Quantitative Analysis I

Quantitative Analysis
Quantitative Analysis- I
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Agenda
Probability o o Counting Principle (1 hr) Probability Concepts, Bayes Theorem (1 hr)
Moments (1 hr) Probability distributions (2 hr)
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Counting Principle
Number of ways of selecting r objects out of n objects o o nCr n!/(r!)*(n-r)!
Number of ways of giving r objects to n people, such that repetition is allowed

o N^r
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Example-Counting Principle
In how many ways 3 stocks can be chosen out of 10 stocks in a portfolio?(Combination) o Choosing 3 out of 10 stocks is basically the number of combinations of 3 objects out of 10 o Therefore, the number of ways are
In how many ways 3 stocks can be sold, if the sold stock is bought back in the portfolio before the next stock is sold? o First stock can be sold in 10 ways o Second can be sold in again 10 ways o Third stock can again be sold in 10 ways o Therefore total number of ways become =103 =1000
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Question
You wish to choose a portfolio of 3 bonds and 4 stocks from a list of 5 bonds and 8 stocks. How many different 7 asset portfolio can you make from this list. A. 80
B. 700 C. 1,716 D. 100,800
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Solution
Answer: B o Solution: C(5, 3) x C(8, 4)
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Probability - Definitions
A probability experiment involves performing a number of trials to enable us to measure the chance of an event occurring in the future. A trial is a process by which an outcome is noted. Examples of Definitions: o o Experiment: Roll a die two hundred times noting the outcomes Event of interest: A six faces upwards
o
o o
Trial: Roll the die once

Number of trials: 200 Outcomes: 1, 2, 3, 4, 5 or 6
Probability of an event to occur is defined as number of cases favorable for the event, over the number of total outcomes possible in unbiased experiment o o For example, if the event is "occurrence of an even number when a die is rolled The probability is given by 3/6=1/2, since 3 faces out of the 6 have even numbers and each face has the same probability of appearing.
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Conditional & Joint Probability

Joint Probability o A statistical measure where the likelihood of two events occurring together and at the same point in Time are calculated. Joint probability is the probability of event Y occurring at the same time event X occurs. Notation for joint probability takes the form: P(X Y) or P(X,Y)
Which reads the joint probability of X and Y.

o o The following table shows the joint probability of different events. Lets say an economist is predicting the market scenario and the price of IBM stock fro the next year. Next year market can be Good, Bad or Neutral
IBM stock may go up or go down
o o
The probability of IBM stock being Up and Market being Good is 10% Similarly, the probability of IBM stock being down and Market being neutral is 40%
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Conditional & Joint Probability

Conditional Probability Probability of an event or outcome based on the occurrence of a previous event or outcome. Conditional probability is calculated by multiplying the probability of the preceding event by the updated probability of the succeeding event The probability of event A given that the event B has occurred is P(A/B), which is equal to the ratio of joint probability of A and B, and unconditional probability of B.
The unconditional probability of market being Neutral is 45%. Then using the table below we can find 3 conditional probabilities. P(Up/Neutral) = 0.05 / 0.45
P(Up/Good) = 0.1/0.1
P(Down/Bad) = 0.15/0.45
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Conditional and Unconditional Probabilities
Calculate: Unconditional Probability of market to be good next year? Conditional Probability of IBM stock rising when the market is neutral? Conditional Probability of market being good when IBM stock is down?
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Some definitions and properties of Probability

Definitions o o Mutually Exclusive: If one event occurs, then other cannot occur Exhaustive: all exhaustive events taken together form the complete sample space (Sum of probability =1) Independent Events: One event occurring has no effect on the other event
The probability of any event A: If the probability of happening of event A is P(A), then the probability of A not happening is (1 o o For example, if the probability of a company going bankrupt within one year period is 20%, then the probability of company surviving within next one year period is 80%.
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Question
For a bond with B rating, assume 1 year probability of default for each issuer is 6%, and that default probability of each issuer are independent. What is the probability that both issuers avoid default during the 1st year. A. 88% B. 88.4% C. 94% D. 96.4%
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Solution
Answer: o o Both would avoid default only if None defaults This implies that first does not default AND second does not default = (1 PD (first)) x (1 PD (second))
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Some Properties of Probability

The probability of happening of event A or event B can be given as the sum of the three portions defined by the figure below.
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Question
Jensen, a portfolio manager is managing two portfolios. One for High Net Worth Individuals(HNI) and second for Low Net Worth Individuals (LNI). HNI portfolio contains 5 bonds and 7 stocks and LNI contains 6 bonds and 11 stocks. One instrument from HNI is transferred to LNI portfolio. Now Jensen selects an instrument from LNI, what is the probability that instrument selected is stock? I. II. III. IV. 0.5382 0.7821 0.6435 None of these
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Solution
Answer: III Here required probability = [P(stock transferred from HNI) AND P(Stock selected from LNI)] OR [P(bond transferred from HNI) AND P(Stock selected from LNI)] So, the required probability = (7/12) (12/18) + (5/12) (11/18) = 139/216 = 0.6435 Hence option II is correct.
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Sum Rule & Bayes Theorem

