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MS&E 252
Decision Analysis I
Problem Session 5
What concepts do we expect you to master?
· UCurves
· When do we need them?
· How do we assess them?
· How do we use them?
· Solving problems using
a ucurve
· PIBP and PISP
revisited
· Delta property
· Delta people
· Risk aversion
2
How much do you value a deal?
· When there is no uncertainty. we do not need uvalues
at all...
· . But people place diIIerent values on uncertain
deals.
· People react diIIerently due to many Iactors:
their taste Ior risk
their wealth state
When we study risk preIerence.
we study Ucurves.
'A persons risk preference (or risk attitude)
describes the relation between an uncertain deal and
that persons PISP and PIBP for the deal.`
TradeoII between greed and Iear
$150.000
$75.000
0.5
~
?
Greed
Fear
3
Why do we need Ucurves?
· Ucurves are a good means Ior us to assess the
values people place on uncertain deals.
· Types oI risk preIerence:
riskaverse riskneutral riskseeking
Using Ucurves
How do we 'roll back¨ a tree?
.4*.95·.6*.32
Uncertainties:
Take evalue of uvalues
÷ 0.63
Decisions:
Pick best uvalue
÷ 0.57
Max(.4. .57. .63)
0.4
0.6
S
R
0.95
0.32
u
O
I
0.40
0.63
0.57
P
u
4
Using Ucurves Finding a Certain
Equivalent graphically.
Example 
Finding the CE oI a deal with 50° chance oI $80
and 50° chance oI $10.
$100 $0 $80 $10
u($10)
u($80)
.5u($80)¹.5u($10)
÷ u(CE)
CE
Using Ucurves Why is it important?
· Can also be used to determine the
Value oI Clairvoyance (iterative
construction).
· Reminds you that you should
calculate the evalue oI the uvalues.
not the evalue of the dollar
amounts placed on the prospects.
'When faced with a decision tree. unless the decision maker
is riskneutral. alwavs remember to go to uspace. then take
the evalue. then go back to $space.`
5
What concepts do we expect you to master?
· UCurves
· When do we need them?
· How do we assess them?
· How do we use them?
· Solving problems using
a ucurve
· PIBP and PISP
revisited
· Delta property
· Delta people
· Risk aversion
Let us show how we use
uvalues and ucurves in an example!
· DA Corp. would like to invest in research on a new drug. 'Clear Voyance.¨
'Clear Voyance¨ would instantly and painlessly cure any eyesight problem.
"What should DA Corp. do?"
· DA Corp. presently has cash and assets worth $49
million in total; investing in research on 'Clear
Voyance¨ is estimated to cost $13 million.
· They estimate that iI they decide to invest in research.
technical success will only be 20° likely. However.
once they have technical success. they have a 90°
chance oI marketing success.
· Total success would bring $72 million proIit.
Marketing Iailure or technical Iailure will lead to $0
proIit.
· DA Corp.`s ucurve is given by u(x) ÷ \x. with x their total wealth.
6
First step Set up the decision tree!
DA Corp. needs to make a decision without knowing about
technical success and marketing success.
0.9
Marketing Success
0.2 $121
Technical Success
10.5 0.1
No Marketing Success
Invest $36
6.9
0.8
No Technical Success
2 $36
7
$49
Don't Invest
$49
$ M
Second step Go to uspace
Uvalues
11
6
6
7
Forget about the dollar values for now.
0.9
Marketing Success
0.2 $121
Technical Success
10.5 0.1
No Marketing Success
Invest $36
6.9
0.8
No Technical Success
2 $36
7
$49
Don't Invest
$49
$ M
7
Third step Roll back the tree
0.9
Marketing Success
0.2 $121
Technical Success
10.5 0.1
No Marketing Success
Invest $36
6.9
0.8
No Technical Success
2 $36
7
$49
Don't Invest
$49
Uvalues
11
6
6
7
10.5
6.9
7
Uncertaintv nodes take the evalue of the uvalues,
Decision nodes take the max of the uvalues.
$ M
Last step Go back to $space!
0.9
Marketing Success
0.2 $121
Technical Success
10.5 0.1
No Marketing Success
Invest $36
6.9
0.8
No Technical Success
2 $36
7
$49
Don't Invest
$49
Uvalues
11
6
6
7
10.5
6.9
7
CE ÷ $49M
Who reallv cares about Uvalues?
$ M
8
More questions on
'Clear Voyance¨ example
· Now. suppose that DA Corp. can
proceed to preliminary tests that
would give them a better sense oI
how likely technical success is.
What is the most thev should be willing to
spend on these tests?
Decision tree to compute
the Value oI Clairvoyance
And what about JoC on both Technical Success AND Marketing Success?
