MS&E 252 Handout #15

Decision Analysis I November 4
th
. 2004

Page 1 oI 6 HW #5
Homework Assignment #5
Due on Thursday November 11
th
. 11:59 pm


In this assignment you are required to turn in the probabilistic section only. Again the
"Food Ior thought" section is optional but will help you think in depth about the concepts
covered and will help with your grade on participation. As mentioned in the course guide.
we will expect Iull knowledge oI all sections on this assignment.

Assigned Reading
1) 'The Foundation oI Decision Analysis¨ Chapter 4

Distinctions
From the class lectures. explain the Iollowing concepts:
• Risk attitude
• Risk neutral
• Risk averse
• Risk preIerring
• Risk odds
• Risk tolerance
• Risk aversion
• Delta property
• Value oI clairvoyance
• Value with Iree clairvoyance


Probabilistic questions
Jimmy is a huge baseball Ian. and no sooner had the Red Sox broken the Curse oI the
Bambino and won the 2004 World Series than he decided to travel to Las Vegas to bet on
the next Series.
For $100. he bought a certiIicate Irom a casino. which allows him to stake that $100 on
whether the Red Sox will win the 2005 Series. The casino is oIIering Iour-to-one odds Ior
the Red Sox not to win a second time consecutively. That is. iI Jimmy declares that the
Red Sox will win. he will receive $500 iI he is correct. and iI he declares that they will
not win. he will receive $125 iI he is correct. In either case. iI he is incorrect. he gets
nothing.
Assume that to Jimmy. any dollar amount one year Irom now is worth as much as any
dollar amount today. Use this situation to answer the Iollowing three questions:

MS&E 252 Handout #15
Decision Analysis I November 4
th
. 2004

Page 2 oI 6 HW #5
1) Suppose that Jimmy thinks that the Red Sox have a 40° chance oI winning the 2005
Series. and that the clairvoyant comes to Jimmy and oIIers to tell him who is going to
win. Ior a Iee. Assuming that Jimmy is risk neutral. in what range does his Value oI
InIormation lie with respect to the deal he Iaces?

a) Greater than or equal to $0. but strictly less than $50
b) Greater than or equal to $50. but strictly less than $100
c) Greater than or equal to $100. but strictly less than $150
d) Greater than or equal to $150.

2) Now suppose Jimmy thinks that the Red Sox do have a Iour-to-one chance oI losing
their title next year; that is. he agrees with the casino`s assessment oI the odds. and
believes that there is a 0.8 chance that the Red Sox will lose next year. UnIortunately
you do not know whether Jimmy Iollows the delta property. and you don`t even know
what his initial wealth is you iust know that he Iollows the Five Rules oI Actional
Thought. and preIers more money to less.
What should Jimmy bet on?

a) There is not enough inIormation to answer this question.
b) He should bet on the Red Sox winning iI he is risk averse. on their losing iI he
is risk-preIerring
c) He should bet on the Red Sox losing iI he is risk averse. on their winning iI he
is risk-preIerring
d) No matter what his risk attitude is. he should be indiIIerent between the two
alternatives

3) Going back to the case in which Jimmy Iollows the delta property how many oI the
Iollowing could possibly change his choice oI a best alternative?

I. His u-values Ior all prospects get divided by 2.
II. He reads in the newspaper that the World Series might be open to more
teams in 2005 than in 2004. and speciIically to the top Japanese teams.
III. BeIore making up his mind on what to bet on. he loses $1.000 at the roulette
table.
IV. He learns that no matter what he bets on. he will be charged a $2 processing
Iee Ior placing his bet.

a) 0
b) 1
c) 2
d) 3 or 4

4) Assume that Paul does not Iollow the delta property. He has iust paid $150 Ior a
certiIicate that allows him to Ilip a coin Ior which he believes that it is equally likely
MS&E 252 Handout #15
Decision Analysis I November 4
th
. 2004

Page 3 oI 6 HW #5
to land 'heads¨ or 'tails¨ (both equal 0.5). II the coin lands 'heads¨ he will win $500.
II it lands 'tails¨ he will win $100. His PISP Ior the certiIicate is $225.

The clairvoyant oIIers to tell him the outcome oI the impending coin toss. What is
Paul`s PIBP Ior the clairvoyant`s inIormation?

a) Less than or equal to $50
b) More than $50 but less than or equal to $100
c) More than $100
d) Need Paul`s u-curve to determine his PIBP Ior the inIormation

5) Consider the Iollowing seven statements:

I. The value oI clairvoyance is always equal to the diIIerence between the
certain equivalent oI a deal with Iree clairvoyance and the certain equivalent
oI that deal without the clairvoyance.
II. The certain equivalent oI a deal is deIined as the e-value oI the dollar values
oI the prospects in the deal.
III. The value oI clairvoyance on an uncertainty may be positive. negative. or
equal to zero.
IV. Around a cycle oI ownership. the PIBP and the PISP Ior an obiect are the
same Ior a person who does not Iollow the delta property.
V. It is necessary to have a monetary value measure to calculate the best
decision.
VI. A person`s preIerence probability Ior a given outcome will always be greater
than her assessed probability Ior the outcome.
VII. The uninIormative removal oI an alternative Irom the set oI alternatives
under consideration cannot cause reordering oI preIerences Ior the remaining
alternatives.

