Uncertainly Analysis and its Application

By1) Nitin Kumar Bharti 2) Abhishek Bupkya 3) Prateek Garodia 4) Aditi Gupta 5) Uday Kiran Reddy

Structure

Defining Uncertainty Thorough discussion of Paper Conditional Investment tool : Option Trading Multiple stock investment Greenhouse Inventory

Introduction

The denition of uncertainty as the lack of surety or certainty is readily dened in a statistical or probabilistic context as the implication that uncertainty exists when the probability of an event occurring is not zero or one.

Uncertainty analysis - part of risk assessment that focuses on the

identification of uncertainties in the assessment.

The analysis may be qualitative or quantitative, depending on the level of resolution required and the amount of information available.

Important components:
Qualitative analysis that identies the uncertainties ,quantitative analysis of the effects of the uncertainties on the decision process, and communication of the uncertainty.

The analysis of the uncertainty depends on the situation.

Application of uncertainty analysis in various fields may it be environment risk assessment or financial risk modeling : have analogous principle

To a large extent, the analysis of uncertainty is based on statistics and statistical thinking.

The general model that forms the basis of statistical modeling is the model that posses that measurements may be interpreted as adding together a deterministic part with a random component: response = deterministic model +error

Measuring Uncertainties

In statistical analysis, measurement of uncertainty is based on measures of the distribution that describes the uncertainty. The most common measure of uncertainty is variance. The variance of an estimated parameter describes how the parameter estimate would vary in repeated sampling.

Uncertainty Analysis

In the given article author has stressed upon the

importance of recognition of uncertainty in risk assessment and management not just as a tool of hindsight instead a means to improve the performance and as a critical ally in process of decision making in form of QUA (quantitative uncertainty analysis.)

Key points from Paper

Present status of QUA in decision making process. The author has tried to illustrate 4 key points applicable to Risk Management by means of an investment example: 1. Conflicting best estimates 2. Conservatism : relative and absolute meanings 3. Outliers 4. Best QUA : - discriminate among real options,

- provision of alternatives

Query before the decision maker:

You have $1000 to invest in the stock of a new company. You wish to hold the stock for 100 years, for your great-

grandchild to cash in to finance his or her education. All you

know about this volatile stock is that each year, it will either rise by 60% of its previous value or fall by 40% of its previous value. Each and every year, the chances of it being a good year or a bad year are equal (50/50).

Is this a wise investment?

Probability Density Function

Probability Density Function

The above plots provided by analyst D puts the erstwhile obtained information in perspective and on the whole investor is informed that there is about 69% chance that 1000$ investment wont be recouped, but any of the outcomes in the top 25% of the distribution will represent gains that at least outweigh the maximum loss of $1000, and could dwarf it i.e. to illustrate the point there is at least a 2% chance that this investment will make the investors descendant a millionaire. Now, the decision has been converged to the question How to weigh a

70% chance of a loss against a 20% chance of a large gain?

Here, the analyst D brings in the utility theory to aid the investor in the decision. Based on the interaction with the investor, he formulates the following table of utility:

Analyst E: Provides with the options of conditional investment as an alternative to the unconditional investment option discussed till this point.

These conditional investment options provide the investor with tools to limit the risk factor in the impending decision at the cost of limiting the profits too.

The financial tools like options and futures are examples of such
conditional investments.

Introduction to Option

An option is a contract written by a seller that conveys to the buyer the right but not the obligation to buy or to sell a particular asset, at a particular price.

Index options, Stock options etc.

Terminologies

Buyer of an option Seller of an option Call option Put option Option price/Premium Strike price Spot price American and European option

Synthetic Long Call : Buy stock Buy Put

Covered Call

- The covered call is a strategy in which an investor Sells a Call option on a stock he owns (netting him a premium) - The Call would not get exercised unless the stock price increases above the strike price. Neutral to moderately Bullish

Modern Portfolio Theory

Markowitz Introduced Investment theory Maximize Portfolio Return for given Risk Minimize Risk for given Expected Return Concept of Diversification in Investing Diversification lowers risk even if assets returns are not negatively correlated ,it can even if they are positively correlated.

Modern Portfolio Theory

Markowitz Introduced Investment theory Maximize Portfolio Return for given Risk Minimize Risk for given Expected Return Concept of Diversification in Investing Diversification lowers risk even if assets returns are not negatively correlated ,it can even if they are positively correlated.

MPT models an asset's return as a normally distributed function Define risk as standard deviation and Expected Return as Mean It assumes that investors are rational and markets are efficient Also assumes investor are Risk Averse In general, assets with higher expected returns are riskier

 Expected return
where,

Rp is the return on the portfolio, Ri is the return on asset i wi is the weighting of component asset i (that is, the share of asset i in the portfolio)

Portfolio return variance:

where ij is the correlation coefficient between the returns on assets i and j

For a three asset portfolio Portfolio return: Portfolio variance:

Suppose we have two assets, US and JP, with: mean US JP 13.6% 15.0% Standard Deviation 15.4% 23.0%

and with correlation 27%. If an investor holds 60% in the US and 40% in JP what is the mean and volatility of the portfolio?

Portfolio mean:

E(Rp) = 0.6*0.136 + 0.4*0.150 = 14.2%

Portfolio variance:

Var(Rp) =

(0.6)2*(0.154)2(0.4)2*(0.230)2+2*0.6*0.4*0.27*0.154*0.230
= 0.022

p = 14.7% risk than the US market alone!