You would go through
the same steps as
beIore. iteratively Ior
diIIerent values oI x.
The x that gives you a
certain equivalent oI
$49M is the value oI
clairvoyance.
$ M
0.9
Marketing Success
$121  x
Invest
0.1
0.2 No Marketing Success
"Technical Success" $36  x
1
Don't Invest
$49  x
0
$36  x
Invest
0.8
"No Technical Success" $36  x
1
Don't Invest
$49  x
9
What concepts do we expect you to master?
· UCurves
· When do we need them?
· How do we assess them?
· How do we use them?
· Solving problems using
a ucurve
· PIBP and PISP
revisited
· Delta property
· Delta people
· Risk aversion
How do you Iind your PISP
Ior an uncertain deal?
~
Me
¹ s
Me
¹ Deal
~
s ¹ w
x
1
¹ w
p
1
p
2
p
3
x
2
¹ w
x
3
¹ w
÷
u (s + w) _ p
i
u (x
i
+ w)
PISP ÷ s
10
How do we Iind your PIBP
Ior an uncertain deal?
~
Me
Me ¹ Deal
 b
~
w
x
1
¹ w  b
p
1
p
2
p
3
x
2
¹ w  b
x
3
¹ w  b
÷
u (w) _ p
i
u (x
i
+ w  b)
PIBP ÷ b
Example:
Buying and selling a certiIicate.
50
2 1 ) (
x
x u
−
− =
75 . 20 $ ) 25 . 0 (
25 . 0 ) (
) 5 . 0 ( 5 . 0 ) (
) 0 ( 5 . 0 ) 50 ( 5 . 0 ) (
1
= =
=
=
+ =
−
u s
s u
s u
u u s u
) 2 1 ( 5 . 0 ) 2 1 ( 5 . 0 0
) ( 5 . 0 ) 50 ( 5 . 0 ) 0 (
50
0
50
50 b b
b u b u u
−
−
−
−
− + − =
− + − =
$50
$0
0.5
~
s
Selling
$50  b
$0  b
0.5
~
$0
Buying
In this case, s ¬ b. But does this alwavs hold?
11
What concepts do we expect you to master?
· UCurves
· When do we need them?
· How do we assess them?
· How do we use them?
· Solving problems using
a ucurve
· PIBP and PISP
revisited
· Delta property
· Delta people
· Risk aversion
What does it mean
to Iollow the deltaproperty?
~
x
1
p
1
p
2
p
3
x
2
x
3
x
~
~
p
1
p
2
p
3
x
1
¹ ∆
x
2
¹ ∆
x
3
¹ ∆
?
Do vou want to follow this rule?
We will add an amount ∆ to all possible outcomes.
What happens to vour PISP?
Q
A
If vou are a ∆person.
then vour PISP should go up bv ∆'
12
Let us examine this in two examples.
~
$100
.5
.5
$0
$45
~
$200
.5
.5
$100
$145
In some cases. vou naturallv want to follow the delta propertv.
Let us examine this in two examples.
~
$100
.5
.5
$0
$45
. but in other cases. it is far from being obvious'
~
$0
.5
.5
$ 100
$ 55?
13
II you choose to Iollow this property. some
other nice properties will Iollow.
· For a deltaperson. PIBP oI a deal ÷
PISP oI that deal.
· Much easier to calculate the value
oI clairvoyance: VOC÷VFCVNC.
· We can characterize your ucurve
by asking a single question.
· Exponential Ucurve.
· CE does not depend on initial
wealth or on other existing deals.
∆ ∆∆ ∆
∆ ∆∆ ∆
1) When you satisIy the deltaproperty. your
PISP÷PIBP Ior any monetary deal.
~
b
x
1
p
1
p
2
p
3
x
2
x
3
By deltaproperty.
~Add b to both sides¨
Compare:
s ÷ b
~
s
x
1
p
1
p
2
p
3
x
2
x
3
PISP
~
0
x
1
 b
p
1
p
2
p
3
x
2
 b
x
3
 b
PIBP
14
What types oI ucurves satisIy
the deltaproperty?
¯
∆ + = ∆ +
i
i i
x u p x u ) ( )
~
(
Note that this is the same as the Iollowing tree:
~
p
1
p
2
p
3
x
1
¹ ∆
x
2
¹ ∆
x
3
¹ ∆
∆ + x
~
The ufunction must satisfv the following equation.
What types oI ucurves satisIy
the deltaproperty?
Onlv two tvpes of ufunctions satisfv the deltapropertv:
* The proof is in the manuscript.
rho x x
ge f bc a x u
/
) (
−
+ = + = Exponential
bx a x u + = ) ( Linear
15
2) Deltapeople can easily calculate their
VOC.
· To calculate VOC.
· calculate CE without clairvoyance.
· calculate CE with free clairvoyance.
· take the diIIerence:
VOC ÷ VFC  VNC.
· We used this procedure with Jane; now we
can use it Ior Kim as well.
· Both Kim and Jane are deltapeople. so we
can Iind their VOC easily.
3) A deltaperson`s ucurve can be
characterized by a single number.
We can assess a deltaperson`s ucurve
by asking a single question.
This means we need not ask the
multitude oI questions we asked Kim.
Jane. and Mary. We iust need the risk
odds or the risk tolerance.
You can assess a ucurve without
having a particular problem in Iront oI
you.
16
Why are risk odds important?
Recall that delta people must have a linear (risk
neutral) or exponential ucurve.
· Risk neutral:
· Otherwise:
x x u = ) (
x x
r x u br a x u
− −
+ = ¬ + = 1 ) ( ) (
So. if we know r. we know their ucurve.
How do we Iind risk odds?
Definition:
p
1  p
$1
$1
~ $0
II
then
p
p
r
−
=
1
We can also prove:
p
1  p
$m
$m
~ $0
II
then
m
m
p
p
r
p
p
r
1
1 1


