MSc In Technology Entrepreneurship

Decision & Risk Analysis

Bert De Reyck
Department of Management Science & Innovation
University College London
MSc In Technology Entrepreneurship

Risk Management Strategies

─ Session 7 ─
Freemark Abbey Winery
 Freemark Decision Tree
LABEL FALSE
$2,800 $2,800

HEAVY 50% SELLING ?

$26,400
BULK TRUE
$26,400 $26,400

AFTER STORM
FALSE RAIN ?
$63,300
HIGH 25%
$168,000 $168,000
YES 50% SELLING PRICE ?
$126,000
50%
MEDIUM
$117,600 $117,600
LOW 25%
$100,800 $100,800
LIGHT 50% BOTRYTIS ?
$100,200
LOW 20%
$60,000 $60,000
NO 50%
ACIDITY ?
$74,400
25% 50%
$84,000 $84,000
OK 80% SUGAR ?
$78,000
20% 50%
$72,000 $72,000
HARVEST ?
FREEMARK
$68,400
BEFORE STORM
TRUE
$68,400 $68,400
 Botrytis Spores
FALSE 0%
LABEL
$2,800 $2,800

HEAVY 50% SELLING ?

$26,400
TRUE 50%
BULK
$26,400 $26,400

AFTER STORM
TRUE RAIN ?
$76,200
HIGH 25% 12.5%
$168,000 $168,000
100% SELLING PRICE ?
YES
$126,000
50% 25%
MEDIUM
$117,600 $117,600
LOW 25% 12.5%
$100,800 $100,800
LIGHT 50% BOTRYTIS ?
$126,000
LOW 20% 0%
$60,000 $60,000
NO
0%
ACIDITY ?
$74,400
25% 50% 0%
$84,000 $84,000
OK 80% SUGAR ?
$78,000
20% 50% 0%
$72,000 $72,000
HARVEST ?
FREEMARK
$76,200
BEFORE STORM
FALSE 0%
$68,400 $68,400
$68,400.00
 Botrytis Spores

. With– spores
Harvest after the storm, average revenue = $ 76,200

. Without spores
– Harvest before the storm, average revenue = $68,400

. Average Value of Mitigating Botrytis Risk

– $76,200 - $ 68,400 = $7,800
– Net benefit of spores = $7,800 - $20,000 = $ -12,200

. Spores also reduce risk

100% 100%
1 : AFTER STORM
80%
Probability

80% 2 : BEFORE STORM

Probability

60% 60%

40% 40%

20% 20%

0% 0%
$0 $50,000 $100,000 $150,000 $200,000 $0 $50,000 $100,000 $150,000 $200,000

Revenue Revenue
 Perfect Weather Information
LABEL FALSE
$2,800
$2,800.00
AFTER STORM FALSE SELLING ?
$26,400
BULK TRUE
$26,400
$26,400.00
HEAVY 50% HARVEST ?
$68,400
BEFORE STORM TRUE
$68,400
$68,400.00
FREEMARK PI RAIN PREDICTED ?
$84,300
HIGH 25.0%
$168,000
$168,000.00
YES 50% SELLING PRICE
$126,000
MEDIUM 50.0%
$117,600
$117,600.00
LOW 25.0%
$100,800
$100,800.00
AFTER STORM TRUE BOTRYTIS ?
$100,200
LOW 20.0%
$60,000
$60,000.00
NO 50% ACIDITY
$74,400
0.25 50%
$84,000
$84,000.00
OK 80.0% SUGAR
$78,000
0.2 50%
$72,000
$72,000.00
LIGHT 50% HARVEST ?
$100,200
BEFORE STORM FALSE
$68,400
$68,400.00
 Perfect Weather Information

. With– information
If SuperDoppler predicts heavy rain then harvest before storm: avg. profit = $ 68,400
– If SuperDoppler predicts light rain then harvest after storm: avg. profit = $ 100,200
– Average profit with perfect weather information = $ 84,300

. Without information
– Harvest before the storm, average revenue = $68,400

. Average Value of Mitigating Rain Risk

– $84,300 - $ 68,400 = $15,900

. Information also reduces risk

100% 100%

80% 80%
Probability

Probability

60% 60%

40% 40%

20% 20%

0% 0%
$0 $50,000 $100,000 $150,000 $200,000 $0 $50,000 $100,000 $150,000 $200,000

