MS&E 252 Handout #19

Decision Analysis I November 12
th
. 2004

Page 1 oI 10 HW #5 Solutions
Homework Assignment #5 Solutions

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Question 2
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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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