Risk Management

Megha Sharma
Indian Institute of Management
Calcutta
Session 2
Thompson Lumber Company (TLC)
TLC is in the lumber business for over 40 years. Management at
TLC is deliberating whether to manufacture and market a new
product, backyard sheds.

The alternatives are to construct (1) a large new plant, (2) a

small plant, or (3) no plant at all (i.e. TLC does not manufacture
the backyard sheds at all). There are two possible outcomes: the
market for the sheds could be favorable or there could be low
demand.

The potential profits are as follows: with a favorable market a

large facility will result in a net profit of Rs. 200000 whereas if
the market is unfavorable there would be a net loss of Rs.
180000. A small plant would result in a net profit of Rs. 100000
in a favorable market but a net loss of Rs. 20000 in a
unfavorable market. Doing nothing would result in profit of Rs. 0
in both the market conditions.
 EMV for Thompson Lumber Company

Each market has a probability of 0.50

Which alternative would give the highest EMV?
The calculations are

lant) = (0.50)(Rs.200,000) + (0.50)( Rs.180,000)

= Rs.10,000
lant)= (0.50)(Rs.100,000) + (0.50)( Rs.20,000)
= Rs. 40,000
hing) = (0.50)(Rs. 0) + (0.50)(Rs. 0)
= Rs. 0
EMV for Thompson Lumber Company

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET (Rs.) MARKET (Rs.) EMV (Rs.)
Construct a large 200,000 180,000 10,000
plant
Construct a small 100,000 20,000 40,000
plant
Do nothing 0 0 0
Probabilities 0.50 0.50

Largest EMV
EVPI for TLC

Scientific Marketing, Inc. offers analysis

that will provide certainty about market
conditions
Additional information will cost Rs.
65,000
Is it worth purchasing the information?
 Expected Value of Perfect Information
Expected Value of Perfect Information (EVPI)
places an upper bound on what you should pay
for additional information
EVPI = EVwPI Maximum EMV

EVwPI is the long run average return if we have

perfect information before a decision is made
EVwPI= (best payoff for first state of nature)
x (probability of first state of nature)
+ (best payoff for second state of nature)
x (probability of second state of nature)
+ + (best payoff for last state of nature)
x (probability of last state of nature)
EVPI for TLC

1. Best alternative for favorable state of nature is

build a large plant with a payoff of Rs. 200,000
Best alternative for unfavorable state of
nature is to do nothing with a payoff of Rs. 0
EVwPI = (Rs. 200,000)(0.50) + (Rs. 0)(0.50) =
Rs.100,000

2. The maximum EMV without additional

information is $40,000
EVPI = EVwPI Maximum EMV
= Rs.100,000 Rs. 40,000
= Rs. 60,000
So the maximum TLC should
pay for the additional
Sensitivity Analysis

Sensitivity analysis examines how our decision

might change with different input data

For the Thompson Lumber Company

P = probability of a favorable market
(1 P) = probability of an unfavorable market
Sensitivity Analysis

EMV(Large Plant) = Rs. 200,000P Rs.180,000(1 P)

= Rs. 380,000P Rs.180,000

EMV(Small Plant) = Rs. 100,000P Rs. 20,000(1 P)

= Rs. 120,000P Rs. 20,000

EMV(Do Nothing) = Rs. 0P + Rs. 0(1 P)

= Rs. 0
Sensitivity Analysis

EMV Values
300,000

200,000

Point 2 EMV (large plant)

100,000

Point 1 EMV (small plant)

0
EMV (do nothing)
100,000 0.167 0.615 1
Values of P

200,000
Sensitivity Analysis

Point 1:
EMV(do nothing) = EMV(small plant)
20,000
0 $120,000 P $20,000 P 0.167
120,000

Point 2:
EMV(small plant) = EMV(large plant)

$120,000 P $20,000 $380,000 P $180,000

160,000
P 0.615
260,000
Sensitivity Analysis
BEST RANGE OF P
ALTERNATIVE VALUES
Do nothing Less than 0.167
EMV Values
300,000
Construct a small plant 0.167 0.615

200,000 Construct a large plant Greater than 0.615

Point 2 EMV (large plant)
100,000

Point 1 EMV (small plant)

0
EMV (do nothing)
100,000 0.167 0.615 1
Values of P

200,000
Expected Opportunity Loss (EOL)
Expected opportunity loss (EOL) is the cost of
not picking the best solution
1. First construct an opportunity loss table
2. For each alternative, multiply the opportunity
loss by the probability of that loss for each
possible outcome and add these together

Minimum EOL will always result in the same

decision as maximum EMV!