The unconditional probability of event B is equal to the sum of joint probabilities of event (A,B) and the probability of event (A,B). Here A is the probability of not happening of A.
The joint probability of events A and B is the product of conditional probability of B, given A has occurred and the unconditional probability of event A.
We know that P(AB) = P(B/A).P(A)
o
o
Also P(BA)= P(A/B).P(B)

Now equating both P(AB) and P(BA) we get:
P(B) can be further broken down using sum rule defined above:
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Example
Use the given information to answer next two questions Out of a group of 100 patients being treated for chronic back trouble, 25% are chosen at random to receive a new, experimental treatment as opposed to the more usual muscle relaxant therapy which the remaining patients receive. Preliminary studies suggest that the probability of a cure with the standard treatment is 0.3, while the probability of a cure from the new treatment is 0.6. How many patients (on an average) out of the 100 patients selected at random would be cured? A. 30 B. 40 C. 37.5 D. 42.5
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Solution
Answer: C o o 25% are given new treatment =>75% are given old treatment. P(Cure) = P(Cure/New) * P(New) + P(Cure/Old) * P(Old) = 0.375 So out of 100. 37.5 will get cured
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Example
Some time later, one of the patients returns to thank the staff for her complete recovery. What is the probability that she was given the new treatment?
A. 0.375
B. 0.425
C. 0.4 D. 0.425
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Solution
Answer: C o Apply Bayes Theorem
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Question
Calculate the probability of a subsidiary and parent company both defaulting over the next year.Assume that the subsidiary will default if the parent defaults, but the parent will not necessarily default if the subsidiary defaults. Assume that the parent had a 1 year PD = 0.5% and the subsidiary has 1 year PD of 0.9%. A. 0.45% B. 0.5%
C. 0.545%
D. 0.55%
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Solution
Answer: B o o P (S| P) = 1 = P(P & S)/P(P) P(P & S) = P(P) = 0.5%
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Probability Distribution
A Random Variable is a function, which assigns unique numerical values to all possible outcomes of a random experiment under fixed conditions. A random variable is not a variable but rather a function that maps events to numbers Probability distribution describes the values and probabilities that a random event can take place. The values must cover all of the possible outcomes of the event, while the total probabilities must sum to exactly 1, or 100%
Example Suppose you flip a coin two times. There are four possible outcomes: HH, HT, TH, and TT. Let the variable X represent the number of Heads that result from this experiment
o It can take on the values 0, 1, or 2. o X is a random variable (its value is determined by the outcome of a statistical experiment)
A probability distribution is a table or an relation that links each outcome of a statistical experiment with its probability of occurrence
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Probability distribution
Cumulative Probability is a rule or equation which describes the sum of all the probabilities till that observation.
Take the previous example of flipping of coin twice. The following table gives the probability of occurrence of heads and the cumulative probability as well.
The point to note here is that the cumulative probability of the first event is equal to the probability of that event. The cumulative probability of the last event is always 1
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Continuous & Discrete Probability Distributions
If a variable can take on any value between two specified values, it is called a continuous variable
otherwise, it is called a discrete variable
If a random variable is a discrete variable, its probability distribution is called a discrete probability o For example, tossing of a coin & noting the number of heads (random variable) can take a discrete value
Binomial probability distribution, Poisson probability distribution
If a random variable is a continuous variable, its probability distribution is called a continuous probability distribution o The probability that a continuous random variable will assume a particular value is zero
o
o o o
A continuous probability distribution cannot be expressed in tabular form.

An equation or formula is used to describe a continuous probability distribution (called a probability density function or density function or PDF) The area bounded by the curve of the density function and the x-axis is equal to 1, when computed over the domain of the variable Normal probability distribution, Student's t distribution are examples of continuous probability istributions
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Agenda
Probability Moments o Mean, Variance & Covariance, Skewness and Kurtosis (1hr)
Probability distributions
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Moments
A random variable is characterized by its distribution function. Instead of having to report the whole function, it is convenient to summarize it by a few parameters, or moments.
There are 4 moments:

o Mean Variance Skewness Kurtosis
o o o
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Mean
The expected value(Mean) measures the central tendency, or the center of gravity of the population. It is given by :
A family has 4 members, father, mother and 2 kids (Hemal and Rishi) who are twins. The average age of the family members is 20 years. Age of mother and father is 30 and 32 respectively. Can you tell the age of Hemal?
The graph shows the mean of 3 different distributions.
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Variance & Standard deviation

Variance is the squared dispersion around the mean.
The standard deviation is more convenient to use, as it has the same units as the original variable X o SD(X) =
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Covariance and Correlation

Covariance is the measure of how two variable move with each other. o The mathematical expression for covariance of two variables X and Y is given as:
Here E(X) is the expected value of X and E(Y) is the expected value of Y
Similarly correlation measures the linear relationship between two variable.
o
o
Correlation() is actually the normalized form of covariance.