For somebody who Iollows the Five Rules oI Actional Thought. how many oI the above
statements are always true?

a) 0 or 1
b) 2 or 3
c) 4 or 5
d) 6 or 7

6) Ryan is the CEO oI McBurger. a relatively inexpensive Iast-Iood chain. Rai. a
consumer. is suing McBurger Ior damages because he became sick aIter eating a meal
there. Ryan consults his lawyer Ior guidance and signs a Iixed Iee contract to pay
$5.000 Ior his services. II Ryan chooses to go to trial. he believes he has a 0.65
chance oI losing. thus paying $50.000 plus $5.000 oI Rai`s lawyer Iees. II he wins the
trial. he pays nothing. Ryan can also choose to settle with Rai and believes that he has
MS&E 252 Handout #15
Decision Analysis I November 4
th
. 2004

Page 4 oI 6 HW #5
a 0.4 chance oI paying $40.000. a 0.5 chance oI paying $30.000. and a 0.1 chance oI
paying $20.000.
Assuming that Ryan is risk-neutral. what should he do?
a) Go to trial.
b) Settle.
c) It does not matter which one he chooses (i.e. he should be indiIIerent).
d) There is not enough inIormation to decide.

7) Suppose that a company. Greedy Associates. can compile data on past settlement
results in similar cases and inIorm Ryan oI the amount that Rai will accept iI they
decide to settle. What amount c is the most he should be willing to pay Ior this
inIormation?

a) $0 < c < $1.000
b) $1.000 · c < $2.000
c) $2.000 · c < $3.000
d) c ~ $3.000

8) Kate preIers more money to less. and she Iollows the Five Rules oI Actional Thought
and the delta property. II her risk odds Ior +$100 are 2:1. how many oI the Iollowing
are NOT valid u-curve Iunctions?

I. u(y) ÷ 1 (2)
-y/100

II. u(y) ÷ 1 (2)
-y

III. u(y) ÷ 100*(1/2)
y/100

IV. u(y) ÷ 1 (1/2)
-y/100


a) 0
b) 1
c) 2
d) 3 or 4

9) Alicia has iust bought a single share oI stock Irom DA Corporation Ior $50. and she is
considering buying a put option Ior the stock. which would cost her an additional $10.
A put option would allow her to sell the stock one year Irom now at the current price
oI $50. II she does not buy the option. then she would sell the share one year Irom
now at its market price. Alicia believes that the price oI the share will go up to $100
with a probability oI 0.6 and go down to $30 with a probability oI 0.4. Alicia Iollows
the Five Rules oI Actional Thought and preIers more money to less. She Iollows the
delta property Ior prospects up to $200 and she is indiIIerent between receiving $30
Ior sure and a deal with a .6 chance oI getting $50 and a .4 chance oI getting $10.

MS&E 252 Handout #15
Decision Analysis I November 4
th
. 2004

Page 5 oI 6 HW #5
What should Alicia do? (Do not worry about discounting Ior time.)

a) Not buy the option. which means that she will sell it in one year at market
price.
b) Buy the option and use the option only iI the market price goes up to $100.
c) Buy the option and use the option only iI the market price goes down to $30.
d) Buy the option and use it in either case.

10) This question uses the inIormation given in the previous question. Which oI the
Iollowing statements about Alicia`s value oI clairvoyance (VOC) on the Iuture price
oI the share beIore she decides to buy the put option MUST be true?

a) VOC ÷ $0
b) $0 · VOC ≤ $5
c) $5 · VOC ≤ $15
d) $15 · VOC


Quantitative Problems:

1) Risk odds: Wendy adheres to the delta property and has risk odds oI 2:1 Ior a deal
where she could win or lose $100.
a. What are her risk odds Ior a deal where she could win or lose $50?
b. What is her preIerence probability Ior $0 when the best and worst prospects are
winning and losing $1.000?

2) Joe Iollows the rules oI actional thought and the delta property. and has 3:1 risk odds
Ior +$1.000. Give an equation that could describe Joe`s u-Iunction.

3) Consider the Iollowing decision:






a. Using the u-Iunction u(x)÷0.2x¹5. what is the u-value oI the preIerred alternative
Ior the above decision?
b. TransIorm the u-values Ior the dollar amounts in the above problem so that the
highest dollar amount has a transIormed u-value oI 1 and the lowest dollar amount
has a transIormed u-value oI 0. (Hint: Iirst perIorm an additive operation to get a
transIormed u-value oI 0 Ior the lowest dollar amount.)
c. PerIorm the transIormation Irom Part (b) on the u-Iunction given in Part (a) to get
its transIormed u-Iunction v(x).
$20
A
B
$60
–$30 .5
.3
$75
.2
MS&E 252 Handout #15
Decision Analysis I November 4
th
. 2004

Page 6 oI 6 HW #5

4) Suppose Brad Iollows The Five Rules oI Actional Thought and preIers more money
to less. Suppose 0·p·1. 0·q·1. and 0·r·1. Consider Deals W. X. Y. and Z below.









Consider the Iollowing three statements:
I. II p~q. then Brad preIers Deal W to Deal X.
II. II Brad is a 'delta-person¨. his certain equivalent Ior Deal Y is $10 more than
his certain equivalent Ior Deal W.
III. II p~r. then Brad preIers Deal W to Deal Z.

Which oI the above statements is/are true?


Iood for thought (optional)
1) Select three items in your liIe or that you are Iamiliar with and rank them as ProIessor
Howard showed us in lecture. Using the equivalence rule. come up with preIerence
probabilities Ior each oI the items.



$100
– $10
p
1 – p
Deal W
$100
– $10
q
1 – q
Deal X
$110
– $20
p
1 – p
Deal Y
$100
$10
r
1 – r
Deal Z

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