Minimum EOL will always equal EVPI. (WHY?)

 Expected Opportunity Loss (EOL)
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EOL
Construct a large plant 0 180,000 90,000
Construct a small
100,000 20,000 60,000
plant

Do nothing 200,000 0
100,000
Probabilities 0.50 0.50 Minimum EOL
lant) = (0.50)(Rs. 0) + (0.50)(Rs.180,000)
= Rs. 90,000
plant) = (0.50)(Rs.100,000) + (0.50)(Rs. 20,000)
= Rs. 60,000
hing) = (0.50)(Rs. 200,000) + (0.50)(Rs. 0)
= Rs.100,000
Decision Trees
Any problem that can be presented in a
decision table can also be graphically
represented in a decision tree

Decision trees are most beneficial when a

sequence of decisions must be made

All decision trees contain decision points or

nodes and state-of-nature points or nodes
A decision node from which one of several
alternatives may be chosen
A state-of-nature node out of which one state of
nature will occur
Five Steps to Decision Tree Analysis

1. Define the problem

2. Structure or draw the decision tree

3. Assign probabilities to the states of nature

4. Estimate payoffs for each possible combination

of alternatives and states of nature

5. Solve the problem by computing expected

monetary values (EMVs) for each state of nature
node
Structure of Decision Trees
Trees start from left to right
Represent decisions and outcomes in
sequential order
Squares represent decision nodes
Circles represent states of nature
nodes
Lines or branches connect the
decisions nodes and the states of
nature nodes
TLCs Decision Tree

A State-of-Nature Node
Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
s tr Pla
n e
Co arg
L Favorable Market
Construct
Small Plant
2
Unfavorable Market
Do
No
th
in
g
TLCs Decision Tree

EMV for Node

= (0.5)(Rs. 200,000) + (0.5)(Rs.180,000)
1 = Rs. Payoffs
10,000 Favorable Market (0.5)
Rs. 200,000
Alternative with best
EMV is selected 1
Unfavorable Market(0.5)
t
c t Rs. 180,000
u n
s tr Pla
n e
Co arg
L Favorable Market (0.5)
Rs. 100,000
Construct
Small Plant
2
Unfavorable Market(0.5)
Rs.20,000
Do
No
th
in EMV for Node = (0.5)(Rs. 100,000)
g 2 = Rs. + (0.5)(Rs.20,000)
40,000
Rs. 0
Computing EVPI through decision trees
Compute the Expected Value of
Perfect Information for the TLC
problem using a decision tree.
Should TLC conduct market research?
TLC can conduct market survey on its own at a
cost of Rs. 10000. The survey, of course, will
not provide perfect information but it may help
quite a bit nevertheless. There is a 45% chance
that survey will indicate a favorable market for
storage sheds. TLC knows that there is a 78%
chance that the market will actually be
favorable if the survey indicates so. While
there is a 27% chance of a favorable market
when survey indicates an unfavorable market.

Should TLC conduct this market research?

Should TLC conduct market research?

First Decision Second Decision Payoffs

Point Point
Favorable Market (0.78)
Rs. 190,000
nt 2 Unfavorable Market (0.22)
e Pla Rs. 190,000
g
Lar Favorable Market (0.78)
Rs. 90,000
) Small
.45 Plant 3 Unfavorable Market (0.22)
Rs. 30,000
(0
y s e
r ve ult abl No Plant
Rs. 10,000
Su Res vor
1 Surv Fa Favorable Market (0.27)
Rs. 190,000
y

e
Re y (
ve

nt 4 Unfavorable Market (0.73)

Ne su 0. Pla
ur

Rs. 190,000
ga lts 55) ge
Lar
tS

Favorable Market (0.27)

ti v Small Rs. 90,000
ke

e 5 Unfavorable Market (0.73)

ar

Plant Rs. 30,000

tM

No Plant
uc

Rs. 10,000
nd
Co

Do Favorable Market (0.50)

N ot C Rs. 200,000
t 6 Unfavorable Market (0.50)
ond
uct Pla n Rs. 180,000
ge
S urv Lar Favorable Market (0.50)
Rs. 100,000
e y Small
Plant
7 Unfavorable Market (0.50)
Rs. 20,000
No Plant
Rs. 0
Should TLC conduct market research?

1. Given favorable survey results,

EMV(node 2) = EMV(large plant |
positive survey)
= (0.78)($190,000) + (0.22)(
$190,000) = $106,400
EMV(node 3) = EMV(small plant |
positive survey)
= (0.78)($90,000) + (0.22)(
$30,000) = $63,600
EMV for no plant = $10,000

2. Given negative survey results,

EMV(node 4) = EMV(large plant |
negative survey)
= (0.27)($190,000) + (0.73)(
$190,000) = $87,400
EMV(node 5) = EMV(small plant |
negative survey)
Should TLC conduct market research?

