Lesson 2: decision trees and sensitivity analysis

Question 1

Decision Three Nodes

Answer 1

1. Decision node: each arc EMANATING FROM a decision node (square) corresponds to a different choice/alternative
2. Chance node: each arc EMANATING FROM an event node corresponds to the possible outcomes of the random event
3. Terminal node: each node is reached via a unique path and vice-versa

Question 2

what is the value of the terminal node (red square)?

Answer 2

the algebraic sum of the costs and revenues on the unique path that connects the root node (red) with the terminal node (green)

Question 3

what is the value of the event node (yellow circle)?

Answer 3

the expected value of the corresponding random numbers ( IN CASE OF RISK NEUTRALITY )

Question 4

what is the value of the decision node (blue square)

Answer 4

the maximum of the values of the nodes that immediately follow it

Question 5

What is the point of sensitivity analysis?

Answer 5

treat parameters as variables to determine the effects on the model

Question 6

Which are the insights fro 1 way sensitivity plots?

Answer 6

1. indifference: we find the value of the parameter that makes us indifferent between the alternatives
2. stability: we can understand if we are close to indifference or not
3. we can understand whether the expected payoff of the alternative is an increasing or decreasing function of the parameter in question

Question 7

Wha is the tornado diagram?

Answer 7

in sensitivity analysis, the tornado diagram helps us understand:

1. what happens if several parameters undergo the same percentage variation
2. what is the parameter that produces the greatest / least variation of expected value
3. direction of impact: is the change in the variable under consideration going to increase or decrease my expected profit?