Lecture 7

Review of Probability for Risk Management

ENMG 698c: Special Topics - Project Risk Management - Dr. Rayan Khraibani

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Outline
▪A short-duration project
▪Review of probability theory
▪ Probability
▪ Events
▪ Random variables
▪ Summary statistics
▪Theoretical distributions

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A Short-Duration Project

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Context
▪ Each year, a two-day event is organized by the association of students of
AUB

▪ May 2020 theme: The future of graduate engineering education in Lebanon

▪ Panel: Wednesday from 6:00 to 7:30 pm. Important speakers confirmed

their participation

▪ The conference will close with a performance event on Thursday night.

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Your project

▪ Record the panel and a special performance from a local artist

▪ Sell the DVD as a limited-edition souvenir at the door of the

closing event

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Feasibility and costs
▪ Hiring the video crew: at least one month in advance. Cost: 1,000$

▪ Editing and recording (6 hours): 400$

▪ Production cost: 200$ plus 0.50$ per DVD burned; if order is for more than
200, 0.40$ per DVD above 200

▪ Royalty costs: 10% of the sales for the local artist

▪ All DVDs that are not sold during the closing event will be destroyed.

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Feasibility and Costs
▪ Advance registration deadline: two months before the event (very
soon!)

▪ Tickets for the closing event are not included in the registration
package. A 10% discount is offered to participants who reserve in
advance. Tickets are also available at the door (up to capacity)

▪ Attendance data for previous events is available (see data file).

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Modeling
▪ Objective

▪ Decisions

▪ Parameters

▪ Uncertainty

▪ Risk

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 Probability

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What is a Probability?
▪ A probability is a measure of an uncertain event

▪ This measure is applied to the “likelihood” of the event

▪ An event which is more likely to happen than another has a higher

probability

▪ By convention, probabilities are between 0 and 1

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Three Kinds of Probability
▪ Geometric probability

▪ Limit of frequencies

««
▪ Subjective probability ««

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Consistency
▪ Probabilities should satisfy the probability axioms
▪ Axiom 1: The probability of an event is a real number greater than or equal to
0.
▪ Axiom 2: The probability that at least one of all the possible outcomes of a
process will occur is 1.
▪ Axiom 3: If two events A and B are mutually exclusive, then the probability of
either A or B occurring is the probability of A occurring plus the probability
of B occurring.
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Probability Tree

high
10%
Attendance

70% medium

20%
low

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Venn Diagram

Positive
profit

low
medium
high

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 Events

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Dependent and Independent Events
0,1 0,6

B B

0,2 0,2
NB NB
A A
0,9 0,4

0,7 0,6
NA NA
B B
0,8 0,8

NB NB

0,3 0,4

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Notation
▪ 𝑃(𝐵|𝐴): Probability that B is realized, given that A is realized

▪ 𝑃(𝐴 ∩ 𝐵): Probability that both A and B are realized

▪ 𝑃(𝐴 ∪ 𝐵): Probability that either A or B is realized

▪ 𝑃 𝐴 ∩ 𝐵 = 𝑃(𝐴) × 𝑃(𝐵|𝐴)

▪ 𝑃 𝐴 ∪ 𝐵 = 𝑃 𝐴 + 𝑃 𝐵 − 𝑃(𝐴 ∩ 𝐵)
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Bayes Formula
𝑃 𝐴∩𝐵 =𝑃 𝐴 ×𝑃 𝐵 𝐴
𝑃 𝐴 ∩ 𝐵 = 𝑃(𝐵) × 𝑃(𝐴|𝐵)

𝑃 𝐴∩𝐵
𝑃 𝐵𝐴 =
𝑃(𝐴)
𝑃(𝐵) × 𝑃(𝐴|𝐵)
𝑃 𝐵𝐴 =
𝑃(𝐴)

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Random Variables

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Random Variables

▪ X: number of points on the die

▪ Probability distribution:

x 1 2 3 4 5 6
P(X=x) 1/6 1/6 1/6 1/6 1/6 1/6

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Random Variables

Construction costs ($/KW)

▪ X: construction cost
▪ Probability density:

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Probability Distribution/Density
b
P(a  X  b) = a x b P( X = x i ) =  f (x)dx
i
a

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Summary Statistics

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Position indicators

▪Mode

▪Median

▪Mean (μ)

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Dispersion indicators
▪ Range

▪ Variance (𝜎 2 )

▪ Standard deviation

▪ Interquartile range

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Risk Indicators
▪ Variance

▪ Semi-variance

▪ Value at risk
TVaR95=9

▪ Tail VaR

95% VaR=7,5

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Dependency Indicator
▪ Correlation: a measure of linear dependency between two variables, usually
denoted by ρ
Positive correlation, rho=0.93 Negative correlation, rho=-0.35
600 300

500 250

400 200

300 150

200 100

100 50

0 0
0 20 40 60 80 100 120 0 20 40 60 80 100 120

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Independency and Correlation

No correlation No correlation
120 35

100 30

25
80
20
60
15
40
10

20 5

0 0
0 20 40 60 80 100 120 0 20 40 60 80 100 120

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Theoretical Distributions

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▪ Number of equipment failures in a week: Poisson of mean 2

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▪ Number of producing wells in 100 drillings: Binomial (n=100, p=0.9)

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▪ Variable production costs: normal with mean of $10 per MW and standard
deviation of 2$ per MW

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▪ Return on investment: lognormal with mean of $150 and standard deviation
of $150

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▪ Annual demand for CFC: triangular, minimum 24 tons, probable 30 tons,
maximum 60 tons

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▪ Delay: uniform between 0 minutes and 5 minutes

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Exponential Distribution
▪ Time between two machine shut-downs: exponential of mean 10

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Beta Distribution

• The support of the beta

distribution is the
interval [0,1]
𝛼−1
• Mode:
𝛼+𝛽−2
𝛼
• Mean:
𝛼+𝛽
1
• Variance:
4(2𝛽+1)

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Assignment
▪ Set up an EXCEL model to evaluate the feasibility and profitability of your
project
▪ Define the risk breakdown structure
▪ Evaluate the sensitivity of the outcome of your projet to various parameters
▪ What additional information would you like to collect?

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