10-Risk%20and%20Uncertainty

10-Risk%20and%20Uncertainty - Engineering Economics ECO...

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Engineering Economics ECO 1192 Lecture 10: Risk and Uncertainty Claude Théoret University of Ottawa
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ECO 1192A -- Fall 2009 10. Risk and Uncertainty 2 Recommended Reading Fraser et al. chapter 12 Newnan et al. Engineering Economics , Canadian Edition, chapter 10 Park chapter 10 Riggs, Bedworth, Randhawa and Khan Engineering Economics , 2 nd Canadian edition, McGraw-Hill Ryerson, Toronto, 1997
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ECO 1192A -- Fall 2009 10. Risk and Uncertainty 3 Introduction Risk & uncertainty: definitions Uncertainty Rules Risk Analysis Expected value Expected Variance Decision Trees Monte Carlo Simulations
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ECO 1192A -- Fall 2009 10. Risk and Uncertainty 4 Introduction Previous lectures assumed that future project cash flows were known without risk and uncertainty as to their timing and magnitude But these cash flows are essentially “best estimates” and subject to errors. Future events may be uncertain or risky Uncertain if we do not have information about the probability that the event will happen (or not) Risky if we have some information about the probability of a future event’s occurrence This lecture examines decision-making in a risk environment. But first some uncertainty rules and principles.
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ECO 1192A -- Fall 2009 10. Risk and Uncertainty 5 “Precise” Estimates Are Still Only Estimates All estimates are inherently variable and future estimates are often more variable than present estimates. Minor changes in any estimate(s) may alter the results of the economic analysis. Using breakeven and sensitivity analysis allows an understanding of how changes in variables will affect the economic analysis.
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Uncertainty
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ECO 1192A -- Fall 2009 10. Risk and Uncertainty 7 Uncertainty Identification of future events (states of nature) is possible Insufficient information (or unwillingness) to assign the probability of occurrence of the future events.
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ECO 1192A -- Fall 2009 10. Risk and Uncertainty 8 Decisions under uncertainty Several rules and principles have been developed to assist project decision-making in an environment with uncertainty. Laplace Maximin (minimax) Maximax Hurwicz Maximax Regret (Savage)
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NPW of profits Projects Net Present Worth (NPW) A B C D P1 15 11 12 9 P2 7 9 12 20 P3 8 8 14 17 P4 17 5 5 5 P5 6 14 8 19 5 projects: P1 to P5 4 possible future states of nature: A, B, C & D
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Laplace (Principle of insufficient reason) Projects Net Present Worth (NPW) A B C D Average Profit P1 15 11 12 9 11.75 P2 7 9 12 20 12.0** P3 8 8 14 17 11.75 P4 17 5 5 5 8.0 P5 6 14 8 19 11.75 Nature doesn’t care about you one way or the other; it is neither friendly nor unfriendly to your cause.
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Maximin Rule (Maximize the minimum) Projects Net Present Worth (NPW) A B C D P1 15 11 12 9 P2 7 9 12 20 P3 8 8 14 17 P4 17 5 5 5 P5 6 14 8 19 Projects Minimum P1 9** P2 7 P3 8 P4 5 P5 6 Maximum of minima = 9 [P1]
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Maximax Rule (Maximize the maximum) Projects Net Present Worth (NPW) A B C D P1 15 11 12 9 P2 7 9 12 20 P3 8 8 14 17 P4 17 5 5 5 P5 6 14 8 19 Projects Maximum P1 15 P2 20** P3 17 P4 17 P5 19 Largest payoff = 20 [P2] Optimistic method which assumes that nature is friendly to your cause. Hence, you expect the best outcomes.
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This note was uploaded on 06/24/2010 for the course FIR 4440 taught by Professor Moore during the Spring '08 term at U. Memphis.

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10-Risk%20and%20Uncertainty - Engineering Economics ECO...

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