Valuing risky projects: option pricing theory and decision analysis

Article Abstract:

A variety of alternative and opposing techniques for the valuation of risky projects have emerged in both academic and professional circles. A study was conducted to determine their effectiveness by comparing and contrasting three of such approaches. The three methods studied were risk-adjusted discount-rate analysis, option pricing analysis and decision analysis. The examination showed how the proper application of option pricing and decision analysis methods can result in consistent outcomes. The study also revealed how to effectively integrate option pricing and decision analysis techniques. The investigation also demonstrated that option pricing techniques can be employed for the simplification of decision analyses when certain risks can be hedged. Decision analysis techniques were also shown to be applicable in extending option pricing techniques to problems having incomplete securities markets.

Risk management, Pricing

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Should scoring rules be 'effective'?

Article Abstract:

A scoring rule is considered to be strictly proper if it leads the forecaster to state true subjective probabilities, with no incentive to hedge; it is considered to be effective if it is associated with a metric on the set of probability distributions. The relationship between strictly proper scoring rules and metrics is developed. What the requirement of effectiveness adds is not a monotonicity property, but is instead a transitivity property, which is difficult to justify behaviorally and which is not satisfied by the logarithmic rule. It is shown that the requirement of effectiveness is excessively restrictive and does not resolve the difficulties that may arise in articulating and interpreting continuous probability forecasts.

Evaluation, Forecasts and trends, Forecasting, Probabilities, Probability theory

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Joint coherence in games of incomplete information

Article Abstract:

Noncooperative game theory is devoted principally to the study of decision-making made by rational players under highly uncertain conditions. A key aspect of noncooperative game theory is the formulation of games of incomplete information as suggested by Harsanyi. Harsanyi's key solution concept for an incomplete-information game is the idea of a Bayesian equilibrium that is jointly drawn at random from populations of typical ratios of types. A model, which adopts an extension of the axiom of coherence as postulated by Finetti, is developed to show how this game-theoretic concept of Bayesian equilibrium can be linked to subjective probability theory.

Decision-making, Decision making, Bayesian statistical decision theory, Bayesian analysis, Game theory

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