Example of a Decision Tree

A simple example of using a decision tree to help us with decision-making.

A couple renting an apartment and is wondering whether they should sign a 1-year contract on the rent.  If they sign a contract, their rent is guaranteed not to increase during the 1-year period. If they don’t sign a contract, their rent will increase by about $20 after 6 months.

This seems like a simple decision.  But there is a drawback to signing the contract. If the couple decides to terminate the contract before the end of 1 year, they are liable to pay up to 25 weeks worth of rent to the landlord, unless the landlord is able to get someone else to rent the place earlier. 

The couple intends to buy their own home if the right opportunity comes, so there is a chance that they would need to terminate any contract they sign.

Supposing the initial rent is $900 per month, what is the couple’s best option?

Let us choose the simplest situation first.  Let’s assume there is zero chance that the couple will terminate the contract.  So the decision tree looks like this:

The tree says that the option to sign a lease contract will result in a total 1-year rent of $10,800 ($900 * 12 months), while not signing a lease contract will result in a total 1-year rent of $11,800 ($900 * 6 months + $900 * 1.2 * 6 months).

But what happens if the couple finds their dream house and moves out of the house after 8 months?

The Essence of Risk Management

All of man’s activities is fraught with uncertainty and risk.  When he undertakes something, he faces uncertainty and risk and loss.  Even when he does not undertake anything new, but simply goes on with life as normal, he still faces uncertainty and risk and loss.

Therein lies the essence of risk management, to which man runs to, to seek an answer to his question: in the face of this uncertainty, what should we do?

Operations Risk

Every company faces risks as it goes about its day-to-day operations.  A bank branch could find itself in the midst of a robbery.  A fastfood restaurant could suddenly have a cook badly burned by an overturned pot filled with boiling water.  A shipping company may have one of its ships boarded by pirates.  A veterinary clinic may have one of its staff or customers bitten by a dog. A data centre may find the building it is located in collapsing due to an earthquake. These risks are called ‘Operations Risk’, or alternatively ‘Operational Risk’. 

The types of operations risk a company faces depends heavily on its line of business, although the nature of risk is that it is often unexpected: the bank could suddenly discover that the pirates who boarded the ship in the above example are actually the bank’s customers.  The shipping company may find its cook burned badly while preparing food.

Operations risk is different from the other types of risks that companies face.  It is not credit risk, which is the risk related to debtors not paying the company.  It is not strategic risk.  It is not market risk.  It is not reputation risk.  Nevertheless, risks arising from operations can cascade into these types of risks.  The revelation that a pirate has been hoarding its loot in your bank can rapidly discredit the bank (reputation risk).