Question 7

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Question 8

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Question 9

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Question 10

10% 50% 90%

MS&E 252 Handout #19

Decision Analysis I November 12

th

. 2004

Page 2 oI 10 HW #5 Solutions

Distinctions

These distinctions were prepared by the teaching team and reIlect our best belieI oI the

meanings oI these terms.

Risk attitude: A person`s risk attitude is determined by the relationship between his or her

certain equivalent oI a monetary deal and the e-value oI the monetary measure

Risk neutral: certain equivalent Ior any monetary deal is the e-value oI monetary measure.

U-curve is linear.

Risk averse: certain equivalent Ior any monetary deal is always ·÷ e-value oI monetary

measure. U-curve is concave.

Risk preIerring: certain equivalent Ior any monetary deal is always ~÷ e-value oI

monetary measure. U-curve is convex.

Risk odds: r characterizes the risk attitude oI a person who satisIies the delta property.

Risk odds. r ÷ p/(1-p). equals the odds oI winning one monetary unit versus losing one

monetary unit so that person is indiIIerent between accepting and reiecting the deal.

p

1-p

+1

-1

0 ~

Risk tolerance: 1/ln(r) where r is the risk odds as described above.

Risk aversion: ln(r) where r is the risk odds as described above

Delta property: A person satisIies the delta property iI adding a constant amount b to all

prospects oI a deal increases the certain equivalent oI that deal by b. For such a person.

PISP and PIBP oI a deal are the same. Also. his/her certain equivalent can be computed

without considering the person`s current wealth.

Value oI Clairvoyance: The most decision maker D would be willing to pay (PIBP) Ior a

clairvoyant`s services to eliminate uncertainties in a particular decision situation. Value

oI experiment ÷ value oI clairvoyance on result oI experiment.

Value with Iree clairvoyance: is the certain equivalent oI a deal with clairvoyance on a

given uncertainty. when the PIBP oI clairvoyance on that uncertainty is $0.

Probabilistic questions

1) Solution: b

MS&E 252 Handout #19

Decision Analysis I November 12

th

. 2004

Page 3 oI 10 HW #5 Solutions

Consider the Iollowing trees. From the Iirst. we compute the certain equivalent oI

Jimmy`s decision situation as $200. In the second. we see that with Iree clairvoyance. the

certain equivalent is $275. The diIIerence is $75.

Red Sox win $500

Bets “Red Sox win” 0.4

$200 Red Sox lose $0

0.6

$200 Red Sox win $0

Bets “Red Sox lose” 0.4

$75 Red Sox lose $125

0.6

Red Sox win $500

Bets “Red Sox win” 1

$500 Red Sox lose $0

Clairvoyant says

“Red Sox will win” 0

0.4 Red Sox win $0

Bets “Red Sox lose” 1

$0 Red Sox lose $125

0

$275 Red Sox win $500

Bets “Red Sox win” 0

$0 Red Sox lose $0

Clairvoyant says

“Red Sox will lose” 1

0.6 Red Sox win $0

Bets “Red Sox lose” 0

$125 Red Sox lose $125

1

2) Solution: c

This can be seen Irom the Iollowing chart. The curved line corresponds to a risk-

preIerring u-curve. The positions 'W¨ and 'L¨ show the certain equivalents oI a bet on

the Red Sox winning or losing. respectively. When Jimmy is risk-neutral. the points 'W¨

and 'L¨ coincide. II Jimmy is at all risk-preIerring. the picture shows that 'L¨ is strictly

less than 'W¨. Conversely. iI Jimmy is risk averse. 'L¨ is strictly more than 'W¨.

MS&E 252 Handout #19

Decision Analysis I November 12

th

. 2004

Page 4 oI 10 HW #5 Solutions

3) Solution: b

I. would not change his bet u-curves can always be shiIted or scaled.

II. could change his bet because it represents a new piece oI inIormation that could make

Jimmy revise his belieIs regarding who will win next year`s World Series.

III. would not change his bet when people Iollow the delta property. their Certain

Equivalents are not aIIected by changes in their initial wealth.

