Professional Documents
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Accepting or rejecting a proposal or project Selecting from a set of non-mutually exclusive alternatives Selecting the best decision from a set of mutually exclusive alternatives Choosing a best decision strategy when a sequence of choices and chances events may occur
Potential alternative decisions Factory locations Products to introduce Investments Criteria by which to evaluate decisions Net profit Cost Environmental impact
(1 i )
Internal rate of return (IRR) IRR is the discount rate that makes the total present value of all cash flows zero: n F
(1 IRR )
t t 0
Example
Cost/benefit ratios
Example
Scoring model - a quantitative assessment of a decision alternatives value based on a set of attributes.
Identify decision alternatives Identify possible outcomes or chance events Evaluate the payoff associated with each alternative and outcome (payoff table)
Market rises $600 $200 Market falls -$1500 -$500 $300 Market stable $0 $200 $100
Decision/Event
Risk
Decision/Event
Aggressive fund
Balanced fund Bond fund
$1000
$600 $200
-$1500
-$500 $300
$0
$200 $100
Little risk
Highest risk
Decision Strategies
Average Payoff
Decision/Event
Aggressive fund
Balanced fund
Bond fund
$600
$200
-$500
$300
$200
$100
$100
$200
Aggressive Strategy
Decision/Event Market rises
Aggressive fund
$1000
Balanced fund
Bond fund
$600
$200
-$500
$300
$200
$100
$600
$300
Conservative Strategy
Decision/Event Market rises
Aggressive fund
$1000
Balanced fund
Bond fund
$600
$200
-$500
$300
$200
$100
-$500
$100
Opportunity Loss
Decision/ Event
Market stable
$0 $200
Aggressive fund
$1000 $0
-$1500 $1800
Balanced fund
Bond fund
$600 $400
$200 $800
-$500 $800
$300 $0
$200 $0
$100 $100
$800
$800
Understanding Risk
Decision/Eve nt
Aggressive fund
Balanced fund Bond fund
$1000
$600 $200
-$1500
-$500 $300
$0
$200 $100
-$166.67
$100 $200
Less variation
More variation
Measuring Risk
Standard deviation Measures variation, but does not account for magnitude of return or loss Return to risk the ratio of mean return to the standard deviation Similar to the Sharpe ratio in finance
Project A: 7.80
Project B: 5.656
Average payoff strategy is appropriate for repeated decisions Real estate development Day trading Pharmaceutical research
where P(Sj) = the probability that event Sj occurs and n = the number of events.
Example
EVPI
Expected opportunity loss - the average additional amount the investor would have achieved by making the right decision instead of a wrong one Expected value of perfect information (EVPI) - the maximum improvement in the expected return that can be achieved if the decision maker is able to acquirebefore making a decisionperfect information about the future event that will take place.
Example
EVPI = expected value of perfect information = minimum expected opportunity loss = 360. That is, by having perfect information, we can increase our expected return by at most $360
Portfolio - a collection of assets, such as stocks, bonds, or other investments, that are managed as a group. Objective: maximize expected return while minimizing risk Expected return = wE[X] + (1-w)E[Y] w = fraction of portfolio for asset X 1 w = fraction of portfolio for asset Y Standard deviation
P w (1 w) 2w(1 w) XY
2 2 X 2 2 Y
Single period purchase decision Purchase goods for $c Sell goods for $r Unsold goods sold for $s d = Demand during period x = number purchased How many goods should be purchased to maximize the expected profit?
General Model
If y = f(x) represents a generic decision model, then E[y] is not necessarily equal to f(E[x]). In other words, you cannot use the average value of an input in a model to determine the expected output.
Decision Trees
Decision trees model a sequence of decisions and chance events. Nodes points in time at which events take place Decision (choice) nodes Event (chance) node Branches choices or outcomes A decision strategy is a specification of an initial decision and subsequent decisions that are contingent on the occurrence of events. A decision strategy has an associated payoff distribution, called a risk profile, that shows possible payoffs and their probabilities.
Utility theory an approach or assessing risk attitudes quantitatively by quantifying a decision makers relative preferences for particular outcomes.
Example
Decision/Event Bank CD Bond fund Rates rise $400 -$500 Rates stable $400 $840 Rates fall $400 $1000
Stock fund
-$900
$600
$1700
Using expected values, the stock fund is best, but this does not account for risk. Convert monetary payoffs into utility measures.
Process
Rank payoffs from highest to lowest For each payoff x, Suppose you have the opportunity of achieving a guaranteed return of x, or taking a chance of receiving $1,700 (the highest payoff) with probability p or losing $900 (the lowest payoff) with probability 1 - p. What value of p (the utility) would make you indifferent to these two choices?
On the basis of expected utility, the Bank CD is now the best decision.
Finding R
Find the maximum payoff $P for which the decision maker is willing to take an equal chance on winning $P or losing $P/2. This is the value of R.
Example
Suppose R = 400