Decision Trees

In some valuations, risk is not only discrete, but sequential. In other words, for the asset to have value, it must pass through a series of tests. Failure at any point potentially can translate into a complete loss of value. This is the case, for instance, with a pharmaceutical drug that is just being tested on human beings. The three-stage FDA approval process lays out the hurdles that must be passed for this drug to be sold. Failure at any of the three stages dooms the drug’s chances. Decision trees allow us not only to consider the risk in stages but also to devise the right response to outcomes at each stage.

Steps in Decision Tree Analysis

The first step in understanding decision trees is to distinguish between root nodes, ...

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