This portfolio has higher expected return and lower

Risk and Return with Varying Weights

Let be the weight in the US, and 1- the

weight in JP.
The expected return of the portfolio is: E(rp) = *0.136 + (1-)*0.150

The variance of the portfolio return is:

var(rp) = 2*(0.154)2 + (1-)2*(0.230)2+

2**(1-)*0.27*0.154*0.230

Optimal Portfolio Choice with 2 Risky Assets

Any (mean-variance) investor should choose an efficient portfolio to benefit from diversification. The specific choice depends on the investors risk aversion A more risk-averse investor should choose a portfolio with lower risk lower expected return

Problem 1:

Choosing the Efficient Portfolio-Percentages from 3 stocks.

STOCKS A B C

RETURNS(%) 10 14.5 21

STANDARD DEVIATION 14 28 26

Accepted Standard Deviation = 20 Maximum Expected Returns = 17.1 95% confidence interval [Min. Return=18.1]
STOCK
A B C

% INVESTMENT
22 23 55

Problem 2:

Choosing the Efficient Portfolio-Percentages from 4 stocks.

STOCK A

RETURN(%) 10

STANDARD DEVIATION 14

B
C D

14.5
21 25

28
26 30

Accepted Standard Deviation: 20 Maximum Expected Return: 20.3 95% confidence interval [Min. Return=21.3]
STOCK A B C D % INVESTMENT 16 33 35 16

Greenhouse Gas Inventory

It is an accounting of the amount of pollutants discharged into the atmosphere, originating from all source categories in a certain geographical area and within a specified time span.

Used for - making atmospheric models - Develop strategies and policies for emission reductions. - Regulatory agencies

Greenhouse Gas Inventory

Greenhouse gas inventories, typically use Global Warming Potential (GWP) values to combine emissions of various greenhouse gases into a single weighted value of emissions. Global warming potential (GWP) is a measure of how much a given mass of greenhouse gas is estimated to contribute to global warming. Mention of Time interval is compulsory.

The GWP depends on the following factors:

o o o

the absorption of infrared radiation by a given species

the spectral location of its absorbing wavelengths the atmospheric lifetime of the species

Greenhouse Gas Inventory

Activity Data : Data on the magnitude of human activity resulting in emissions or removals taking place during a given period of time. Emission factor : Coefficient relating activity data to the amount of chemical compound Confidence Interval : The way used to express uncertainty ( range in which it is believed that the true value lies ). Where there is sufficient information to define the underlying probability

distribution for conventional statistical analysis, a 95 per cent confidence

interval should be calculated as a definition of the range.

Important point

Difference between Standard Deviation of Mean (Std Deviation of data set by square root of No. of data points ) and Standard Deviation of data set.

Choosing the appropriate measure of uncertainty depending on the context of analysis. Use of standard deviation(from known PDF) to estimate the limits of confidence interval. ( Experts judgment is required in non standard PDFs)

Arising Uncertainty in inventories

Uncertainties from definitions Uncertainties from natural variability of the process that produces an emission or uptake Uncertainties resulting from the assessment of the process or quantity, including, depending on the method used,: (i) uncertainties from measuring; (ii) uncertainties from sampling; (iii) uncertainties from reference data that may be incompletely described; and (iv) uncertainties from expert judgement.

Estimating inventory uncertainty

Method to determine uncertainties in individual terms in inventories Method to aggregate uncertainty

Representative Sampling

An emission factor is considered representative if it is calculated as the weighted average of all the emission factors related to all the different typologies of processes or products, where the weights are the percentages that different productions/products are of the total.

Activity data can be considered representative if they include all of the

activities in the period considered. Process of extrapolation and proxy variables are used (which further adds uncertainty). Stratification: to manage and reduce the uncertainty in inventory estimates

Issues and Resolutions

To reduce uncertainties periodic and random sampling methods are frequently employed which further add uncertainty of: Random Sample error and Lack of representativeness The collection and recording of information about the uncertainty in input data is critical to the success and transparency of the uncertainty analysis. Due to few observations present Expert judgment is required.

Representative Sampling

Requirement of covariance or correlation coefficient between various activities and an activity and its associated emission factor.

Methods for combining uncertainties

Two methods which are generally used in inventories are:

i)

Error propagation Equation ( used when ) The uncertainties are relatively small, the standard deviation divided by the mean value being less than 0.3; The uncertainties have Gaussian (normal) distributions; The uncertainties have no significant covariance.

ii) Monte Carlo method

Error Propagation Method

Uses Taylors expansion Gives perfect result in linear model Emission Inventories (non-linear model) : E tot= Ai * Fi A= Activity data F= Emission Factor e2 =a2F2 + f2A2 + 2 raf*af*A*F

Monte Carlo Approach

Used when

Uncertainties are large; Their distribution are non-Gaussian; The algorithms are complex functions; Correlations occur between some of the activity data sets, emission factors, or both.

Monte Carlo Approach

Perform the inventory calculation many times by electronic computer, each time with the uncertain emission factors or model parameters and activity data chosen randomly (by the computer) within the distribution of uncertainties specified initially by the user. Well suited in this case but very time consuming

Propagation in whole inventory

Aggregation of emission of a single gas Aggregation of emission from several gases. Emission and uptakes must be reduced to a common scale.