W7-8 Risk and Strategy Under Uncertainty - PPT

Week 007- 008
Risk Analysis
Decision making under risk and uncertainty
Risk Analysis
Decision making under risk and uncertainty
Decision Making Under Risk Outline
Risk and Uncertainty
Risk Preferences, Attitude and Premiums
Examples of simple decision trees
Decision trees for analysis
Flexibility and real options

Decision making
Uncertainty and Risk
“risk” as uncertainty about a consequence
Preliminary questions
• What sort of risks are there and who bears them in project management?
• What practical ways do people use to cope with these risks?
• Why is it that some people are willing to take on risks that others shun?
Some Risks
• Weather changes
• Different productivity • Community opposition
• (Sub)contractors are • Infighting & acrimonious relationships
• Unreliable • Unrealistically low bid
• Lack capacity to do work • Late-stage design changes
• Lack availability to do work • Unexpected subsurface conditions
• Unscrupulous • Soil type
• Financially unstable • Groundwater
• Late materials delivery • Unexpected Obstacles
• Lawsuits • Settlement of adjacent structures
• Labor difficulties • High lifecycle costs
• Unexpected manufacturing costs • Permitting problems
• Failure to find sufficient tenants
Importance of Risk
Much time in construction management is • Payment Terms
spent focusing on risks
• Delivery Method
Many practices in construction are driven
by risk • Selection mechanism
• Bonding requirements
• Insurance
• Licensing
• Contract structure
• General conditions
Outline
Risk and Uncertainty
Risk Preferences, Attitude and Premiums

Decision making under risk
Available Techniques
Decision modeling
• Decision making under uncertainty
• Tool: Decision tree
Strategic thinking and problem solving:
• Dynamic modeling (end of course)
Fault trees
Introduction to Decision Trees
We will use decision trees both for Represent
• Illustrating decision making with • Flow of time

uncertainty
• Decisions
• Quantitative reasoning
• Uncertainties (via events)
• Consequences (deterministic or
stochastic)
Risk Preference
People are not indifferent to uncertainty • value gaining $x far more than
they disvalue losing $x.
• Lack of indifference from
uncertainty arises from uneven Individuals differ in comfort with
preferences for different outcomes uncertainty based on circumstances and
preferences
• E.g. someone may
Risk averse individuals will pay “risk
• dislike losing $x far more than
premiums” to avoid uncertainty
gaining $x
Risk preference
The preference depends on decision maker point of view

Categories of Risk Attitudes
Risk attitude is a general way of classifying risk preferences

Classifications
• Risk averse fear loss and seek sureness
• Risk neutral are indifferent to uncertainty
• Risk lovers hope to “win big” and don’t mind losing as much
Risk attitudes change over
• Time
• Circumstance
Decision Rules
 The pessimistic rule (maximin = ◦ The risklover seeks to maximize the
minimax) maximum gain
◦ The conservative decisionmaker  Compromise (the Hurwitz rule):
seeks to: ◦ Max (α min + (1- α) max) , 0 ≤ α ≤
 maximize the minimum gain (if 1
outcome = payoff)  α = 1 pessimistic
 or minimize the maximum loss (if  α = 0.5 neutral
outcome = loss, risk)
 α = 0 optimistic
 The optimistic rule (maximax)
The bridge case – decision
The pessimistic rule (maximin = minimax)
• Min (Ei) = Min (1.09 , 1.04) = $ 1.04 repair
In this case = optimistic rule (maximax)
• Awareness of probabilities change risk attitude

Other criteria
Most likely value
• For each policy option we select the outcome with the highest
probability
Expected value of Opportunity Loss

To buy soon or to buy later
-100
Buy soon
Buy later -100-30+5 = -125
-100+5 = -95
-100+5+30 = -65
Current price = 100
S1 = + 30%
S2 = no price variation
S3 = - 30%
Actualization = 5
To buy soon or to buy later
-100
Buy soon
Buy later -125

