Risks and uncertainity

Insurable risks
Non-insurable risks
Investment decisions under risk:
Strategies and state of nature.
Outcome and pay-off matrix.
Risk-Return evaluation.
Risk preference.
risk seeker
risk averter
risk indifferent

Adjustments for risk and criteria for decisions:

1.
2.
3.
4.
5.
6.
7.
8.

Finite-horizon method
Risk discounting model.
The shackle approach.
The probability theory approach.
Sensitivity analysis.
Simulation.
Hedging.
Decision tree.

Investment decisions under

uncertainity

The maximin criteria.

The minimax regret criteria.
The hurwicz alpha index.
The maximax criteria.
The laplace criterion.

Treatments of Risks and Uncertainty in

Projects
The availability of partial or imperfect
information about a problem leads to two
new category of decision-making techniques
Decisions under risk (In terms of a probability function)
Decisions under Uncertainty (No probability function is
secure)

Decisions under risk

Decisions under risk are usually based on one
of the following criteria

Expected Value
Combined Expected value and variance
Known Aspiration level
Most likely occurrence of a future state

Expected Value Criterion

Expressed in terms of either actual money or its utility
Decision Makers attitude towards the worth or utility of
money is important
The final decision should ultimately be made by considering
all pertinent factors that affect the decision makers attitude
towards the utility of money
The drawback of this is that use of expected value criterion
may be misleading fro the decisions that are applied only a
few number of times i.e small sample sizes

Example 1
A preventive maintenance policy requires making decisions about when a
machine (or a piece of equipment) should be serviced on a regular basis in
order to minimize the cost of sudden breakdown
The decision situation is summarized as follows. A machine in a group of n
machines is serviced when it breaks down. At the end of T periods,
preventive maintenance is performed by servicing all n machines. The
decision problem is to determine the optimum T that minimizes the total
cost per period of servicing broken machines and applying preventive
maintenance

 Let pt be the probability that machine would break down in period t

Let nt be the random variable representing the number of broken machines in
the same period.
C1 is the cost of repairing a broken machine
C2 the preventive maintenance of the machine
The expected cost per period can be written as

T 1

c1 Ent c2 n

EC (T ) t 1
T

Where E{nt} is the expected number of broken machines in period t.

nt is a binominal random variable with parameter (n,pt), E{nt}=npt
The necessary condition for T* to minimize EC(T) are
EC(T*-1)>= EC(T*) and EC(T*+1)>= EC(T*)

 To illustrate the above formulation, suppose

c1=Rs.100, c2=Rs.10 and n=50
The values of pt and EC(T) are tabulated below

T*

T
1
2
3
4
5

pt
0.05
0.07
0.10
0.13
0.18

Cumulative pt
0
0.05
0.12
0.22
0.35

EC(T)
500
375
366.7
400
450

Expected Value-Variance Criterion

We indicated that the expected value criterion is suitable for
making long-run decisions
To make it work for the short-run decision problems Expected
Value-Variance criterion is used
A possible criterion reflecting this objective is
Max E[Z]-k*var[z]
Where z is a random variable for profit and k is a constant
referred to as risk aversion factor
Risk aversion factor k is an indicator of the decision makers
attitude towards excessive deviation from the expected
values.

 Applying this criteria to example 1 we get

T

pT

pT 2

Cum. pT2

EC(T)+varcT

0.05

0.0025 0

500

0.07

0.0049 0.05

0.0025

6312

0.10

0.0100 0.12

0.0074

6622

0.13

0.0169 0.22

0.0174

6731

0.18

0.0324 0.35

0.0343

6764

Cum. pT

Ct is the variance of EC(T)

This criteria has resulted in a more conservative decision that applies
preventive maintenance every period compared with every third period
previously

Aspiration Level Criterion

This method does not yield an optimal decision in the sense
of maximizing profit or minimizing cost
It is a means of determining acceptable courses of action

Most Likely Future Criterion

Converting the probabilistic situation into deterministic
situation by replacing the random variable with the single
value that has the highest probability of occurrence

Decisions under uncertainty

They assume that there is no probability distributions
available to the random variable.
The methods under this are

The Laplace Criterion

The Minimax criterion
The Savage criterion
The Hurwicz criterion

Laplace Criterion
This Criterion is based on what is known as the principle of
insufficiency
ai is the selection yielding the largest expected gain

Selection of the action ai* corresponding

1 n

max vai , j
n j 1

ai

where 1/n is the probability that

Example 2

A recreational facility must decide on the level of supply it must stock to meet the needs
of its customers during one of the holiday. The exact number of customers is not known,
but it is expected to be of four categories:200,250,300 or 350 customers. Four levels of
supplies are thus suggested with level i being ideal (from the view point of the costs) if the
number of customer falls in category i. Deviation from these levels results in additional
costs either because extra supplies are stocked needlessly or because demand cannot be
satisfied. The table below provides the costs in thousands of dollars

Customer Category

a1

10

18

25

a2

23

a3

21

18

12

21

a4

30

22

19

15

a1, a2, a3 and a4 are the supplies level

Solution by Laplace Criterion

E{a1} = (1/4)(5+10+18+25) = 14.5
E{a2} = (1/4)(8+7+8+23) = 11.5
E{a3} = (1/4)(21+18+12+21) = 18.0
E{a4} = (1/4)(30+22+19+15) = 21.5

Thus the best level of inventory according to

Laplace criterion is specified by a2.

Minimax (Maxmini) Criterion

This is the most conservative criterion since it is based on
making the best out of the worst possible conditions
If the outcome v(ai,j) represents loss for the decision maker,
then, for, ai the worst loss regardless of what j may be is max
j [v(ai,j)]
The minimax criterion then selects the action ai associated
with min ai max j [v(ai,j)]
Similarly if v(ai,j)] represents gain, the criterion selects the
action ai associated with max ai min j [v(ai,j)]
This is called the maxmini criterion

 Applying this criterion to the Example 2

Customer Category
Supply

Max

a1

10

18

25

25

a2

23

23

a3

21

18

12

21

21

a4

30

22

19

15

30

Minimax value

Thus the best level of inventory according to this criterion is

specified by a3

Savage Minimax Regret criterion

This is an extremely conservative method
The Savage Criterion introduces what is called as regret matrix
which is defined as
r(ai,j) =

maxvak , j vai , j

if v is profit

vai , j minvak , j

if v is loss

ak

ak

 Applying this criteria to Example 2

The regret matrix is shown below
Customer Category
Supply

Max

a1

10

10

10

a2

a3

16

11

16

a4

25

15

11

25

minimax

Thus the best level of inventory according to this criterion is specified by a2

Hurwicz Criterion

This Criterion represents a range of attitudes from the most optimistic to the most
pessimistic
The Hurwicz criterion strikes a balance between extreme pessimism and extreme
optimism by weighing the above two conditions by the respective weights and
1- , where 0<= <=1
If v(ai,j) represents profit, select the action that yields

max max vai , j 1 min vai , j

j
ai
j

If v(ai,j) represents cost, select the action that yields

min min v ai , j 1 max v ai , j

ai
j
j

 Applying this criterion to Example 2 Set =0.5

min

max

min+(1-)max

25

15

23

15

12

21

16.5

15

30

22.5

minimum

Resolving with =0.75 for selecting between a1 and

a2