IFAP - Third Tutorial: Decisions under Uncertainty

Jorge Pinheiro

University of Glasgow
[Link]@[Link]

November 16, 2020

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Overview

1 Question 1: Application to Expected Utility and Uncertainty

Expected Utility
Indifference Under Uncertainty
Absolute risk aversion

2 Question 2: Application to Investment under Undertainty

NPV: Net Present Value
Change in the initial cost/investment
Change in the cash flows

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 Question 1: Application to Expected Utility and Uncertainty Expected Utility

Expected Utility
In the exercise, we are informed that the agent’s utility is dependent
√
on the amount of money, x, and is given by u(x) = x

The agent’s money is given by his initial wealth of 9$, and the lottery
ticket that pays 16$ with probability (1/4) and will pay 0$ with
probability (3/4)

In the first question, we are asked to calculate the expected utility,

which is given by:

√ √
E [u(x)] = (1/4) ∗ 25 + (3/4) ∗ 9 = (5/4) + (9/4) = 3.5 (1)
Notice that this is not the same as the utility of the expected
value:
p √
u(E [x]) = (1/4) ∗ 25 + (3/4) ∗ 9 = 13 ≈ 3.6 (2)
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 Question 1: Application to Expected Utility and Uncertainty Indifference Under Uncertainty

Indifference Under Uncertainty

In the second question, we are asked what is the lowest price at which
the agent would sell the lottery ticket

On one hand, selling the lottery ticket would give the agent additional
money without uncertainty. But on the other hand, he would also lose
the possibility of winning the lottery.

The lowest price at which the agent is willing to sell the lottery ticket
is the one that makes him indifferent between selling or owning the
lottery ticket:
p
u(9 + p) = E [u(x)] ⇒ 9 + p = 3.5 ⇒ p = 3.25 (3)

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 Question 1: Application to Expected Utility and Uncertainty Absolute risk aversion

Absolute risk aversion

For the third question, we are asked to calculate if the agent has a
constant, increasing, or decreasing absolute risk aversion, given by the
Arrow-Pratt measure

We start by calculating the absolute risk-aversion, using the formula

that was given:

U 00 (x) (1/4)x −(3/2)

rA = − = = (1/2)x −1 (4)
U 0 (x) (1/2)x −(1/2)

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 Question 1: Application to Expected Utility and Uncertainty Absolute risk aversion

Absolute risk aversion

To understand how the absolute risk aversion changes with x, we can
simply calculate the derivative:

drA 1
= −(1/2)x −2 = − 2 < 0 (5)
dx 2x

The agent has a decreasing absolute risk aversion: the higher the
amount of money x, the lower the absolute risk aversion

Notice that these results will depend on the utility function:

risk-averse: concave utility ⇐⇒ u(E [x]) ≥ E [u(x)] ⇐⇒ dr dx < 0
A

risk-neutral: linear utility ⇐⇒ u(E [x]) = E [u(x)] ⇐⇒ dr dx = 0

A

drA
risk-lover: convex utility ⇐⇒ u(E [x]) ≤ E [u(x)] ⇐⇒ dx > 0

You can confirm this with u(x) = x or u(x) = x 2 . Try it out.

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 Question 2: Application to Investment under Undertainty NPV: Net Present Value

Investment Options

1M$ 0.5M$ until ∞

−20M$ 2M$ 2M$ until ∞

3M$ 5M$ until ∞

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 Question 2: Application to Investment under Undertainty NPV: Net Present Value

Overall scenario

Step 1: Establish the investment scenario and respective cash flows

(see previous slide).

Step 2: Define the probabilities for the different scenarios, in the

different periods. For year t=2, we have 3 possible scenarios: High,
Moderate, and Low. They all have equal proability, which implies
each has p = 1/3. After the event in the second year, the cash flows
for all future periods will be the same for future years, and will only
differ according to the scenario in year t=2.

Step 3: Establish the calculation for the value of the project. We

should use the Net Present Value (NPV).

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 Question 2: Application to Investment under Undertainty NPV: Net Present Value

NPV: Net Present Value I

NPV is the discounted sum of expected cash flows of the investment

project:
∞
X Rt
NPV = (6)
(1 + r )t
t=0

where Rt is the returns net costs in period t and r is the discount rate.

Notice that this is very similar to the dynamic problems we solved in

1 t
previous tutorials (can think of (1+r )t as β , and Rt as πt or u(ct ))

Difference: The outcomes in each period do not depend on our

choices, but the probabilities of the different scenarios. Our only
decision will be wether to invest or not invest in the project.

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 Question 2: Application to Investment under Undertainty NPV: Net Present Value

NPV: Net Present Value II

Step 4: Establish the NPV for the specific project:

1
NPV = −20 + [CFL + CFM + CFH ] (7)
3

Step 5: Calculate the respective cash flows for each scenario, using
the formula from condition (6):

R1 R2 R3
CF = + 2
+ + ... (8)
(1 + r ) (1 + r ) (1 + r )3

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 Question 2: Application to Investment under Undertainty NPV: Net Present Value

Perpetuity condition

 
1 0.5 0.5 1 0.5 1 1
CFL = + + +... = + 1+ + + ...
(1.1) (1.1)2 (1.1)3 (1.1) (1.1)2 (1.1) (1.1)2
(9)

Step 6: Use the perpetuity condition to simplify the calculations.

