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Applying simulation to investment decisions 197
Utility U(x)
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
Probability density
U(x) = 0.4x − 0.04x 2
Profit
(a)
0.1
0
0 1 2 3 4
x
5
Money ($m)
(b)
U(x) = 0.25x − 0.01x 2
Figure 7.9 – (a) A normal probability distribution for profit; (b) examples of quadratic
utility functions
averse). Second, a plot of the cumulative probability distributions for
the profits earned by the plate and the figurine showed that the figurine
had second-degree stochastic dominance over the plate. Thus while the
figurine had a slightly higher probability of yielding a loss, it could also
generate much larger profits than the plate, and this was sufficient for it
to have the highest expected utility, even though the manager was risk
averse. A decision was therefore made to go ahead with production of
the figurine.
Applying simulation to investment decisions
The techniques which we have outlined in this chapter have been most
widely applied in the area of investment appraisal. In this section we will