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401 Project Management Spring 2006

Risk Analysis Decision making under risk and uncertainty

Department of Civil and Environmental Engineering Massachusetts Institute of Technology

Preliminaries

Announcements

Remainder

email Sharon Lin the team info by midnight, tonight Monday Feb 27 - Student Experience Presentation Wed March 1st Assignment 2 due

Today, recitation Joe Gifun, MIT facility Next Friday, March 3rd, Tour PDSI construction site

1st group noon 1:30 2nd group 1:30 3:00

Construction nightmares discussion

16 - Psi Creativity Center, Design and Bidding phases

Project Management Phase

FEASIBILITY

DESIGN PLANNING

DEVELOPMENT CLOSEOUT

OPERATIONS

Financing&Evaluation Risk Analysis&Attitude

Risk Management Phase


FEASIBILITY DESIGN PLANNING DEVELOPMENT CLOSEOUT OPERATIONS

RISK MNG

Risk management (guest seminar 1st wk April)


Assessment, tracking and control Tools:


Risk Hierarchical modeling: Risk breakdown structures Risk matrixes Contingency plan: preventive measures, corrective actions, risk budget, etc.

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 (Sub)contractors are


Unreliable Lack capacity to do work Lack availability to do work Unscrupulous Financially unstable

Community opposition Infighting & acrimonious relationships Unrealistically low bid Late-stage design changes Unexpected subsurface conditions

Late materials delivery Lawsuits Labor difficulties Unexpected manufacturing costs Failure to find sufficient tenants

Soil type Groundwater Unexpected Obstacles

Settlement of adjacent structures High lifecycle costs Permitting problems

Importance of Risk

Much time in construction management is spent focusing on risks Many practices in construction are driven by risk
Bonding requirements Insurance Licensing Contract structure

General conditions Payment Terms Delivery Method Selection mechanism

Outline
Risk and Uncertainty Risk Preferences, Attitude and Premiums Examples of simple decision trees Decision trees for analysis Flexibility and real options

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


Illustrating decision making with uncertainty Quantitative reasoning

Represent
Flow of time Decisions Uncertainties (via events) Consequences (deterministic or stochastic)

Decision Tree Nodes

Time

Decision (choice) Node

Chance (event) Node

Terminal (consequence) node

Outcome (cost or benefit)

Risk Preference

People are not indifferent to uncertainty


Lack of indifference from uncertainty arises from uneven preferences for different outcomes E.g. someone may

dislike losing $x far more than gaining $x value gaining $x far more than they disvalue losing $x.

Individuals differ in comfort with uncertainty based on circumstances and preferences Risk averse individuals will pay risk premiums to avoid uncertainty

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 dont mind losing as much

Risk attitudes change over


Time Circumstance

Decision Rules

The pessimistic rule (maximin = minimax)

The conservative decisionmaker seeks to:


maximize the minimum gain (if outcome = payoff) or minimize the maximum loss (if outcome = loss, risk)

The optimistic rule (maximax)

The risklover seeks to maximize the maximum gain Max ( min + (1- ) max) , 0 1

Compromise (the Hurwitz rule):

= 1 pessimistic = 0.5 neutral = 0 optimistic

The bridge case unknown probties


$ 1.09 million replace
$1.61 M

repair
$0.55 $1.43

Investment PV

Pessimistic rule min (1, 1.61) = 1 replace the bridge The optimistic rule (maximax) max (1, 0.55) = 0.55 repair and hope it works!

The bridge case known probties


$ 1.09 million replace 0.25 repair 0.5 0.25
$1.43 $1.61 M $0.55

Investment PV

Expected monetary value E = (0.25)(1.61) + (0.5)(0.55) + (0.25)(1.43) = $ 1.04 M

Data link

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

0. 5 0.25 0.25

-125 -95 -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

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

125

100

65

Defining the Preference Function


Suppose to be awarded a $100M contract price Early estimated cost $70M What is the preference function of cost?