Revenue Revenue
 SuperDoppler
. Prediction for heavy or light rain: $2,000 cost
. Assume SuperDoppler capable of predicting rain flawlessly

100%
Heavy Rain Predicted Heavy Rain
100%
Light Rain Predicted Light Rain

 Value = $15,900 (net benefit $13,900) + reduced downside risk

. In reality, SuperDoppler can make mistakes

Heavy Rain Predicted Heavy Rain

Light Rain Predicted Light Rain

 Value = ?
Suggested Policy
50% HARVEST ?
HEAVY
$68,400
TRUE
BEFORE STORM
TRUE $68,400 $68,400
YES FORECAST ?
$-2,000 $76,920
20%
HEAVY

TRUE RAIN ?
AFTER STORM
$85,440

80%
LIGHT

50% $85,440
LIGHT

FREEMARK SD
RENT SUPERDOPPLER ?
$74,920
NO HARVEST ?
FALSE BEFORE STORM
TRUE
$68,400 $68,400
 SuperDoppler (Imperfect Weather Information

. With– (imperfect) information

If SuperDoppler predicts heavy rain then harvest before storm: avg. profit = $ 68,400
– If SuperDoppler predicts light rain then harvest after storm: avg. profit = $ 85,440
– Average profit with imperfect weather information = $ 76,920

. Without information
– Harvest before the storm, average revenue = $68,400

. Average Value of (imperfect information), i.e. of mitigating rain risk

– $76,920 - $ 68,400 = $8,520

. Net– benefit of SuperDoppler

$8,520 - $ 2,000 = $6,520

. Effectiveness SuperDoppler
– Average Value of Imperfect Information / Average Value of Perfect Information
– $ 8,520 / $ 15,900 = 54%
 Sensitivity Analysis w.r.t. Initial Weather Forecast

$120,000

$100,000

$80,000
With Doppler
$60,000
Without Doppler
$40,000

$20,000

$0
Probability of
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 00% Heavy Rain
1
 SuperDoppler and Spores

. If SuperDoppler predicts heavy rain, then harvest before the storm

– expected profit = $ 68,400 -$ 2000 = $ 66,400

. Ifstorm
SuperDoppler predicts light rain, then BUY SPORES and harvest after the

– expected profit = $ 106,080 -$ 2000 - $20,000 = $ 84,080

. Expected profit
– = 0.5 * $ 66,400 + 0.5 * $ 84,080 = $ 75,240

. Net– benefit of spores (above value added by SuperDoppler)

= $ 75,240 - $ 74,920 = $320

. Buying spores is now worthwhile when the SuperDoppler

predicts a light rain!
Recap Decision Analysis
. Decision Trees: structuring problem
– Make sure sequence of decisions and risks is correct
– Associate probabilities with risks
– Associate results with decisions and risks
. “Roll-back” or “Fold back” the tree
– Decisions: take best decision
– Risks: compute average value
. Risk– Average values can mask risks, use risk profiles
– Using average values assume risk neutrality
• risk aversion: willing to accept lower average value in return for risk reduction
• risk seeking: willing to accept lower average value in return for possibility of high payoffs

. Sensitivity Analysis
– Are your recommendations robust to different assumptions?
. Value of Information
– Improves average value and reduces risk
– Value of perfect information: bound on information value
– Value of imperfect information: Bayes’ Rule
. Value of Control
 Decision Making under Risk - Insights

. Structuring a problem allows dealing with it systematically

– Framing (alternatives, risks, objectives)
– Decision trees

. Probabilities are the key to determine the value of risky ventures

– Risk profiles
– Determine average value

. Probabilities represent judgement, which includes experience and information, and

can be adjusted with new information
– Sensitivity analysis

. The– value of a risky venture depends on one’s attitude toward risk

Risk profiles  risk aversion & risk seeking behaviour
. The economic value of gathering more information can be calculated before making
a decision
– Average value of (imperfect) information

. Distinguish between the quality of the decision and its outcome