Professional Documents
Culture Documents
Gold
Junk Bond
Growth Stock
Certificate of Deposit
Stock Option Hedge
5
TOM BROWN
The return on each investment depends on the
(uncertain) market behavior during the year.
Tom would build a payoff table to help make the
investment decision
S1 S2 S3 S4
D1 p11 p12 p13 p14
D2 p21 p22 p23 P24
D3 p31 p32 p33 p34
Criterion
P1
P2
P37
DJA is up
[+300,+1000]
DJA moves
within
[-300,+300]
DJA is down
[-300, -800]
Define
the states
of nature.
Decision
States
of Nature
Alternatives Large Rise Small Rise No Change Small Fall Large Fall
Gold
-100
100
200
300
0
are mutually
Bond
250 The states
200 of nature150
-100
-150
Stock
500 exclusive
250and collectively
100 exhaustive.
-200
-600
C/D account
60
60
60
60
60
Stock option
200
150
150
-200
-150
8
13
=MAX(H4:H7)
=MIN(B4:F4)
Drag to H7
=VLOOKUP(MAX(H4:H7),H4:I7,2,FALSE)
16
I4
Cell I4 (hidden)=A4
Drag to I7
17
18
Decision
Decision Large
Largerise
rise Small
Smallrise
rise No
Nochange
changeSmall
Smallfall
fall Large
Largefall
fall
-100
100
300
Gold
-100
100
200
300 no 00
Gold
Investing
in200
Stock generates
250
200
-100
Bond
250
200 when150
150
-100
-150
Bond
regret
the market
exhibits -150
500
250
-600
Stock
500
250
100
-200
-600
Stock
a100
large rise-200
60
60
60
60
60
C/D
60
60
60
60
60
C/D
The
TheRegret
RegretTable
Table
Decision
Decision Large
Largerise
riseSmall
Smallrise
riseNo
Nochange
changeSmall
Smallfall
fall Large
Largefall
fall
600
150
00
00
60
Gold
600
150
60
Gold
Let
us
build
the
Regret
Table
250
50
50
400
210
Bond
250
50
50
400
210
Bond
00
00
100
500
660
Stock
100
500
660
Stock
21
440
190
140
240
0
C/D
440
190
140
240
0
C/D
Decision
Decision Large
Largerise
rise Small
Smallrise
rise No
Nochange
changeSmall
Smallfall
fall Large
Largefall
fall
-100
100
300
00
Gold
-100
100
300 a regret
Gold
Investing 200
in200
gold generates
250
200
150
-100
-150
Bond
250
200
150 the market
-100 exhibits
-150
Bond
of 600 when
500
250
100
-200
-600
Stock
Th rise
500
250
100
-200
-600
Stock
a large
e
60
60
60
60
C/D
op 60
60
60
60
60
60
C/D
tim
al
de
cis
ion
The
Maximum
TheRegret
RegretTable
Table
Maximum
Decision
Decision Large
Largerise
rise Small
Smallrise
riseNo
Nochange
change Small
Smallfall
fall Large
Largefall
fall Regret
Regret
600
150
00
00
60
600
Gold
600
150
60
600
Gold
250
50
50
400
210
400
Bond
250
50
50
400
210
400
Bond
00
00
100
500
660
660
Stock
100
500
660
660
Stock
22
440
190
140
240
00
440
C/D
440
190
140
240
440
C/D
=MAX(B$4:B$7)-B4
Drag to F16
=MAX(B14:F14)
Drag to H18
=VLOOKUP(MIN(H13:H16),H13:I16,2,FALSE)
23
25
al
The Maximax Criterion
Maximum
de
Decision Large rise Small rise No change Small fall Largecisfall Payoff
-100
100
200
300
0 ion
300
Gold
250
200
150
-100
-150
200
Bond
500
250
100
-200
-600
500
Stock
60
60
60
60
60
60
C/D
26
Gold
Bond
Stock
C/D
500 Dollars
350 Dollars
50 Dollars
300 Dollars
29
30
Decision
Gold
Bond
Stock
C/D
Prior Prob.
opt
ima
The Expected Value Criterion l deci
sion
Expected
Value
Large rise Small rise No change Small fall Large fall
-100
250
500
60
0.2
100
200
250
60
0.3
200
150
100
60
0.3
300
-100
-200
60
0.1
0
-150
-600
60
0.1
100
130
125
60
32
33
=MAX(G4:G7)
=SUMPRODUCT(B4:F4,$B$8:$F$8)
Drag to G7
=VLOOKUP(MAX(G4:G7),G4:H7,2,FALSE)
34
35
Stock
-100
Large rise
Large
rise
-100
250
Small rise
250
500
60
600.2
500
100
200
250
60
0.3
No change
200
150
100
60
0.3
Small fall
300
-100
-200
60
0.1
Large fall
0
-150
-600
60
0.1
36
Decision
Gold
Bond
Stock
C/D
Probab.