Preference means utility or satisfaction

utility

70

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

Certainty Equivalent Example

Consider a risk averse individual with preference fn f faced with an investment c that provides

50% chance of earning $20000 50% chance of earning $0 .5*$20,000+.5*$0=$10000 .5*f($20,000)+.5*f($0)=.25

.50 .25

Mean satisfaction with investment

Average money from investment =

Certainty equivalen of investment

Average satisfaction with the investment=

Mean value Of investme

This individual would be willing to trade for a sure investment yielding satisfaction>.25 instead

Can get .25 satisfaction for a sure f-1(.25)=$5000

We call this the certainty equivalent to the investment

Therefore this person should be willing to trade this investment for a sure amount of money>$5000

$5000

Example Contd (Risk Premium)

The risk averse individual would be willing to trade the uncertain investment c for any certain return which is > $5000 Equivalently, the risk averse individual would be willing to pay another party an amount r up to $5000 =$10000-$5000 for other less risk averse party to guarantee $10,000
Assuming the other party is not risk averse, that party wins because gain r on average The risk averse individual wins b/c more satisfied

Certainty Equivalent

More generally, consider situation in which have


Uncertainty with respect to consequence c Non-linear preference function f

Note: E[X] is the mean (expected value) operator The mean outcome of uncertain investment c is E[c]

In example, this was .5*$20,000+.5*$0=$10,000 In example, this was .5*f($20,000)+.5*f($0)=.25 Size of sure return that would give the same satisfaction as c In example, was f-1(.25)=f-1(.5*20,000+.5*0)=$5,000

The mean satisfaction with the investment is E[f(c)]

We call f-1(E[f(c)]) the certainty equivalent of c


Risk Attitude Redux

The shapes of the preference functions means can classify risk attitude by comparing the certainty equivalent and expected value

For risk loving individuals, f-1(E[f(c)])>E[c]

They want Certainty equivalent > mean outcome

For risk neutral individuals, f-1(E[f(c)])=E[c] For risk averse individuals, f-1(E[f(c)])<E[c]

Motivations for a Risk Premium

Consider
Risk averse individual A for whom f-1(E[f(c)])<E[c] Less risk averse party B

A can lessen the effects of risk by paying a risk premium r of up to E[c]-f-1(E[f(c)]) to B in return for a guarantee of E[c] income
The risk premium shifts the risk to B The net investment gain for A is E[c]-r, but A is more satisfied because E[c] r > f-1(E[f(c)]) B gets average monetary gain of r

Gamble or not to Gamble

EMV (0.5)(-1) + (0.5)(1) = 0

Preference function f(-1)=0, f(1)=100 Certainty eq. f-1(E[f(c)]) = 0 No help from risk analysis !!!!!

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

The bridge case - Multiple tradeoffs


Computation of Pareto-Optimal Set For decision D2
Replace MTTF 10.0000 Cost 1.00

C3 MTTF 6.6667 Cost 0.30 C4 MTTF 5.7738 Cost 0.00


Aim: maximizing bridge duration, minimizing cost

MTTF = mean time to failure

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

03/06/06 - Preliminaries

Announcements

Due dates Stellar Schedule and not Syllabus Term project


Phase 2 due March 17th Phase 3 detailed description posted on Stellar, due May 11 Decision making under uncertainty

Assignment PS3 posted on Stellar due date March 24

Reading questions/comments?

Utility and risk attitude You can manage construction risks Risk management and insurances - Recommended

Decision Making Under Risk


Risk and Uncertainty Risk Preferences, Attitude and Premiums Examples of simple decision trees Decision trees for analysis Flexibility and real options

Multiple objective The students dilemma

Decision Making Under Risk


Risk and Uncertainty Risk Preferences, Attitude and Premiums Examples of simple decision trees Decision trees for analysis Flexibility and real options

Bidding

What choices do we have? How does the chance of winning vary with our bidding price? How does our profit vary with our bidding price if we win?