3. Compute the expected value of the

market survey,
EMV(node 1) = EMV(conduct survey)
= (0.45)($106,400) + (0.55)
($2,400)
= $47,880 + $1,320 = $49,200

4. If the market survey is not conducted,

EMV(node 6) = EMV(large plant)
= (0.50)($200,000) + (0.50)(
$180,000) = $10,000
EMV(node 7) = EMV(small plant)
= (0.50)($100,000) + (0.50)(
$20,000) = $40,000
EMV for no plant = $0

5. Best choice is to seek marketing

information
Should TLC conduct market research?

First Decision Second Decision Payoffs

Point Point
Rs. 106,400Favorable Market (0.78)
Rs. 190,000

Rs. 106,400
nt Unfavorable Market (0.22)
la
rg eP Rs.190,000
La Rs. 63,600Favorable Market (0.78)
) Small Rs. 90,000
.45 Plant
Unfavorable Market (0.22)
Rs.30,000
(0
e y ts le
rv sul rab No Plant
u Rs.10,000
S Re vo
Su a Rs. 87,400
rv F Favorable Market (0.27)
Rs. 190,000
y

e
Re y (
ve

n t Unfavorable Market (0.73)

la
Rs. 2,400
Ne su 0.
ur

e P Rs. 2,400 Rs.190,000

ga lts 55) rg
tS

La Favorable Market (0.27)

ti v Small Rs. 90,000
ke

e Unfavorable Market (0.73)

ar

Plant Rs.30,000
tM

No Plant
c
Rs. 49,200
du

Rs.10,000
on
C

Do Rs. 10,000Favorable Market (0.50)

N ot C Rs. 200,000
nt
Rs. 40,000

ond l a Unfavorable Market (0.50)

uct P Rs.180,000
S arge Rs. 40,000Favorable Market (0.50)
urv L Rs. 100,000
e y Small
Unfavorable Market (0.50)
Plant Rs.20,000
No Plant
Rs. 0
Expected Value of Sample Information

Thompson wants to know the actual value of

doing the survey

Expected value Expected value

EVSI = with sample
of best decision
information, without sample
assuming information
no cost to gather it
= (EV with sample information + cost)
(EV without sample information)

EVSI = (Rs. 49,200 + Rs. 10,000) Rs. 40,000 = Rs. 19,200

Sensitivity Analysis

How sensitive are the decisions to

changes in the probabilities?
How sensitive is our decision to the
probability of a favorable survey result?
That is, if the probability of a favorable
result (p = .45) were to change, would we
make the same decision?
How much could it change before we
would make a different decision?
 Sensitivity Analysis

p = probability of a favorable survey

result
(1 p) = probability of a negative
EMV(node 1)= (Rs.result
survey 106,400)p +(Rs. 2,400)(1 p)
= Rs. 104,000p + Rs. 2,400

We are indifferent when the EMV of node 1 is

the same as the EMV of not conducting the
survey, $40,000
Rs. 104,000p + Rs. 2,400 = Rs. 40,000
Rs. 104,000p = Rs. 37,600
p = Rs. 37,600/ Rs. 104,000 = 0.36
Practice Problem
Max Flyer is the founder and sole owner of the Goferbroke Company, which develops
oil wells in unproven territory. He has poured his life savings into the company in the
hope of making it big with a large strike of oil. Finally his chance has possibly come.
His company has purchased various tracts of land that larger oil companies have
spurned as unpromising even though they are near some large oil fields. Now Max has
received an exciting report about one of these tracts. A consulting geologist has just
informed Max that he believes there is one chance in four of oil there.
Max has learned from bitter experiences in the past to be sceptical about the chances
of oil reported by consulting geologists. Drilling for oil on this tract would require an
investment of $100,000. If the land turns out to be dry (no oil), the entire investment
would be lost. Since his company does not have much capital left, this loss would be
quite serious. On the other hand, if the tract does contain oil, the consultant geologist
estimates that there would be enough oil to generate revenue of $800,000.
There is another option. Another oil company has gotten wind of the consulting
geologists report and has offered to purchase the land from Max at $90,000.
Max can also arrange for a detailed seismic survey of the land. The cost for doing such
a survey is $30,000. There are 60% chances that the seismic survey would provide
favourable results i.e. say that there is a high chance of getting oil whereas 40%
chances are there that it would give unfavourable results. Based on past experiences,
Max estimates, there is a 0.9 probability that oil will be found given a favourable
outcome from the study and there is only a probability of 0.12 of getting oil if the
survey results are not favourable.
What should be Maxs optimal decision?
How do we get these probability values?
Many ways of getting probability
data

