Expected Monetary Value

In a business environment, we frequently use

probabilities to assess alternative financial decisions
Example 1: A coin is tossed ten times.
When a head is obtained, 4 is won.
When a tail is obtained, 2 is lost
Calculate the expected winnings.
Outcome

HEAD

TAIL

Winnings

-2

Probability

0.5

0.5

Expected winnings in one toss:

Expected Monetary Value (or just Expected Value
(EV)
= 1

EV 4

1
1
2
2
2

Note: You never actually receive 1; you either receive

4 or lose 2. Play this game many times, sometimes
you receive 4, sometimes lose 2, but it averages out
at 1 per game.
This is your Expected Value.
Expected winnings in ten plays:

EMV 10 1 10

Decision Making using Expectation

Example 2:
A potential customer for a 50,000 fire insurance policy
has a home in an area that, according to experience, may
sustain a total loss in a given year with a probability of
0.001 and a 50% loss with a probability of 0.01. There is
a 98.9% chance that no claim will be made.
Ignoring partial losses, what premium should the
insurance company charge to break even?

Solution:
Expected Claim =

50000*0.001 (Full claim)

+ 25000*0.01 (Partial Claim)
+ 0*0.989 (No Claim)

= 300
A premium of 300 would break even in the long run

Decision Making using Expectation

Example 3:
An investor has a certain amount of money to invest. Three alternative portfolio
selections are available. The estimated profits depend on the economic conditions as
follows:
Profit (000)

Portfolio Selection
A

Economy declines

.5

-2

-7

No change

1.0

-1

Economy expands

2.5

22

The probabilities of the occurrence of the economic

conditions are:
P(economy declines) = 0.3
P(no change) = 0.5
P(economy expands) = 0.2
Determine the best portfolio for the investor.
Weight each possible outcome by the probability of
its occurrence to calculate its expected value of
profit on each portfolio (000):

EV(A) = (0.5)(0.3) + (1.0)(0.5) + (2.5)(0.2) = 1.15

EV(B) = (-2.0)(0.3) + (2.0)(0.5) + (5.0)(0.2) =
1.40
EV(C) = (-7.0)(0.3) + (-1.0)(0.5) + (22.0)(0.2) =
1.80
To maximise expected profit, choose portfolio C.

DECISION THEORY
Elements of a decision problem:
1.
2.
3.
4.

Decision maker
Alternative courses of action
Events and associated probabilities
Consequences

Decision making under risk

Example:-

Concession problem
States/events
Cold weather
Warm weather
(p = 0.3)
(p = 0.7)

Action
a1 : sell cola
a2 : sell coffee

1,500
4,000

5,000
1,000

Choice criterion Expected value

EV(a1) = 1500 (0.3) +
EV(a2) = 4000 (0.3) +
1.
2.

5000 (0.7) = 3,950

1000 (0.7) = 1,900

Maximise expected value

Minimise expected opportunity loss (EOL)

An investor has a certain amount of money to invest.

Three alternative portfolio selections are available. The
estimated profits depend on the economic conditions as
follows:
Payoff matrix:

Profit (000)

Portfolio Selection

Economy declines

0.5

-2

-7

No change

1.0

-1

Economy expands

2.5

22

P(economy declines) = 0.3

P(no change) = 0.5
P(economy expands) = 0.2

Determine the best portfolio for the investor.

Weight each possible outcome by the probability of its
occurrence to calculate its expected value of profit on
each portfolio (000):
EV(A) = (0.5)(0.3) + (1.0)(0.5) + (2.5)(0.2) = 1.15
EV(B) = (-2.0)(0.3) + (2.0)(0.5) + (5.0)(0.2) = 1.40
EV(C) = (-7.0)(0.3) + (-1.0)(0.5) + (22.0)(0.2) = 1.80

Minimise opportunity loss:

Identify best action for each event
Subtract each payoff from best
Regret Matrix:Profit (000)

Portfolio Selection
A

Economy declines

2.5

7.5

No change

1.0

3.0

Economy expands

19.5

17.0

EOL(A) = (0.0)(0.3) + (1.0)(0.5) + (19.5)(0.2) = 4.40

EOL(B) = (2.5)(0.3) + (0.0)(0.5) + (17.0)(0.2) = 4.15
EOL(C) = (7.5)(0.3) + (3.0)(0.5) + (0.0)(0.2) = 3.75
To Minimise Expected Opportunity Loss choose C
Note: Same conclusion as maximising expected value.

Is it worth getting more information?

How much is additional information worth?
What is Perfect Information worth?
Expected Value of Perfect Information (EVPI)
Investment problem:EV(A) = 1,150
EV(B) = 1,400
EV(C) = 1,800

If condition known in advance (certainty) choice

would be:
Economy declines Choose A
No change Choose B
Economy expands Choose C
Expected value under certainty:0.3(500) + 0.5(2,000) + 0.2(22,000)= 5,550
Expected value under uncertainty:EV(C) = 1,800
EVPI = 5,550 1,800

3,750

If you were offered perfect information, you

should not pay more than this amount for
that information.

Other criteria may be preferred by

risk averters
risk takers

Decision trees
Nodes represent points in time
Square nodes decision points
Round nodes chance events
Arcs represent actions
Example:
An investor has a certain amount of money to invest.
Three alternative portfolio selections are available. The
estimated profits depend on the economic conditions as
follows:
Payoff matrix:
Profit (000)

Portfolio Selection
A

Economy declines (1)

(0.3)

.5

-2

-7

No change (2)

(0.5)

1.0

-1

Economy expands (3)

(0.2)

2.5

22

Payoffs (000)
0.5

(0.3)
2

2
3

(0.5)
(0.2)

Portfolio A

2.5
1 (0.3)

Portfolio B

1.0

2 (0.5)

- 2.0
2.0

3 (0.2)
Portfolio C

5.0
1 (0.3)
4

2 (0.5)

-7.0
-1.0

3 (0.2)
22.0

Expected value at node 2 = 1.15

Expected value at node 3 = 1.40
Expected value at node 4 = 1.80
Therefore at node 1 the optimal route is go to node 4,
i.e. choose Portfolio C.

Example
An oil company must decide whether to drill (a1) or not
to drill (a2) in a particular place in the Celtic sea. The
well may turn out to be dry (1), wet (2), or soaking (3),
and on the basis of other drillings in the Celtic sea the
company believes that the probabilities for these states
are as follows:
P(1) = 0.5
P(2) = 0.3
P(3) = 0.2
The cost of drilling is $70,000. If the well turns out to be
wet the revenue will be $120,000 and if it turns out to be
soaking the revenue will be $270,000. (There is no
revenue for a dry well). Should the company drill or
not?
E(drill) = (-70)(0.5) + (50)(0.3) + (200)(0.2) = 20
E(do not drill) = 0
Therefore the company should drill