IV. would not change his bet when people Iollow the delta property. adding or

subtracting the same quantity Irom all oI the prospects they Iace does not have any impact

on the ordering oI the alternatives.

4) Solution: a

Clairvoyance has value only iI you can make a diIIerent decision aIter you receive the

inIormation. In this case. Paul has no decision to make regarding the coin Ilip. II it lands

'heads¨ he wins $500. II it lands 'tails¨ he wins $100. Thus. the value oI clairvoyance is

equal to $0.

5) Solution: b

I. False. This statement is only guaranteed to be true Ior delta-people.

II. False. The certain equivalent is the amount a decision maker will take Ior

certain in lieu oI an uncertain deal he owns. It only equals the e-value oI the

prospect dollar values iI the decision maker is risk neutral.

III. False. The value oI clairvoyance can never be negative Ior a decision maker

that Iollows the Five Rules oI Actional Thought. You could always choose to

ignore the clairvoyant`s inIormation.

IV. True. Around a cycle oI ownership PISP ÷ PIBP Ior all decision makers.

V. False. See the party problem.

VI. False. PreIerence probability Ior an outcome (which expresses how much we

like it) is unrelated to the assessed probability oI the outcome (which

expresses how likely it is to occur).

VII. True. The uninIormative removal oI an alternative cannot cause a reordering

oI the remaining alternatives. For example. you walk into an ice cream shop

and say: 'I would like a vanilla cone.¨ The shop owner says. 'I am sorry but

we don`t have strawberry.¨ Would you say. 'OK. I`ll have chocolate.¨?

$125 $500

u(x)

'W¨ 'L¨

MS&E 252 Handout #19

Decision Analysis I November 12

th

. 2004

Page 5 oI 10 HW #5 Solutions

6) Solution: b

Since the certain equivalent oI settling (-$33.000) is greater than the certain equivalent oI

going to trial (-$35.750). Ryan should settle.

0.65

-$55.000

Lose

0.35

Win

$0

-$33.000

Goes to trial

Settle

0.4

Settle $30K

-$30.000

Settle $40K

0.5

0.1

-$20.000

-$40.000

-$35.750

Settle $20K

0.65

-$55.000

Lose

0.35

Win

$0

-$33.000

Goes to trial

Settle

0.4

Settle $30K

-$30.000

Settle $40K

0.5

0.1

-$20.000

-$40.000

-$35.750

Settle $20K

7) Solution: b

The most Ryan should pay Ior inIormation on the amount oI the settlement is the value oI

clairvoyance (VOC). Since he is risk-neutral. value oI clairvoyance is equal to value oI

the situation with free clairvoyance minus the value oI the situation with no

clairvoyance (VOC ÷ VFC VNC). From Solution 6 above. we know that VNC ÷ -

$33.000.

To Iind VFC. we roll back the tree below:

MS&E 252 Handout #19

Decision Analysis I November 12

th

. 2004

Page 6 oI 10 HW #5 Solutions

0.65

-$55.000

Lose

0.35

Win

$0

Go to trial

Settle

Settle $40K

-$40.000

-$35.750

0.4

Settle $30K

Settle $40K

0.5

0.1

Settle $20K

Go to trial

Settle

Settle $30K

-$30.000

-$35.750

...

Go to trial

Settle

Settle $20K

-$20.000

-$35.750

...

-$30.000

-$20.000

VFC ÷ -$31.300

~

-$40.000

0.65

-$55.000

Lose

0.35

Win

$0

Go to trial

Settle

Settle $40K

-$40.000

-$35.750

0.4

Settle $30K

Settle $40K

0.5

0.1

Settle $20K

Go to trial

Settle

Settle $30K

-$30.000

-$35.750

...

Go to trial

Settle

Settle $20K

-$20.000

-$35.750

...

-$30.000

-$20.000

VFC ÷ -$31.300

~

-$40.000

ThereIore. VOC ÷ VFC VNC ÷ -$31.300 (-$33.000) ÷ $1.700.