-100
-100
250
Large rise
250
500
60
600.2
500
Small rise
100
200
250
60
0.3
No change
200
150
100
60
0.3
Small fall
Large fall
300
-100
-200
60
0.1
0
-150
-600
60
0.1
37
The Forecast
predicted
80%
20%
70%
30%
50%
50%
Small Fall
40%
60%
Large Fall
0%
100%
41
P(B|Ai)P(Ai)
P(B|A1)P(A1)+ P(B|A2)P(A2)++ P(B|An)P(An)
Posterior Probabilities
Probabilities determined
after the additional info
becomes available.
Prior probabilities
Probability estimates
determined based on
current info, before the
42
new info becomes available.
Nature
Large Rise
Small Rise
No Change
Small Fall
Large Fall
Prior
Prob.
0.2
0.3
0.3
0.1
0.1
Prob.
(State|Positive)
X
0.8
0.7
0.5
0.4
0
Joint
Prob.
0.16
0.21
0.15
0.04
0
Posterior
Prob.
0.286
0.375
0.268
0.071
0.000
43
Nature
Large Rise
Small Rise
No Change
Small Fall
Large Fall
Prior
Prob.
0.2
0.3
0.3
0.1
0.1
Prob.
(State|Positive)
X
0.8
0.7
0.5
0.4
0
Joint
Prob.
0.16
0.21
0.15
0.04
0
Posterior
Prob.
0.16
0.56
0.286
0.375
0.268
0.071
0.000
44
Nature
Large Rise
Small Rise
No Change
Small Fall
Large Fall
Prior
Prob.
0.2
0.3
0.3
0.1
0.1
Prob.
(State|Positive)
Joint
Prob.
0.8 = 0.16
0.7
0.21
Observe
0.5 the revision
0.15 in
the 0.4
prior probabilities
0.04
0
0
X
Posterior
Prob.
0.286
0.375
0.268
0.071
0.000
Nature
Large Rise
Small Rise
No Change
Small Fall
Large Fall
Prior
Prob.
0.2
0.3
0.3
0.1
0.1
Prob.
Joint
(State|negative) Probab.
0.2
0.3
0.5
0.6
1
0.04
0.09
0.15
0.06
0.1
Posterior
Probab.
0.091
0.205
0.341
0.136
0.227
Indicator
Indicator22
States
Prior
Conditional
Joint
Posterior
States
Prior
Conditional
Joint
Posterior
ofofNature
Probabilities
Probabilities
Probabilities
Probabilites
Nature Probabilities Probabilities Probabilities Probabilites
Large
0.2
0.8
0.16
0.286
LargeRise
Rise
0.2
0.8
0.16
0.286
Small
Rise
0.3
0.7
0.21
0.375
Small Rise
0.3
0.7
0.21
0.375
No
Change
0.3
0.5
0.15
0.268
No Change
0.3
0.5
0.15
0.268
Small
Fall
0.1
0.4
0.04
0.071
Small Fall
0.1
0.4
0.04
0.071
Large
Fall
0.1
0
0
0.000
Large Fall
0.1
0
0
0.000
s6
0
0
0.000
s6
0
0
0.000
s7
0
0
0.000
s7
0
0
0.000
s8
0
0
0.000
s8
0
0
0.000
P(Indicator
1)
0.56
P(Indicator 1)
0.56
States
Prior
Conditional
Joint
Posterior
States
Prior
Conditional
Joint
Posterior
ofofNature
Probabilities
Probabilities
Probabilities
Probabilites
Nature Probabilities Probabilities Probabilities Probabilites
Large
0.2
0.2
0.04
0.091
LargeRise
Rise
0.2
0.2
0.04
0.091
Small
Rise
0.3
0.3
0.09
0.205
Small Rise
0.3
0.3
0.09
0.205
No
Change
0.3
0.5
0.15
0.341
No Change
0.3
0.5
0.15
0.341
Small
Fall
0.1
0.6
0.06
0.136
Small Fall
0.1
0.6
0.06
0.136
Large
Fall
0.1
1
0.1
0.227
Large Fall
0.1
1
0.1
0.227
s6
0
0
0.000
s6
0
0
0.000
s7
0
0
0.000
s7
0
0
0.000
s8
0
0
0.000
s8
0
0
0.000
P(Indicator
2)
0.44
P(Indicator 2)
0.44
47
48
-100
250
500
60
0.286
0.091
100
200
250
60
0.375
0.205
200
150
100
60
0.268
0.341
300
-100
-200
60
0.071
0.136
0
-150
-600
60
0
0.227
EV(Invest in.