0. 5
0.25
-95
0.25
-65
The Utility Theory
 When individuals are faced with uncertainty they make choices as is they are
maximizing a given criterion: the expected utility.
 Expected utility is a measure of the individual's implicit preference, for each policy
in the risk environment.
 It is represented by a numerical value associated with each monetary gain or loss in

order to indicate the utility of these monetary values to the decision-maker.
Adding a Preference function
1.35
1
.7
125 100 65
Expected (mean) value
E = (0.5)(125) + (0.25)(95) + (0.25)(65) = -102.5
Utility value:
f(E) = ∑ Pa * f(a) = 0.5 f(125) + 0.25 f(95) + .25 f(65) =
= .5*0.7 + .25*1.05 + .25*1.35 = ~0.95
Certainty value = -102.5*0.975 = -97.38
Notion of a Risk Premium
A risk premium is the amount paid by a (risk averse) individual to avoid risk
Risk premiums are very common – what are some examples?
• Insurance premiums
• Higher fees paid by owner to reputable contractors
• Higher charges by contractor for risky work
• Lower returns from less risky investments
• Money paid to ensure flexibility as guard against risk

Conclusion: To buy or not to buy
The risk averter buys a “future” contract that

allow to buy at $ 97.38
The trading company (risk lover) will take

advantage/disadvantage of future
benefit/loss
Multiple Attribute Decisions
Frequently we care about multiple attributes
• Cost
• Time
• Quality
• Relationship with owner
Terminal nodes on decision trees can capture these factors – but still need to
make different attributes comparable
Pareto Optimality
 Even if we cannot directly weigh one attribute vs. another, we can rank some
consequences
 Can rule out decisions giving consequences that are inferior with respect to all
attributes
◦ We say that these decisions are “dominated by” other decisions
 Key concept here: May not be able to identify best decisions, but we can rule out
obviously bad
 A decision is “Pareto optimal” (or efficient solution) if it is not dominated by any

other decision
Decision Making Under Risk
Risk Preferences, Attitude and Premiums

Decision Making Under Risk
Risk Preferences, Attitude and Premiums
Examples of simple decision trees

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Week 007- 008

Risk and Uncertainty

Risk Preferences, Attitude and Premiums

Examples of simple decision trees

Decision trees for analysis

Flexibility and real options

“risk” as uncertainty about a consequence

• What practical ways do people use to cope with these risks?

Risk and Uncertainty

Risk Preferences, Attitude and Premiums

Examples of simple decision trees

Decision trees for analysis

Flexibility and real options

• Decision making under uncertainty

• Tool: Decision tree

Strategic thinking and problem solving:

• Dynamic modeling (end of course)

We will use decision trees both for Represent

• Illustrating decision making with • Flow of time

The preference depends on decision maker point of view

Risk attitude is a general way of classifying risk preferences

The pessimistic rule (maximin = minimax)

• Min (Ei) = Min (1.09 , 1.04) = $ 1.04 repair

In this case = optimistic rule (maximax)

• Awareness of probabilities change risk attitude

Most likely value

Expected value of Opportunity Loss

Buy later -100-30+5 = -125

Buy later -125

 It is represented by a numerical value associated with each monetary gain or loss in

Risk premiums are very common – what are some examples?

• Higher fees paid by owner to reputable contractors

• Higher charges by contractor for risky work

• Lower returns from less risky investments

• Money paid to ensure flexibility as guard against risk

The risk averter buys a “future” contract that

The trading company (risk lover) will take

Frequently we care about multiple attributes

• Relationship with owner

 A decision is “Pareto optimal” (or efficient solution) if it is not dominated by any

Risk and Uncertainty

Risk Preferences, Attitude and Premiums

Examples of simple decision trees

Decision trees for analysis

Flexibility and real options

Risk and Uncertainty

Risk Preferences, Attitude and Premiums

Examples of simple decision trees

Decision trees for analysis

Flexibility and real options

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