8) Solution: c

We know that r

+n

÷ (r

+m

)

n/m

ThereIore. r

+1

÷ (r

+100

)

1/100

÷ (2)

1/100

The general Iorm Ior a u-curve is u(y) ÷ a ¹ b*(r

+1

)

-y

where y are dollar values.

I. is a valid u-curve.

II. is not a valid u-curve. since it does not take into account the Iact that her risk odds

were assessed Ior +$100.

MS&E 252 Handout #19

Decision Analysis I November 12

th

. 2004

Page 7 oI 10 HW #5 Solutions

III. is a valid u-curve. since (2)

-y

÷ (1/2)

y

. Note that b is iust a scalar. and does not

necessarily have to be 1.

IV. is not a valid u-curve since r ÷ ½ instead oI 2.

9) Solution: c

Since Alicia Iollows the delta property and is indiIIerent between receiving $30 Ior sure

and a deal with .6 chance oI getting $50 and a .4 chance oI getting $10. she is indiIIerent

between receiving $0 (÷30-30) Ior sure and a deal with a .6 chance oI getting $20 (÷50-

30) and a .4 chance oI loosing $20 (-20÷ 10-30).

Let r be the risk-odds Ior Alicia. From the above statement. we know that r ÷ (.6/.4)

1/20

1.02048. We can then set a u-Iunction Ior Alicia. We choose u(x) ÷ 1-r

x

For each prospect. we compute the corresponding u-value using our u-Iunction. Note that

any u-Iunction oI the Iorm u(x) ÷ a ¹ b r

x

works Ior solving the problem. provided that r

is the risk odds computed above.

Note also that we do not take into account the initial $50 spent on the DA Corporation

shares. since it is a sunk cost at the time oI the decision oI interest.

The situation can be represented using the Iollowing decision tree (u-values are in bold

italic blue Iont):

exercise option

0.6 $40.00 (=50-10)

price goes up 50 40 0.56

2 0.555556

0 90

0.84 do not exercise option

$90.00 (=100-10)

Buy option 100 90 0.84

0.838717

-10 63.76036

0.73 exercise option

0.4 $40.00 (=50-10)

price goes down 50 40 0.56

1 0.555556

0 40

1 0.56 do not exercise option

$63.76 $20.00 (=30-10)

0.725 30 20 0.33

0.333333

0.6

price goes up

$100.00

Do not Buy option 100 100 0.87

0.868313

0 59.9254 0.4

0.70 price goes down

$30.00

30 30 0.46

0.455669

Buying the option is the alternative that has the highest u-value. and so Alicia chooses to

buy the option. II the price goes up. she decides not to exercise the option. II the price

goes down. she decides to exercise the option.

The value oI the deal without clairvoyance is:

VNC ÷ u

-1

(.725) ÷ -Log(1-.725)/Log(risk odds) ≈ $63.76

MS&E 252 Handout #19

Decision Analysis I November 12

th

. 2004

Page 8 oI 10 HW #5 Solutions

Note that iI Alicia were risk neutral. she would not buy the option.

10) Solution: b

Alicia Iollows the delta property and so her value oI clairvoyance (VOC) on the Iuture

price oI the stock is the diIIerence between the value oI the deal without clairvoyance

(VNC) and the value oI the deal with Iree clairvoyance (VFC).

With Iree clairvoyance. the situation can be described by the Iollowing decision tree:

Exercise option

$40.00 (=50-10)

Buy option 50.000 40.000

2 0.556

-10.000 90.000

0.600 0.839 Do not exercise option

Price goes up $90.00 (=100-10)

2 100.000 90.000

100.000 0.839

0.868

Do Not buy option

$100.00

100.000 100.000

0.868

$67.06 Exercise option

0.743 $40.00 (=50-10)

Buy option 50.000 40.000

1 0.556

-10.000 40.000

0.400 0.556 Do not exercise option

Price goes down $20.00 (=30-10)

1 30.000 20.000

40.000 0.333

0.556

Do Not buy option

$30.00

30.000 30.000

0.456

We can see that the value oI the deal with Iree clairvoyance is

VFC ÷ u

-1

(.743) ≈ $67.06

So the value oI clairvoyance is: VCO ÷ VFC VNC ≈ $3.30.