.

\

−
= ¬
−
=
17
Determining Risk Odds r
DeIinition:
p
p
rx
−
=
1
Risk Attitude Relations
r ÷ 1 Risk Neutral
r ~ 1 Risk Averse
r · 1 Risk Seeking
x
x
p
1p
0 ~
r
m
= r
n
m
n Property:
ThereIore. iI we know a person`s riskodds. we
have characterized their entire ucurve!
What is the decision makers ucurve?
and that the decision maker Iollows the deltaproperty.
0.7
0.3
$2M
$0
~ $1M
Suppose that we are given:
18
ThereIore. iI we know a person`s riskodds. we
have characterized their entire ucurve!
3 .
7 .
1 = M r
0.7
0.3
$2M
$0
~ $1M
0.7
0.3
$1M
$ 1M
~ $0
A property
000 . 000 . 1
1
3 .
7 .

.

\

= r ThereIore And
This is enough to determine the entire ucurve.
Now we know several things about a
Delta person`s ucurve.
· We know which uIunctions satisIy the delta
property.
· We know how to recognize risk attitude Irom
risk odds.
· We know how to assess someone`s whole u
curve through their risk odds.
. But how do we go back to $values once we have the
uvalue of the Certain Equivalent?
· We know how to roll back a tree to determine
the uvalue Ior an uncertain deal.
19
Inversion oI ucurve
Generic exponential ucurve:
u(x) = a + b ⋅ r
−x
ln
u(x) − a
b
= ln r
−x
[ ]
x =
−1
ln(r)
⋅ ln
u(x) − a
b
Case Study Announcements
· Case study reading Irom Yvonne. assignment
available on web
· Group assignments
· Short meeting with TA on Friday. Nov 19
th
· Due date: Thursday. Dec 2
nd
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