It can be based on
Managements experience and intuition
Historical data
Computed from other data using Bayes
theorem

Bayes theorem incorporates initial

estimates and information about the
accuracy of the sources

Allows the revision of initial

Calculating Revised Probabilities
In the Thompson Lumber case we used these
four conditional probabilities
P (favorable market(FM) | survey results positive) = 0.78
P (unfavorable market(UM) | survey results positive) = 0.22
P (favorable market(FM) | survey results negative) = 0.27
P (unfavorable market(UM) | survey results negative) = 0.73

The prior probabilities of these markets are

P (FM) = 0.50
P (UM) = 0.50
Calculating Revised Probabilities
Through discussions with experts TLC has learnt that
it can use this information and Bayes theorem to
calculate posterior probabilities

STATE OF NATURE

RESULT OF FAVORABLE UNFAVORABLE

SURVEY MARKET MARKET (UM)
(FM)
Positive P (survey P (survey
(predicts positive | FM) positive | UM)
favorable market
for product) = 0.70 = 0.20

Negative
(predicts P (survey P (survey
unfavorable negative | FM) negative | UM)
market for = 0.30 = 0.80
product)
Calculating Revised Probabilities
Recall Bayes theorem is

P ( B | A ) P ( A)
P( A | B)
P ( B | A) P ( A) P ( B | A ) P ( A )
where
A, B any two events
A complement of A

For this example, A will represent a favorable

market and B will represent a positive survey
Calculating Revised Probabilities
P (FM | survey positive)

P ( survey positive | FM ) P ( FM )

P(survey positive |FM) P(FM) P(survey positive |UM) P(UM)

(0.70)(0.50) 0.35
0.78
(0.70)(0.50) (0.20)(0.50) 0.45

P (UM | survey positive)

P ( survey positive | UM ) P (UM )

P(survey positive |UM) P(UM) P(survey positive |FM) P(FM)

(0.20)(0.50) 0.10
0.22
(0.20)(0.50) (0.70 )(0.50 ) 0.45
Calculating Revised Probabilities

POSTERIOR
PROBABILITY
CONDITIONAL
PROBABILITY
STATE P(SURVEY P(STATE OF
OF POSITIVE | PRIOR JOINT NATURE |
NATUR STATE OF PROBABILI PROBABILIT SURVEY
E NATURE) TY Y POSITIVE)
0.3 0.35/0. 0.
FM 0.70 X 0.50 =
5 45 = 78
0.1 0.10/0. 0.
UM 0.20 X 0.50 =
0 45 = 22
0.4 1.
P(survey results positive) =
5 00
Calculating Revised Probabilities
P (FM | survey negative)

P ( survey negative | FM ) P ( FM )

P(survey negative |FM) P(FM) P(survey negative |UM) P(UM)

(0.30)(0.50) 0.15
0.27
(0.30)(0.50) (0.80)(0.50) 0.55

P (UM | survey negative)

P ( survey negative | UM ) P (UM )

P(survey negative |UM) P(UM) P(survey negative |FM) P(FM)

(0.80)(0.50) 0.40
0.73
(0.80)(0.50) (0.30 )(0.50 ) 0.55
Calculating Revised Probabilities

POSTERIOR
PROBABILITY
CONDITIONA
L
PROBABILITY
P(SURVEY P(STATE OF
STATE NEGATIVE | PRIOR JOINT NATURE |
OF STATE OF PROBABILI PROBABILIT SURVEY
NATURE NATURE) TY Y NEGATIVE)
0.1 0.15/0. 0.
FM 0.30 X 0.50 =
5 55 = 27
0.4 0.40/0. 0.
UM 0.80 X 0.50 =
0 55 = 73
0.5 1.
P(survey results positive) =
5 00
Practice Problem 3
John wants to develop a small driving range for
golfers of all abilities. He believes that the
chance of a successful driving range is only
about 40%. A friend has suggested to conduct a
survey in the community to get a better feeling
of the demand for such a facility. There is a 0.9
probability that the research will be favorable if
the driving range will be successful.
Furthermore, it is estimated that there is a 0.8
probability that the marketing research will be
unfavorable if indeed the facility will be
unsuccessful. John would like to determine the
chances of a successful driving range given a
favorable result from the marketing survey.