Recall that, after the second year, the amount received in each period
is the same, and is received forever. We can refer to this amount as a
perpetuity. The general formula for the present value of a perpetuity
is given by:

C C C C
+ 2
+ 3
+ ... = (10)
(1 + r ) (1 + r ) (1 + r ) r

Notice that the condition (10) is very similar to what we have in the
[] brackets in condition (9)
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 Question 2: Application to Investment under Undertainty NPV: Net Present Value

Perpetuity vs Convergence of Geometric Series

When we use the perpetuity condition (10), we can simplify the cash
flows of condition (9):

 
1 0.5 1 1 0.5
CFL = + 2
1+ = + [11] = 5.45 (11)
(1.1) (1.1) 0.1 (1.1) (1.1)2

As an alternative to the perpetuity condition, we can use the

condition of convergence of geometric series. When |b| < 1, we have
that:

C
C + C ∗ b + C ∗ b 2 + C ∗ b 3 + ... = (12)
1−b

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 Question 2: Application to Investment under Undertainty NPV: Net Present Value

Perpetuity vs Convergence of Geometric Series II

1 1
Notice that if you define C=1 and b = (1+r ) , and since (1+r ) < 1,
we can use condition (12) to simplify the terms in [] brackets in
condition (9):

" #
1 0.5 1 1 0.5
CFL = + 1
= + [11] = 5.45 (13)
(1.1) (1.1)2 1 − 1.1 (1.1) (1.1)2

We should achieve the same result using either the perpetuity

condition, or the convergence of geaometric series condition

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 Question 2: Application to Investment under Undertainty NPV: Net Present Value

NPV: Net Present Value III

Step 7: Repeat the calculation of the cash flows for each scenario:

 
2 2 2 2 1 1
CFM = + + ... = + 1+ + + ...
(1.1) (1.1)2 (1.1) (1.1)2 (1.1) (1.1)2
 
2 2 1 2 2
= + 2
1+ = + [11] = 20 (14)
(1.1) (1.1) 0.1 (1.1) (1.1)2

 
3 5 3 5 1 1
CFH = + + ... = + 1+ + + ...
(1.1) (1.1)2 (1.1) (1.1)2 (1.1) (1.1)2
 
3 5 1 3 5
= + 2
1+ = + [11] = 48.18 (14)
(1.1) (1.1) 0.1 (1.1) (1.1)2

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 Question 2: Application to Investment under Undertainty NPV: Net Present Value

NPV: Net Present Value IV

Step 8: Replace the calculated cash flows in condition (7) to get the
NPV, and make a decision wether to invest or not invest

1 1
NPV = −20 + [5.45 + 20 + 48.18] = −20 + [73.63] = 4.54 (14)
3 3
Decision Rule:
If NPV > 0 ⇒ Accept the project
If NPV < 0 ⇒ Reject the project
If NPV = 0 ⇒ Indifferent between accepting or rejecting the project

Since the NPV of the project is > 0, we accept the project

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 Question 2: Application to Investment under Undertainty Change in the initial cost/investment

Change in the initial cost/investment

We are informed that the initial investment/cost of 20M$ was

underestimated by 20%. Therefore, the actual cost has to be such
that:
20
C ∗ (1 − 0.2) = −20 ⇒ C = − = −25 (15)
0.8

Careful: Notice that this is not the same as saying that the actual
cost is 20% higher than initially estimated. If that was the case, we
would have:

C = −20 ∗ (1 + 0.2) = −24 6= −25 (16)

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 Question 2: Application to Investment under Undertainty Change in the initial cost/investment

Calculate the New NPV

We need to recalculate the NPV with the new cost:

1 1
NPV = −25 + [5.45 + 20 + 48.18] = −25 + [73.63] = −0.46 (17)
3 3
Since the NPV < 0, we reject the project

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 Question 2: Application to Investment under Undertainty Change in the cash flows

Change in the cash flows

In the last question, we are informed that the cash flows after the
second year in the high scenario were overestimated. As a result we
need to start by recaulculating the cash flows under this scenario:

 
3 3.5 3 3.5 1 1
CFH = + + ... = + 1+ + + ...
(1.1) (1.1)2 (1.1) (1.1)2 (1.1) (1.1)2
 
3 3.5 1 3 3.5
= + 2
1+ = + [11] = 34.55 (18)
(1.1) (1.1) 0.1 (1.1) (1.1)2

Then, recalculate the NPV:

1
NPV = −20 + [5.45 + 20 + 34.55] = −20 + 20 = 0 (18)
3
Since the NPV = 0, we are indifferent between accepting or
rejecting the project
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