Probabilistic Risk Analysis

CHAPTER 13
PROBABILISTIC RISK
ANALYSIS
RANDOM VARIABLES
• Factors having probabilistic outcomes
• The probability that a cost, revenue, useful life,
or other economic factor value will occur, is
usually considered to be the subjectively
estimated likelihood that an event (value) occurs
• Random variable information that is particularly
helpful in decision making are the expected
values and variances
• These values make the uncertainty associated
with each alternative more explicit
RANDOM VARIABLES
• Capital letters such as X, Y, and Z are

used to represent random variables
• Lower-case letters (x,y,z) denote the
particular values that these variables
take on in the sample space (I.e., the
set of possible outcomes for each
variable)
RANDOM VARIABLES
• When random variable X follows some
discrete probability distribution, its mass
function is usually indicated by p(x) and
its cumulative distribution function by
P(x)
• When X follows a continuous probability
distribution, its probability density
function function and it cumulative
distribution function are usually
indicated by f(x) and F(x), respectively
DISCRETE RANDOM VARIABLES
• A random variable X is discrete if it can
take on a finite number of values (x1,x2…
xL)
• The probability that a discrete random
variable X takes on the value xi is given
by
Pr{X = xi} = p(xi) for i = 1,2,….,L (i is a
sequential index of the discrete values, xi,
that the variable takes on)
where p(xi) > 0 and Si p(xi) = 1
CONTINUOUS RANDOM VARIABLES
A random variable is continuous if:
Pr{c < X < d} =∫cd f(x)dx
In the nonnegative function f(x),this is the probability that
X is within the set of real numbers (c,d)
∫-∞∞f(x)dx = 1
The probability that the value X is less than or equal x = k,
the cumulative distribution function F(x) for a
continuous case is
Pr{X < k} = F(k) = ∫-∞k f(x)dx
Pr{c < X < d} =∫cd f(x)dx = F(d) – F( c )
• In most applications, continuous random variables
represent measured data, such as time, cost and
revenue on a continuous scale
MATHEMATICAL EXPECTATIONS AND
SELECTED STATISTICAL MOMENTS
• The expected value of a single random variable X,
(E(X), is a weighted average of the distributed
values x that it takes on and is a measure of the
central location of the distribution
• E(X) is the first moment of the random variable
about the origin and is called the mean of the
distribution
E(X) = Si xi p( xi ) for x discrete and i = 1,2,…,L
E(X) = ∫-∞∞[x – E(X)]2 f(x)dx for x continuous
MATHEMATICAL EXPECTATIONS AND
SELECTED STATISTICAL MOMENTS
• From binomial expansion of [X – E(X)]2
V(X) = E(X2) – [E(X)]2
• V(X) is the second moment of the random
variable around the origin : the expected value of
X2, minus the square of its mean
• V(X) is the variance of the random variable X
V(X) = Si x2p(xi) – [E(X)]2 for x discrete
V(X) = ∫-∞∞xi2(x)dx – [E(X)]2 for x continuous
• The standard deviation of a random variable,
SD(X) is the positive square root of the variance
SD(X) = [V(X)]1/2
MULTIPLICATION OF A RANDOM
VARIABLE BY A CONSTANT
• When a random variable, X, is multiplied by a
constant, c, the expected value E(cX), and the
variance, V(cX) are:
E(cX) = cE(X) = Si cxi p(xi) for discrete
E(cX) = cE(X) = ∫-∞∞cx f(x)dx for continuous
V(cX) = E{ [cX – E(cX)]2 }
=E{c2X2 – 2c2X . E(X) + c2 [E(X)]2 }
=c2E{ [X – E(X)]2 }
MULTIPLICATION OF TWO INDEPENDENT
VARIABLES
• When a random variable, Z, is a product of two
independent random variables, X and Y, the
expected value, E(Z), and the variance, V(Z) are
Z= XY
E(Z) = E(X) E(Y)
V(Z) = E [XY – E(X)]2
= E { X2Y2 – 2XY E(XY) + [E(XY)]2 }
=EX2 EY2 – [E(X) E(Y)]2
But the variance of any random variable, V(RV), is
V(RV) = E[(RV)2] – [E(RV)]2
E[(RV)2] = V(RV) + [E(RV)]2
MULTIPLICATION OF TWO INDEPENDENT
VARIABLES
V(Z) = { V(X) + [E(X)]2 } { V(Y) + [E(Y)]2 } – [E(X)]2 [E(Y)]2

Or
V(Z) = V(X) [E(Y)]2 + V(Y) [E(X)]2 + V(X) V(Y)
EVALUATION OF PROJECTS WITH
DISCRETE RANDOM VARIABLES
• Expected value and variance concepts
apply theoretically to long-run conditions
in which it is assumed that the event is
going to occur repeatedly
• However, application of these concepts is
often useful when investments are not
going to be made repeatedly over the
long run
Two Frequently Used Assumptions
• Uncertain cash-flow amounts are
distributed according to the normal
distribution
• Uncertain cash flow amounts are
statistically independent
– no correlation between cash flow amounts is
assumed
If there is a linear combination of two or more
independent cash flow amounts (i.e., PW =
c0F0 + … +cNFN, where ck values are
coefficients and Fk values are periodic net
cash flows) the expression V(PW) reduces to
V(PW) = Sk=0N ck2 V(Fk)
E(PW) = Sk=0N ckE(Fk)
EVALUATION OF UNCERTAINTY
USING MONTE CARLO SIMULATION
• Computer-assisted simulation tool for
analyzing more complex project
uncertainties
• Monte Carlo simulation generates random
outcomes for probabilistic factors which
imitate the randomness inherent in the
original problem
EVALUATION OF UNCERTAINTY USING
MONTE CARLO SIMULATION
• Construct an analytical model that represents the
actual decision situation
• Develop a probability distribution from subjective
or historical data for each uncertain factor in the
model
• Sample outcomes are randomly generated by
using probability distribution for each uncertain
quantity and then used to determine a trial
outcome for the model
• Repeating sampling process many times leads to
a frequency distribution of trial outcomes, which
are used to make probabilistic statements
DECISION TREES
• Also called decision flow networks and
decision diagrams
• Powerful means of depicting and facilitating
analysis of important problems, especially
those that involve sequential decisions and
variable outcomes over time
• Practical tool because it permits large
complicated problems to be reduced to a
series of smaller simple problems
• Enable objective analysis and decision making
that includes explicit consideration of the risk
and effect of the future
GENERAL PRINCIPLE OF DIAGRAMING
The Decision Tree Diagram Should Show the Following
(With square symbol to depict decision node and circle
symbol to depict chance outcome node):
1. All initial or immediate alternatives among which the
decision maker wishes to choose
2. All uncertain outcomes and future alternatives the
decision maker wishes to consider
Note alternatives at any point and outcomes at any
chance outcome node must be:
• Mutually exclusive
• Collectively exhaustive; that is, one event must be
chosen or something must occur if the decision point
or outcome node is reached

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CHAPTER 13

• Capital letters such as X, Y, and Z are

V(Z) = { V(X) + [E(X)]2 } { V(Y) + [E(Y)]2 } – [E(X)]2 [E(Y)]2

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