Q1. You are trying to develop a strategy for investing in t different stocks.

The
anticipated annual return for a $1,000 investment in each stock under four different
economic conditions has the following probability distribution:

Probabilities & P X Y
Outcomes:
recession 0.1 -100 50
slow growth 0.3 0 150
moderate growth 0.3 80 -20
fast growth 0.3 150 -100

a. Compute the expected return for X and Y.

b. Compute the standard deviation for X and Y.
c. Compute the covariance of X and Y.
d. Would you invest in X or Y? Explain.
N
(a) E(X) = ∑ X P ( X ) = 59
i =1
i i

N
E(Y) = ∑ Yi P ( Yi ) = 14
i =1
(b)
N

∑  X − E ( X )  P ( X i ) = 78.6702
2
σX = i
i =1

∑ Y − E ( Y )  P ( Y ) = 99.62
2
σY = i i
i =1
N
(c) σ XY = ∑  X
i =1
i − E ( X )  Yi − E ( Y )  P ( X iYi ) = 6306

(d) Stock X gives the investor a lower standard deviation while yielding a higher
expected return so the investor should select stock X.

Q2. Half the portfolio assets are invested in X and half in Y. E(X)=$105, E(Y)=$35,
σ X = 14, 725, σ Y = 11, 025 , σ XY = −12, 675 .Calculate the portfolio expected return
and risk if
a. 30% of the portfolio assets are invested in X and 70% in Y.
b. 70% of the portfolio assets are invested in X and 30% in Y.
c. Which of the two investment strategies (30%, 70% in X) would you recommend?

(a) E(P) = 0.3(105) + 0.7(35) = $56

σ P = (0.3) 2 (14, 725) + (0.7)2 (11, 025) + 2(0.3)(0.7)( −12, 675) = $37.47
σP 37.47
CV = = ( 100% ) = 66.91%
E ( P) 56
(b) E(P) = 0.7(105) + 0.3(35) = $84
 σ P = (0.7) 2 (14, 725) + (0.3)2 (11, 025) + 2(0.7)(0.3)( −12, 675) = $53.70
σP 53.70
CV = = ( 100% ) = 63.93%
E ( P) 84
(c) Investing 70% in X will yield the lower risk per unit average return.

Q3. A study showed that in 2004 only 64% of US income earners aged 15 and older had
a bank account. If a random sample of 20 US income earners aged 15 and older is
selected, what is the probability that:
a. All 20 have a bank account?
b. No more than 15 have a bank account?
c. More than 10 have a bank account?

The assumptions needed are (i) there are only two mutually exclusive and
collective exhaustive outcomes – “have a bank account” and “do not have
a bank account”, (ii) the probabilities of “have a bank account” and “do
not have a bank account” are constant, and (iii) the outcome of “have a
bank account” from one income earner is independent of the outcome of
“have a bank account” from any other income earners.

Data
Sample size 20
Probability 0.64
of an event of
interest
Binomial
Probabilities
Table
X P(X) P(<=X) P(<X) P(>X) P(>=X)
10 0.07788 0.142399 0.064519 0.857601 0.935481
15 0.11605 0.898937 0.782885 0.101063 0.217115
3
20 0.00013 1 0.999867 0 0.000133
3

(a) P(X = 20) = 0.0001329

n!
P(X = 20) = p X (1 − p)n −X
X!(n − X)!
20!
= (0.64) 20 (1 − 0.64)20 −20
20!(20 − 20)!
= (1)(0.64) 20
= 0.0001329
 (b) P(X ≤ 15) = 0.8989
P(X ≤ 15)=1- P(X > 15)=1-[P(X=16)+ P(X=17)+ P(X=18)+
P(X=19)+P(X=20)]

(c) P(X > 10) = 0.8576 (similarly calculated)

Q4. When the cookie production process is in control, the mean number of chip parts per
cookie is 6. What is the probability that in any particular cookie being inspected:
a. Less than four chip parts will be found?
b. Exactly three chip parts will be found?
c. Four or more chip parts will be found?
d. Either two or three chip parts will be found?
e−λ λ x
P( X ) =
X!

