Risk Analysis

Rules to select the best possible

alternative
• Which of the alternative is least preferred (inferior as compared to all
other alternatives) The least preferred alternatives is said to be
dominated

• The minimum aspiration level set by the company

• Expected Values (By taking into account the probabilities)

• Alternatives having maximum probability

 Contract A Contract B Contract C
0.3 0.2 0.5
Alternative 1 5 5 20
Alternative 2 -10 8 25
Alternative 3 0 10 24
Alternative 4 5 15 10
Alternative 5 -15 5 8
1st Rule (Dominance Rule)
• Which of the alternative is least preferred (inferior as compared to all
other alternatives) The least preferred alternatives is said to be
dominated

• Alternative 5 is removed for consideration

Red means Rejected
Green means selected
Contract A Contract B Contract C
0.3 0.2 0.5
Alternative 1 5 5 20
Alternative 2 -10 8 25
Alternative 3 0 10 24
Alternative 4 5 15 10
Alternative 5 -15 5 8
2nd Rules Aspiration Level
• Suppose a company has set aspiration of
• Minimum profit of 20 Lacs
• Maximum Loss of 5 Lac

• Alternative 1 and 3 are possible criterions to be selected

Red means Rejected
Green means selected
Contract A Contract B Contract C
0.3 0.2 0.5
Alternative 1 5 5 20
Alternative 2 -10 8 25
Alternative 3 0 10 24
Alternative 4 5 15 10
Alternative 5 -15 5 8
Rule 3 Expected Values
Expected Values Rs Lacs

Alternative 1 0.3(5) + 0.2(5) +0.5(20) 12.5

Alternative 2 0.3(-10) + 0.2(8) + 0.5 (25) 11.1

Alternative 3 0.3(0) + 0.2(10) +0.5(24) 14

Alternative 4 0.3(5) + 0.2(15) +0.5(10) 9.5

Rule 4 Maximum Probable Criteria
Contract A Contract B Contract C
0.3 0.2 0.5
Alternative 1 5 5 20
Alternative 2 -10 8 25
Alternative 3 0 10 24
Alternative 4 5 15 10
Alternative 5 -15 5 8
• Aspiration Set : A1 and A3

• Expected Values : A3

• Maximum probable Criterion : A2

Decision under uncertainty (When
probabilities are not mentioned)
• Laplace Criterion
• Maximin and Maximax
• Hurwitz Criterion

• In Laplace Criterion
• Equal Probabilities are given to each alternatives and contracts
Laplace Criterion
Expected Values Rs Lacs

Alternative 1 (5+5+20)/3 10

Alternative 2 (-10+8+25)/3 7.66

Alternative 3 (0+10+24) 11.33

Alternative 4 (5+10+15)/3 10
Maximin and Maximax Criterion
• Maximim (Pessimistic View)

• Maximax (Optimistic View)

Maximim (Pessimistic View)

Alternatives Maximin Values

A1 5

A2 -10

A3 0

A4 5
Maximax (Optimistic View)

Alternatives Maximax Value

A1 20

A2 25

A3 24

A4 15
Hurwicz Criterion

α is the index/degree of optimism

α (Max Eij) + (1- α) (Min Eij)
Evaluation Using Expected Values
Expected Value Decision Making Under
Risk
Example: A flood damage in a certain area can destroy crop
Proposal: An embankment should be built
Later the dam is built
History of last 50 years is shown
Level of Water No of years the water level was above Loss of Water level Cost of Initial
cm normal Lacs Investment of
Out of 50 yrs Probability making
Embankment
0 15 0.30 0 0
20 12 0.24 6 20
40 10 0.20 9 30
60 8 0.16 12 50
80 3 0.06 15 65
100 2 0.04 20 80
Study to be done for 15 years
Interest rate = 12 %

Suggest what should be the height of embankment to be built?

Expected Value Decision Making

0 cm Embankment Height
• Initial Investment = 0

• Cost incurred due to flood = 0.24(6) +0.20(9) + 0.16(12) + 0.06(15) +

0.04 (20) = 1.44+1.8+1.92+0.9+0.8
= 6.86

• Total Cost = 6.86 + 0 = 6.86

20 cm Embankment Height
• Initial Investment = 20 (A/P,i,n)

= 20(A/P,12,15)
= 2.94 Lacs

Cost Incurred due to flood = 0.20(6) + 0.16 (9) + 0.06(12) + 0.04 (15)
= 1.2 + 1.44 + 0.72 + 0.6
= 3.96
Total Cost = 6. 9
40 cm Embankment Height
• Initial Investment = 30 (A/P,i,n)

= 30(A/P,12,15)
= 4.41 Lacs

Cost Incurred due to flood = 0.16(6) + 0.06 (9) + 0.04(12)

= 1.98 Lacs
Total Cost = 6.39
60 cm Embankment Height
• Initial Investment = 50 (A/P,i,n)

= 50(A/P,12,15)
= 7.35 Lacs

Cost Incurred due to flood = 0.06(6) + 0.04 (9)

= 0.72 Lacs
Total Cost = 8.07 Lacs
80 cm Embankment Height
• Initial Investment = 65(A/P,i,n)

= 65(A/P,12,15)
= 9.55 Lacs

Cost Incurred due to flood = 0.04(6)

= 0.24 Lacs
Total Cost = 9.79Lacs
100 cm Embankment Height
• Initial Investment = 80(A/P,i,n)

= 80(A/P,12,15)
= 11.76 Lacs

Cost Incurred due to flood = 0

Total Cost = 11.76 Lacs

 Embankment Height Cost
0 6.86
20 6.9
40 6.39
60 8.07
80 9.79
100 11.76

Maximum Loss at 100 cm Embankment Height

Minimum Loss is at 40 cm Embankment Height

Evaluation Using Expected Variance
Expected Value (Mean Value) Expected Variance (Variance)

P1 = 54 P1 = 819

P2 = 52.5 P2 = 596.25

P3 = 54 P3 = 369
Monte Carlo Technique
• Monte Carlo sampling is a simulation method in which a random
sample of outcomes is generated for a specified probability
distribution.

• We use random numbers which follow probability distribution.

• Cases: Elements and Uncertainty are larger in number

Time (years) Probability (Percent) Random Numbers
1 20 00-19
2 30 20-49
3 20 50-69
4 30 70-99

PW Probability (Percent) Random Numbers

40000 60 00-59
70000 40 60-99
• Now generate uniformly distributed random numbers on a excel
sheet
• For Example
Random numbers

17 = year 1

82

49

32
Expected Value (Mean Value)
Alternative 1 = 18
Alternative 2 = 23
Alternative 3 = 16
Alternative 4 = 18
Expected Variance (Variance)
Alternative 1 = 996
Alternative 2 = 731
Alternative 3 = 2224
Alternative 4 = 676
 Laplace Maximin Maximax Hurwicz
Rule

Alternative 70 50 80 68
1

Alternative 50 20 70 50
2

Alternative 60 30 90 66
3