GOLD|Positive forecast) =
=.286(-100)+.375( 100 )+.268( 200)+.071( 300)+0( 0 ) = $84
EV(Invest in .
GOLD | Negative forecast) =
=.091(-100 )+.205( 100 )+.341( 200 )+.136( 300 )+.227( 0 ) = $120
49
Negative forecast
EV(Gold|Positive) = 84
EV(Bond|Positive) = 180
EV(Stock|Positive) = 250
EV(C/D|Positive) = 60
EV(Gold|Negative) = 120
EV(Bond|Negative) = 65
EV(Stock|Negative) = -37
EV(C/D|Negative) = 60
51
Gold
Bond
Stock
C/D Account
d5
d6
d7
d8
Prior Prob.
Ind. 1 Prob.
Ind 2. Prob.
Ind. 3 Prob.
Ind 4 Prob.
0.2
0.286
0.091
0.3
0.375
0.205
0.3
0.268
0.341
0.1
0.071
0.136
0.1
0.000
0.227
Prior
130.00
Bond
Ind. 1
249.11
Stock
Ind. 2
120.45
Gold
Ind. 3
0.00
Ind. 4
0.00
s6
s7
#### ### ##
#### ### ##
0.56
0.44
RESULTS
optimal payoff
optimal decision
EVSI =
EVPI =
Efficiency=
62.5
141
0.44
53
Decision Trees
The Payoff Table approach is useful for a nonsequential or single stage.
Many real-world decision problems consists of a
sequence of dependent decisions.
Decision Trees are useful in analyzing multistage decision processes.
54
Decision
n1
o
i
s
node Deci t 1
Cos
Dec
isio
C os n 2
t2
Chance (S 1)
P
node
P(S2)
P(S
)
3
)
P(S 1 A branch emanating from a state of
P(S2) nature (chance) node corresponds to a
P(S particular state of nature, and includes
3)
the probability of this state of nature.
55
ns
o
c
ih re t = 0
ot
os
n
C
o
Hir
ec
on
su
Co
lt
st
= - ant
50
00
ing
h
t
o
Do n 0
Buy land
-300,000
Pu
rc h
ase
-20
op
,00
tion
0
Le
to t us
no co
t h ns
ire ide
a c r th
on e d
su ec
lta is
nt i on
0
3
59
12
ove
r
p
Ap
0.4
Den
ied
Build
-500,000
Buy land
-300,000
-500,000
950,000
100,000
0.6
-50,000
60
Buy land
-300,000
Build
-500,000
Buy land
-300,000
-500,000
950,000
100,000
Apply 12
for variance
-30,000
Purchase option and
apply for variance
-50,000
61
ant
t
l
u
s
con
e
r
i
h
ot
Do n
0
Hir
e
Do
ict al
d
e v
Pr pro
Ap
0.4
co
n
-50 sulta
nt
00
Done
-5000
g
thin
o
N
Buy land
-300,000
Pu r
ch a
se o
ptio
-20,
n
000
t
dic
Pre nial
De
0.6
BILL GALLEN
The Decision Tree
othin
N
o
D
Buy land
-300,000
Purc
hase
optio
-20,0
n
00
-5000
Apply for variance
-30,000
ved
o
r
App
?
Den
ied
Sell
260,000
?
Co
ns
ult
an
tp
Sell
950,000
r ed
icts
an
ap
p ro
115,000
-75,000
va
l
63
Build
-500,000
Sell
950,000
Sell
260,000
115,000
-75,000
64
Build
-500,000
Sell
950,000
Sell
260,000
115,000
-75,000
22
ved
o
r
App
?
Den .7
ied
?
.3
23
26
Build
-500,000
24
Sell
950,000
Sell
260,000
115,000
25
-75,000
27
67
115,000
23
-75,000
26
115,000
Build
-500,000
-75,000
115,000
115,000
24
Sell
950,000
-75,000
-75,000
Sell
260,000
115,000
115,000
115,000
25
-75,000
-75,000
-75,000
27
68
$10,000
Hi
re $20,000
App
r
ove
d
t
o
$20,000 Do n
e
r
i
h
$58,000
icts
d
e
r
P
val
o
r
p
ap
.4
icts
den
ial
.6
ied
Den
Pre
d
.7
$-5,000
.3
Sell
land
Do nothing
$-75,000
69
70
71
76
p
1-p
Rij
Rmax
Rmin
p
1-p
Rij
Rmax
Rmin
d
d
Alternative 1
A sure event
$100
150
100
-50
140
d
d
150
100
-50
140
U(100)=.7U(150)+.3U(-50)
= .7(1) + .3(0) = .7
$150
1-p
p
-50
80
Data
The highest payoff was $500. Lowest payoff was -$600.
