Risky Models

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Risky Models

Palisade EMEA2012 Risk ConferenceLondon

© 2012 Captum Capital Limited

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Modelling Risk

Estimate probability of future eventsProbabilities based on:Statistical analysis of historic dataExpert opinionWisdom of crowdsSubjective best guess

Risk models used to make decisions

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Subjective Risk Perception

Decision makers:Have a poor appreciation of probabilitiesAre risk averseAre loss averse

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US Masters 2012

Sudden Death Play-off

Final 10th Hole – Camilla Par 4

Augusta National

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10th Hole Playoff

Louis Oosterhuizen (South Africa)

Reached green in 3 shots

15 feet from pin

Bubba Watson (United States)

Reached green in 2 shots

8 feet from pin

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Bubba Wins!

Oosterhuizen – Bogey 5

Watson – Par 4

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H T

0.5 + 0.5 = 1

Toss a coin...

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Risk Perceptions

1. 2.

3. 4.

P=1.0£100

0.75

0.25

£300

- £500

0.5

0.5

£500

- £300

0.25

0.75

£700

- £100

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650 Perceptions

1. 2.

3. 4.

P=1.0£100

0.75

0.25

£300

- £500

0.5

0.5

£500

- £300

0.25

0.75

£700

- £100

14% 26%

35% 26%

© Dr. Kelvin Stott

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Loss AversionUtility

ProfitLoss

£100

- £100

Prospect Theory

Kahneman & Tversky (1974)

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Multiple Milestones

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TAMIX Option Value

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Tamix Option Cash Flow

Year 0 1 2 3 4

Cash Flow -1.00 0 -12.55 0 157.35

P 1 0.5 0.5x0.9

NPV -1.00 -10.00 100.00

rNPV = -1 + 0.5 x -10 + 0.45 x 100= £39,000,000

Cash Flow in £000s

Discount Rate R = 12%

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@Risk Option Value

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TAMIX Model Output

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What does it mean?

rNPV $million) Probability of Happening

-1.00 50%

-6.00 5%

39.00 45%

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Risk Impact Matrix

Insignificant

1Minor

2Moderate

3Major

4Catastrophic

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Rare 1 1 2 3 4 5

Unlikely 2 2 4 6 8 10

Possible 3 3 6 9 12 15

Likely 4 4 8 12 16 20

Certain 5 5 10 15 20 25

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NHS Risk Assurance

All NHS Trusts are required to have a Risk Assurance FrameworkHow useful is it?Different people assign different risk

probabilities & impactsNon-quantifiable risks

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NHS Risk Examples

Risk Risk Rating Real Risk

Service demand exceeds contract budgetLikely 4 Impact 5

[Finance Director]

20 25

EWTD limits availability of junior doctorsCertain 5 Impact 4

[Medical Director]

20 10

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The Monty Hall Problem

Originally proposed by:Steve Selvin in the American Statistician 1975

Named after:Monty Hall, hostLet’s Make a Deal

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The Game

Three doors; one hides a car, the others hide goats

You choose one of the 3 doors The host opens a door you haven’t

chosen to reveal a goat Should you stick with your original

choice – or swap?

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Monty Hall @ Risk Model

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The logic of the problem

£ 0 0

0 £ 0

0 0 £

£ 0 0

0 £ 0

0 0 £

Stick Swap

1:3 chanceto win

2:3 chanceto win

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Decision Tree Solution

Host opens

Total P

Stay Switch

Door 2 1 / 6 Car Goat

Door 3 1 / 6 Car Goat

Door 3 1 / 3 Goat Car

Door 2 1 /3 Goat Car

CarLocation

Door 1

Door 2

Door 3

1 / 2

1 / 2

1

1

Player picks

Door 1

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A Controversial Game

A newspaper column received several thousand complaints about this solution

Experiments show ~80% think there is no difference between staying or switching

Even after training in probability, ~70% still choose the wrong answer

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St Petersburg paradox

Daniel Bernoulli

1700 -1782

Presented the problem and its solution in Commentaries of the Imperial Academy of Science of Saint Petersburg (1738)

The problem was invented by Daniel's cousin Nicolas Bernoulli who first stated it in a letter to Pierre Raymond de Montmort of 9 September 1713

The paradox is a classic problem in probability and decision theory, based on a lottery game

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The game

You start with £1A coin is tossed:Heads – your stake is doubledTails – game over

Keep tossing the coin as long it comes up heads

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Some plays

Payout

1 T £1

2 H – H - T £4

3 H – H – H - T £8

4 H – H – H – H – H - T £32

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What’s the problem?

The Expected Value of the game is unlimited!

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Heads Model

Head?

N=N+1

N=0

End

No

Yes

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1000 Plays

0

100

200

300

400

500

600

0 1 2 3 4 5 6

# Heads

Average Payout per Play £3.30

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Payout

# Heads % Plays Payout0 50 £11 27 £22 12 £43 7 £84 2 £165 2 £326 0.5 £64

16 ~0.0002 £65536

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Summary

Risk Models depend on Probabilities!Decision makers:Have a poor appreciation of probabilitiesAre risk averseAre loss averse

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About Captum

Innovation in Life Sciences

Technology Valuation

Modelling behaviour, innovation, value

See us at

Licensing

Risk Analysis using

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Contact

Michael Brande: mjb@captum.comt: +44 (0) 115 988 6154m: +44 (0) 7980 257 241

Captum Capital LimitedCumberland House35 Park RowNottingham NG1 6EEUnited Kingdom

www.captum.com