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Chapter 4
4-1 Introduction
(slide 1 of 3)
n A key aspect of solving real business problems is dealing appropriately with uncertainty.
n This involves recognizing explicitly that uncertainty exists and using quantitative methods to
model uncertainty.
n In many situations, the uncertain quantity is a numerical quantity. In the language of probability,
it is called a random variable.
n A probability distribution lists all of the possible values of the random variable and their
corresponding probabilities.
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Introduction
(slide 2 of 3)
4-3
Introduction
(slide 3 of 3)
n Uncertainty and risk are sometimes used interchangeably, but they are not really the same.
n You typically have no control over uncertainty; it is something that simply exists.
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n If the probability of A is P(A), then the probability of its complement is given by the equation
below.
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n Events are mutually exclusive if at most one of them can occur—that is, if one of them occurs,
then none of the others can occur.
n Exhaustive events means they exhaust all possibilities—one of the events must occur.
n The addition rule of probability involves the probability that at least one of the events will occur.
n When the events are mutually exclusive, the probability that at least one of the events will
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n A formal way to revise probabilities on the basis of new information is to use conditional
probabilities.
n Let A and B be any events with probabilities P(A) and P(B). If you are told that B has occurred,
then the probability of A might change.
n The new probability of A is called the conditional probability of A given B, or P(A|B).
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n Objective: To apply probability rules to calculate the probability that Bender will meet its end-of-
July deadline, given the information it has at the beginning of July.
n Solution: Let A be the event that Bender meets its end-of-July deadline, and let B be the event
that Bender receives the materials it needs from its supplier by the middle of July.
n Bender estimates that the chances of getting the materials on time are 2 out of 3, so that P(B) =
2/3.
n Bender estimates that if it receives the required materials on time, the chances of meeting the
deadline are 3 out of 4, so that P(A|B) = 3/4.
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n There are situations where the probabilities 𝑃(𝐴), 𝑃(𝐴|𝐵), and 𝑃(𝐴|𝐵') are equal. In this case, A
and B are probabilistically independent events.
n This does not mean that they are mutually exclusive.
n Rather, it means that knowledge of one event is of no value when assessing the probability
of the other.
n When two events are probabilistically independent, the multiplication rule simplifies to:
n To tell whether events are probabilistically independent, you typically need empirical data.
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n Objective probabilities are those that can be estimated from long-run proportions.
n The relative frequency of an event is the proportion of times the event occurs out of the
number of times the random experiment is run.
n A famous result called the law of large numbers states that this relative frequency, in the long
run, will get closer and closer to the “true” probability of an event.
n However, many business situations cannot be repeated under identical conditions, so you must
use subjective probabilities in these cases.
n A subjective probability is one person’s assessment of the likelihood that a certain event will
occur.
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n Usually a discrete distribution results from a count, whereas a continuous distribution results from
a measurement.
n This distinction between counts and measurements is not always clear-cut.
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n The essential properties of a discrete random variable and its associated probability distribution
are quite simple.
n To specify the probability distribution of X, we need to specify its possible values and their
probabilities.
n We assume that there are k possible values, denoted
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n A cumulative probability is the probability that the random variable is less than or equal to
some particular value.
n Assume that 10, 20, 30, and 40 are the possible values of a random variable X, with
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n The mean, often denoted μ, is a weighted sum of the possible values, weighted by their
probabilities:
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n Objective: To compute the mean, variance, and standard deviation of the probability distribution
of the market return for the coming year.
n Solution: Market returns for five economic scenarios are estimated at 23%, 18%, 15%, 9%, and
3%. The probabilities of these outcomes are estimated at 0.12, 0.40, 0.25, 0.15, and 0.08.
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2. To get ready to compute the variance, calculate the squared deviations from the mean by entering
this formula in cell D4:
4. Calculate the standard deviation of the market return in cell B13 with the formula:
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n There are many situations where the mean and variance of a random variable depend on some
external event.
n In this case, you can condition on the outcome of the external event to find the overall mean
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n Simulation is an extremely useful tool that can be used to incorporate uncertainty explicitly into
spreadsheet models.
n A simulation model is the same as a regular spreadsheet model except that some cells contain
random quantities.
n Each time the spreadsheet recalculates, new values of the random quantities are generated,
discrete distribution.
n This procedure is accomplished most easily in Excel
® through the use of a lookup table—by
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1. Copy the possible returns to the range E13:E17. Then enter the cumulative probabilities next to
them in the range D13:D17. To do this, enter the value 0 in cell D13. Then enter the formula:
in cell D14 and copy it down through cell D17. The table in the range D13:E17 becomes the
lookup range (LTable).
2. Enter random numbers in the range A13:A412. To do this, select the range, then type the
formula:
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3. Generate the random market returns by referring the random numbers in column A to the
lookup table. Enter the formula:
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