The indifference probabilities provided by Tom are
Payoff
Prob.
0.25
0.3
0.36
60
100
150
200
250
300
500
0.5
0.6
0.65
0.7
0.75
0.85
0.9
Gold
Bond
Stock
C/D Account
d5
d6
d7
d8
Probability
RESULTS
Criteria
Exp. Utility
Decision
Stock
Certain Payoff
-600
-200
-150
-100
0
60
100
150
200
250
300
500
Utility
0
0.25
0.3
0.36
0.5
0.6
0.65
0.7
0.75
0.85
0.9
1
Value
0.675
82
Utility
U(200)
U(150)
EU(Game)
The
Theutility
utilityofofhaving
having$150
$150on
onhand
hand
U(100)
is
islarger
largerthan
thanthe
theexpected
expectedutility
utility
ofofaagame
gamewhose
whoseexpected
expectedvalue
value
isisalso
also$150.
$150.
100
0.5
150
200
0.5
Payoff
84
Utility
U(200)
U(150)
EU(Game)
AArisk
riskaverse
aversedecision
decisionmaker
makeravoids
avoids
the
thethrill
thrillofofaagame-of-chance,
game-of-chance,
whose
whoseexpected
expectedvalue
valueisisEV,
EV,ififhe
he
can
canhave
haveEV
EVon
onhand
handfor
forsure.
sure.
U(100)
Furthermore,
Furthermore,aarisk
riskaverse
aversedecision
decision
maker
makerisiswilling
willingtotopay
payaapremium
premium
to
tobuy
buyhimself
himself(herself)
(herself)out
outofofthe
the
game-of-chance.
game-of-chance.
100
0.5
CE 150
200
0.5
Payoff
85
Utility
Risk Averse Decision Maker
Ris
l
a
r
ut
e
kN
er
k
a
M
n
o
i
cis
e
D
86
Game Theory
Game theory can be used to determine optimal
decisions in face of other decision making
players.
All the players are seeking to maximize their
return.
The payoff is based on the actions taken by all
the decision making players.
87
Classification of Games
By number of players
Two players - Chess
Multiplayer Poker
By total return
Zero Sum - the amount won and amount lost by all
competitors are equal (Poker among friends)
Nonzero Sum -the amount won and the amount lost by all
competitors are not equal (Poker In A Casino)
By sequence of moves
Sequential - each player gets a play in a given sequence.
Simultaneous - all players play simultaneously.
88
IGA SUPERMARKET
The town of Gold Beach is served by two supermarkets:
IGA and Sentry.
Market share can be influenced by their advertising
policies.
The manager of each supermarket must decide weekly
which area of operations to discount and emphasize in
the stores newspaper flyer.
89
IGA SUPERMARKET
Data
The weekly percentage gain in market share for IGA, as
a function of advertising emphasis.
IGA's
Meat
Emphasis Produce
Grocery
Meat
2
-2
2
Sentry's Emphasis
Produce Grocery Bakery
2
-8
6
0
6
-4
-7
1
-3
91
92
IGAs Perspective
Constraints
IGAs market share increase for any given advertising
focus selected by Sentry, must be at least V.
The model
Max V
IGAs expected change
in market share.
S.T.
Meat
2X1 2X2 + 2X3
Sentrys
Produce 2X1
7 X3
advertising
Groceries -8X1 6X2 + X3
emphasis
Bakery
6X1 4X2 3X3
Probability X1 + X2 + X3
V
V
V
V
= 1
94
Sentrys perspective
Constraints
Sentrys market share decrease for any given advertising
focus selected by IGA, must not exceed V.
The Model
Min V
S.T.
2Y1
-2Y1
2Y1
Y1
+ 2Y2
+ 6Y3
7Y2
+ Y2
8Y3 + 6Y4
V
4Y4 V
+ Y3 3Y4 V
+ Y3 + Y 4 =
1
96
For Sentry
Y1 = .3333; Y2 = 0; Y3 = .3333; Y4 = .3333
97
Name
X1
X2
X3
V
Final
Value
0.388888889
0.5
0.111111111
-6.75062E-29
Reduced
Cost
0
0
0
0
Constraints
Final
Cell Name
$E$4
$E$5
$E$6
$E$7
$E$8
Shadow
Price
Constraint
Allowable
Allowable
Value
R.H. Side
Increase
Decrease
-1.11022E-16 -0.333333333
0
0
1E+30
6.75062E-29
0
0
0
1E+30
3.88578E-16 -0.333333333
0
1E+30
0
-2.77556E-16 -0.333333333
0
1E+30
0
1
0
1 0.000199941
1E+30
98