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What Is The Expected Value (EV) ?

The document discusses expected value (EV), which is a measure of the average outcome when considering all possible outcomes of a random variable and their associated probabilities. It provides a formula for calculating EV as the sum of each possible outcome multiplied by its probability. An example calculates the EV of rolling a six-sided die. The document also discusses using multivariate models and scenario analysis to estimate EV for investments by considering different potential future scenarios and their probabilities. Insurance companies use multivariate models to estimate claim payout probabilities and set premium prices accordingly.

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Althea Ababa
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128 views

What Is The Expected Value (EV) ?

The document discusses expected value (EV), which is a measure of the average outcome when considering all possible outcomes of a random variable and their associated probabilities. It provides a formula for calculating EV as the sum of each possible outcome multiplied by its probability. An example calculates the EV of rolling a six-sided die. The document also discusses using multivariate models and scenario analysis to estimate EV for investments by considering different potential future scenarios and their probabilities. Insurance companies use multivariate models to estimate claim payout probabilities and set premium prices accordingly.

Uploaded by

Althea Ababa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Expected Value (EV)

What is the Expected Value (EV)?


The expected value (EV) is an anticipated value for an investment at some point
in the future. In statistics and probability analysis, the expected value is
calculated by multiplying each of the possible outcomes by the likelihood each
outcome will occur and then summing all of those values. By calculating
expected values, investors can choose the scenario most likely to give the
desired outcome.

Where Σ is summation notation.

The equation is basically the same, but here you are adding the sum of all the
gains multiplied by their individual probabilities instead of just one probability.

Understanding the Expected Value (EV)


Scenario analysis is one technique for calculating the expected value (EV) of an
investment opportunity. It uses estimated probabilities with multivariate
models to examine possible outcomes for a proposed investment. Scenario
analysis also helps investors determine whether they are taking on an
appropriate level of risk given the likely outcome of the investment.

The EV of a random variable gives a measure of the center of the distribution of


the variable. Essentially, the EV is the long-term average value of the variable.
Because of the law of large numbers, the average value of the variable
converges to the EV as the number of repetitions approaches infinity. The EV is
also known as expectation, the mean or the first moment. EV can be calculated
for single discrete variables, single continuous variables, multiple discrete
variables, and multiple continuous variables. For continuous variable situations,
integrals must be used.

Example of Expected Value (EV)


To calculate the EV for a single discrete random variable, you must multiply the
value of the variable by the probability of that value occurring. Take, for
example, a normal six-sided die. Once you roll the die, it has an equal one-sixth
chance of landing on one, two, three, four, five, or six. Given this information, the
calculation is straightforward:

If you were to roll a six-sided die an infinite amount of times, you see the
average value equals 3.5.

Multivariate Model
What Is the Multivariate Model?
The multivariate model is a popular statistical tool that uses multiple variables to
forecast possible outcomes. Research analysts use multivariate models to
forecast investment outcomes in different scenarios in order to understand the
exposure that a portfolio has to particular risks. This allows portfolio managers to
mitigate better the risks identified through the multivariate modeling analysis.

KEY TAKEAWAYS

 A multivariate model is a statistical tool that uses multiple variables to


forecast outcomes.
 One example is a Monte Carlo simulation that presents a range of
possible outcomes using a probability distribution.
 Black swan events rendering the model meaningless even if the data sets
and variables being used are good.
 Insurance companies often use multivariate models to determine the
probability of having to pay out claims.

Understanding the Multivariate Model


Multivariate models assist with decision making by allowing the user to test out
the different scenarios and their probable impact. The Monte Carlo simulation is
a widely used multivariate model that creates a probability distribution that helps
define a range of possible investment outcomes. Multivariate models are used in
many fields of finance.

For example, a particular investment can be run through scenario analysis in a


multivariate model to see how it will impact the whole portfolio return in different
market situations, such as a period of high inflation or low-interest rates. This
same approach can be used to evaluate a company’s likely performance,
value stock options, and even evaluate new product ideas. As firm data points
are added to the model, such as same-store sales data being released prior to
earnings, the confidence in the model and its predicted ranges increase.

Special Considerations
Insurance companies are users of multivariate models. The pricing of an
insurance policy is based on the probability of having to pay out a claim. Given
only a few data points, such as the age of the applicant and the home address,
insurers can add that into a multivariate model that pulls from additional
databases that can narrow in on the appropriate policy pricing strategy. The
model itself will be populated with confirmed data points (age, sex, current
health status, other policies owned, etc.) and refined variables (average regional
income, average regional lifespan, etc.) to assign predicted outcomes that will
be used to price the policy.

Advantages and Disadvantages of Multivariate Modeling


The advantage of multivariate modeling is that it provides more detailed “what if”
scenarios for decision-makers to consider. For example, investment A is likely to
have a future price within this range, given these variables. As more solid data is
put into the model, the predictive range gets tighter, and confidence in the
predictions grows. However, as with any model, the data coming out is only as
good as the data going in.

There is also a risk of black swan events rendering the model meaningless even
if the data sets and variables being used are good. This is, of course, why the
models themselves aren’t put in charge of trading. The predictions of
multivariate models are simply another source of information for the ultimate
decision-makers to think about.

Activity #5

Name:__________________________ Date:________________

Course, Year & Section:____________ Student ID:___________


Solve the following problems based on expected value. Show your solution using handwriting way.
(5 points each)

1. Find a weighted average of the payoffs for a decision alternative.

Alternatives Growing Stable Declining Expected


Monetary value
Bonds 40 45 5 =
Stocks 70 30 -13 =
Mutual Funds 53 45 -5 =
Probability 0.2 0.5 0.3

2. A businessman has been offered a new job with a fixed salary of $ 230. His records from his present
job show that his weekly commissions have the ff. probabilities.

Commission 0 150 250 350 450


probability 0.05 0.15 0.25 0.45 0.1
Should he change jobs?

3. A photographer has a big event that will yield a profit of $ 3000 with a probability of 0.8 or a loss due
to unforeseen circumstances of $ 400 with a probability of 0.2. What is the photographer’s expected
profit?

4. Find the expected number of girls for a three-child family. Assume girls and boys are equally likely.

5. Find the expected value of the random variable X in the graph below.

0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
1 2 3 4 5

Note: Horizontal values are X and the vertical points are probabilities.

6. If X is the number of points rolled with a balanced die, find the expected value of the random variable.

7. Goal is to maximize expected value in the table below.

Investment Choice Strong Economy Stable Economy Weak Economy


(0.3) (0.5) (0.2)
Large Factory 350 75 -25
Average Factory 100 250 -50
Small Factory 20 10 5

8. Find the expected value of the random variable in the table below.

X 2 4 6 8 9 10
P(x) 0.2 0.4 0.3 0 0.1 0

9. A salesman is considering a sale that promises a profit of $ 50,500 with a probability of 0.6 or a loss
due to weather strikes of $ 14,000 with a probability of 0.4. What is the expected profit?

10. You purchase 1 Lotto ticket for $ 10. The outlet is selling 10,000 Lotto tickets. One ticket will be
randomly drawn and the winner will receive $ 20,000. Assuming all the tickets are sold. Compute the
expected value.

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