Example Bidding Decision Tree


Time

Bidding Decision Tree with Stochastic Costs, Competing Bids

Selecting Desired Electrical Capacity

Decision Tree Example: Procurement Timing

Decisions

Choice of order time (Order early, Order late)

Events
Arrival time (On time, early, late) Theft or damage (only if arrive early)

Consequences: Cost

Components: Delay cost, storage cost, cost of reorder (including delay)

Procurement Tree

Decision Making Under Risk


Risk and Uncertainty Risk Preferences, Attitude and Premiums Decision trees for representing uncertainty Decision trees for analysis Flexibility and real options

Analysis Using Decision Trees

Decision trees are a powerful analysis tool Example analytic techniques


Strategy selection (Monte Carlo simulation) One-way and multi-way sensitivity analyses Value of information

Recall Competing Bid Tree

Monte Carlo simulation


Monte Carlo simulation randomly generates values for uncertain variables over and over to simulate a model. It's used with the variables that have a known range of values but an uncertain value for any particular time or event. For each uncertain variable, you define the possible values with a probability distribution. Distribution types include:

A simulation calculates multiple scenarios of a model by repeatedly sampling values from the probability distributions Computer software tools can perform as many trials (or scenarios) as you want and allow to select the optimal strategy

Monetary Value of $6.75M Bid

Monetary Value of $7M Bid

With Risk Preferences: 6.75M

With Risk Preferences: 7M

Larger Uncertainties in Cost (Monetary Value)

Large Uncertainties II (Monetary Values)

With Risk Preferences for Large Uncertainties at lower bid

With Risk Preferences for Higher Bid

Optimal Strategy

Decision Making Under Risk


Risk and Uncertainty Risk Preferences, Attitude and Premiums Decision trees for representing uncertainty Examples of simple decision trees Decision trees for analysis Flexibility and real options

Flexibility and Real Options

Flexibility is providing additional choices Flexibility typically has


Value by acting as a way to lessen the negative impacts of uncertainty Cost

Delaying decision Extra time Cost to pay for extra fat to allow for flexibility

Ways to Ensure of Flexibility in Construction

Alternative Delivery Clear spanning (to allow movable walls) Extra utility conduits (electricity, phone,) Larger footings & columns Broader foundation Alternative heating/electrical

Contingent plans for

Value engineering Geotechnical conditions Procurement strategy

Additional elevator Larger electrical panels Property for expansion Sequential construction Wiring to rooms

Adaptive Strategies

An adaptive strategy is one that changes the course of action based on what is observed i.e. one that has flexibility
Rather than planning statically up front, explicitly plan to adapt as events unfold Typically we delay a decision into the future

Real Options

Real Options theory provides a means of estimating financial value of flexibility

E.g. option to abandon a plant, expand bldg

Key insight: NPV does not work well with uncertain costs/revenues

E.g. difficult to model option of abandoning invest.

Model events using stochastic diff. equations


Numerical or analytic solutions Can derive from decision-tree based framework

Example: Structural Form Flexibility

Considerations

Tradeoffs

Short-term speed and flexibility

Overlapping design & construction and different construction activities limits changes E.g. value engineering away flexibility Selection of low bidder Late decisions can mean greater costs

Short-term cost and flexibility


NB: both budget & schedule may ultimately be better off w/greater flexibility!

Frequently retrofitting $ > up-front $

Decision Making Under Risk


Risk and Uncertainty Risk Preferences, Attitude and Premiums Decision trees for representing uncertainty Examples of simple decision trees Decision trees for analysis Flexibility and real options

Readings

Required

More information:

Utility and risk attitude Stellar Readings section

Get prepared for next class:


You can manage construction risks Stellar On-line textbook, from 2.4 to 2.12

Recommended:
Meredith Textbook, Chapter 4 Prj Organization Risk management and insurances Stellar

Risk - MIT libraries


Haimes, Risk modeling, assessment, and management Mun, Applied risk analysis : moving beyond uncertainty Flyvbjerg, Mega-projects and risk Chapman, Managing project risk and uncertainty : a constructively simple approach to decision making

Bedford, Probabilistic risk analysis: foundations and methods


and a lot more!