Note: iI the clairvoyant tells Alicia that the price is going to go up. Alicia should not buy

the option. II the clairvoyant tells Alicia that the price is going to go down. Alicia should

buy the option.

Quantitative Problems

1) We know that r

÷n

÷ (r

÷m

)

n/m

a) ThereIore r

+50

÷ (r

+100

)

1/2

÷ (2)

1/2

÷ 1.4142 and her risk odds Ior a deal where

she could win or lose $50 are 1.4142:1.

b) Similarly. r

+1000

÷ (r

+100

)

10

÷ (2)

10

÷ 1024

MS&E 252 Handout #19

Decision Analysis I November 12

th

. 2004

Page 9 oI 10 HW #5 Solutions

ThereIore p/(1-p) ÷ 1024. Solving Ior p. we Iind that p ÷ 0.999 which is her preIerence

probability Ior $0 when the best and worst prospect are winning and losing $1000.

2) The general Iorm Ior a u-curve is the Iollowing: u(y) ÷ a ¹ b* (r)

-y

where y are dollar

values.

Using the method described above. we can Iind r easily:

r

÷1

÷ (r

÷1000

)

1/1000

÷ (3)

1/1000

It would be nice to have u(0) ÷ 0. so we Iind the conditions on a and b that will make this

true:

u(0) ÷ a + b ` (r)

-0

÷ a + b ÷ 0

a ÷ -b

In order to have increasing u-values with increasing dollar values. we should choose b to

be negative Ior a risk averse person. To make it easy. we can choose b to be 1.

ThereIore. an equation that describes Joe`s u-Iunction is the Iollowing:

u(y) ÷ 1 - (3)

-y/1000

Note that there are other equations that could represent Joe`s u-Iunction had we chosen a

and b to be diIIerent. However. the above equation is thought by some to be more

intuitive`.

3)

a) The u-value Ior the preIerred alternative is 9 as shown below.

b) and c) We want to Iind some Iunction v(x) where v(-30) ÷ 0 and v(75) ÷ 1. First.

let`s transIorm the u-values so that v(-30) ÷ 0. We know that:

u(-30) ÷ 0.2`(-30) + 5 ÷ -1

This tells us that our new Iunction will be oI the Iorm v(x) ÷ u(x) +1 so that:

v(-30) ÷ (0.2`(-30) + 5) + 1 ÷ -1 + 1 ÷ 0

$ /5

$ 20

0.3

$ 60

- $ 30

A

B

0.2

0.5

20

1/

-1

9

8.9

9

MS&E 252 Handout #19

Decision Analysis I November 12

th

. 2004

Page 10 oI 10 HW #5 Solutions

Now let`s transIorm the u-values so that the highest dollar value has a value oI 1. We

know that:

u(75) ÷ 0.2`75 + 5 ÷ 20

so that our new Iunction v(x)gives us: v(75) ÷ u(75) + 1 ÷ 20 + 1 ÷ 21. So to make this

equal to 1. we need to divide the v-Iunction by 21. This gives us our Iinal Iunction in the

Iorm:

v(u) ÷ (u(x) +1)/21 ÷ (0.2`x + 5 + 1)/21 ÷ (0.2`x + 6)/21

v(x) ÷ (21`x - 6)/0.2 ÷ 105`x - 30

4) I is true. Since there are only two prospects Ior each deal and they are exactly the

same. Brad will always preIer the deal with the highest probability oI the best

prospect.

II is Ialse. This statement does not Iollow the Delta property. The Iollowing deal

does not have a certain equivalent equal to that oI deal Y. given that he is a "delta-

person".

III is Ialse. We cannot make this statement since we do not know his risk attitude Ior

this range oI prospects. There are some u-curves Ior those ranges where Brad could

preIer Deal Z to Deal W Ior some values oI p. where p~r. Try a risk neutral Brad

with p ÷ 0.6 and r ÷ 0.59.

$ 110

$ 0

CE (deal W) + $ 10 ~

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