a. If λ = 6.0, P(X < 4) = P(X = 0) + P(X = 1) + P(X = 2) + P(X = 3)

= 0.0025 + 0.0149 + 0.0446 + 0.0892 = 0.1512
b. P(X = 3)= 0.0892
c. P(X ≥ 4)= 1- P(X<4)=1-0.1512
d. P(X = 2) + P(X = 3)= 0.0446 + 0.0892

Q5. Assume that the number of flaws per foot in rolls of grade 2 paper follows a Poisson
distribution with a mean of 1 flaw per 5 feet of paper (0.2 flaw per foot). What is the
probability that in a :
a. 1-foot roll, there will be at least 2 flaws?
b. 12-foot roll, there will be at least 1 flaws?
c. 50-foot roll, there will be greater than or equal to 5 and less than or equal to 15
flaws?

Poisson
Probabilities

Data
Average/Expected number of successes: 0.2

Poisson Probabilities Table

X P(X) P(<=X) P(<X) P(>X) P(>=X)
2 0.01637 0.99885 0.98247 0.00114 0.01752
5 2 7 8 3

a. If λ = 0.2, P(X ≥ 2) = 1 – [P(X = 0) + P(X = 1)] = 1 – [0.8187 + 0.1637]

= 0.0176
b. If there are 0.2 flaws per foot on the average, then there are 0.2•(12) or 2.4 flaws
on the average in a 12-foot roll, λ = 2.4.

Poisson
Probabilities

Data
Average/Expected number of successes: 2.4

Poisson Probabilities Table

X P(X) P(<=X) P(<X) P(>X) P(>=X)
0 0.09071 0.09071 0.000000 0.90928 1.00000
8 8 2 0
1 0.21772 0.30844 0.090718 0.69155 0.90928
3 1 9 2
If λ = 2.4, P(X ≥ 1) = 1 – P(X = 0) = 1 – 0.0907 = 0.9093

c. If there are 0.2 flaws per foot on the average, then there are 0.2•(50) or 10 flaws on
the average in a 50-foot roll, λ = 10.

Poisson
Probabilities

Data
Average/Expected number of successes: 10

Poisson Probabilities Table

X P(X) P(<=X) P(<X) P(>X) P(>=X)
5 0.03783 0.06708 0.02925 0.93291 0.97074
3 6 3 4 7
6 0.06305 0.13014 0.06708 0.86985 0.93291
5 1 6 9 4
7 0.09007 0.22022 0.13014 0.77977 0.86985
9 1 1 9 9
8 0.11259 0.33282 0.22022 0.66718 0.77977
9 0 1 0 9
9 0.12511 0.45793 0.33282 0.54207 0.66718
0 0 0 0 0
10 0.12511 0.58304 0.45793 0.41696 0.54207
0 0 0 0 0
11 0.11373 0.69677 0.58304 0.30322 0.41696
6 6 0 4 0
12 0.09478 0.79155 0.69677 0.20844 0.30322
0 6 6 4 4
13 0.07290 0.86446 0.79155 0.13553 0.20844
8 4 6 6 4
 14 0.05207 0.91654 0.86446 0.08345 0.13553
7 2 4 8 6
15 0.03471 0.95126 0.91654 0.04874 0.08345
8 0 2 0 8
Sum = 0.9220
If λ = 10, P(5 ≤ X ≤ 15) = 0.9220

Q6. The increase or decrease in the price of a stock between the beginning and the end of
a trading day is assumed to be an equally likely random event. What is the probability
that a stock will show an increase in its closing price on five consecutive days?

Given p = 0.5 and n = 5, P(X = 5) = 0.0312.

n!
P(X = 5) = p X (1 − p)n −X
X!(n − X)!
5!
= (0.5)5 (1 − 0.5)5 −5
5!(5 − 5)!
= (1)(0.5)5 (1)
= 0.0312