Correlation is given by the following expression:
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Some Properties of Variance
Variance of a constant = 0 Covariance between same variables is also their variance
For independent or uncorrelated variables, covariance or correlation = 0
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Skewness
Skewness describes departures from symmetry
Skewness can be negative or positive.
Negative skewness indicates that the distribution has a long left tail, which indicates a high probability of observing large negative values.
If this represents the distribution of profits and losses for a portfolio, this is a dangerous situation.
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Kurtosis
Kurtosis describes the degree of flatness of a distribution, or width of its tails.
Because of the fourth power, large observations in the tail will have a large weight and hence create large kurtosis. Such a distribution is called leptokurtic, or fat tailed.
A kurtosis of 3 is considered average. High kurtosis indicates a higher probability of extreme movements.
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Example
Assuming that the distribution of ABC stock returns is a population, what is the population standard deviation? A. 5.0 B. 6.8 C. 45.22 D. 80.2
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Solution
The population variance is given by taking the mean of all squared deviations from the mean. 2 = [(12-5.67)2 + (5-5.67
)2 + (-7-5.67)
+ (11-5.67)2 + (2-5.67)2 + (11-5.67)2] / 6 = 45.22 (%2)
The standard deviation is the square root of the variance:
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Example
The random variables X and Y have variances of 2 and 3 respectively, and covariance of 0.5. The variance of 2X + 3Y is:
A.
13
B. 29
C. 35 D. 41
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Solution
Answer: C o o Var(X + Y) = Var(X) + Var(Y) +2*Cov(x,y) Var(X - Y) = Var(X) + Var(Y) -2*Cov(x,y) Var(cX) = c^2 * Var(X) Cov (ax,by) = abCov(x,y) So, Var(2X + 3Y) = 22 Var(X) +32 Var(Y) +2*2*3*Cov(x,y) Var(2X + 3Y) = 4*2 + 9*3 + 12*0.5 = 41
o o o o
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Question
You are given the following information about the returns of stock P and stock Q: o o Variance of return of stock P=100.0 Variance of return of stock Q=225.0 Covariance between the return of stock P and the return of stock Q=53.2
At the end of 1999, you are holding USD 4 million in stock P. you are considering a strategy of shifting USD 1 million into stock Q and keeping USD 3 million in stock P. what percentage of risk,as measured by standard deviation of return, can be reduced by this strategy? A. 0.50% B. 5.00% C. 7.40% D. 9.70%
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Answer
Answer: B
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FRM Exam 2009

Which type of distribution produces the lowest probability for a variable to exceed a specified extreme value X which is greater than the mean assuming the distributions all have the same mean and variance? A. A leptokurtic distribution with a kurtosis of 4.
B. A leptokurtic distribution with a kurtosis of 8. C. A normal distribution.
D. A platykurtic distribution
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Answer
Answer: D By definition, a platykurtic distribution has thinner tails than both the normal distribution and any leptokurtic distribution. Therefore, for an extreme value X, the lowest probability of exceeding it will be found in the distribution with the thinner tails.
A. Incorrect. A leptokurtic distribution has fatter tails than the normal distribution. The kurtosis indicates the level of fatness in the tails, the higher the kurtosis, the fatter the tails. Therefore, the probability of exceeding a specified extreme value will be higher . B. C. Incorrect. Since answer A. has a lower kurtosis, a distribution with a kurtosis of 8 will necessarily produce a larger probability in the tails. Incorrect. By definition, a normal distribution has thinner tails than a leptokurtic distribution and larger tails than a platykurtic distribution
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Agenda
Probability Moments Important Probability Distributions Discrete Probability Distributions (1hr) Continuous Distribution (1hr)
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Bernoulli Distribution
Assumptions The outcome of an experiment can either be success (i.e., 1) and failure (i.e., 0).
Pr(X=1) = p, Pr(X=0) = 1-p, or The expected value E[X] of the event is equal to the probability of success(p) E[X] = p The variance of the event is the product of the probability of success and probability of failure: Var(X) = p(1-p)
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Binomial Distribution
Assumptions: There are n trials. Each trial has two possible outcomes, success or failure.
The probability of success p is the same for each trial. Each trial is independent If we take n Bernoulli trials, and say out of those n trials we have total number of x successes, then the probability of such an event can be given as:
The expected number of successes E[X] = n.p

The variance of number of successes Var(X) = np (1 p)
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Example
There are 10 bonds in a credit default swap basket; the probability of default for each of the bonds is 5%. The probability of any one of the bond defaulting is completely independent of what happens to the other bonds in the basket. What is the probability exactly one bond default? A. 5%
B. 50% C. 32%
D. 3%
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Solution
Answer: C one particular bond defaults and other nine do not with the probability 0.05* (0.95)^9 can happen in 10 different ways. = 10*0.05* (0.95)^9 = 32%
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Question
Company ABC was incorporated on January 1, 2004. it has expected annual default rate of 10%. Assuming a constant quarterly default rate, what is the probability that company ABC will not have defaulted by April 1, 2004? A. 2.4%
B. 2.5% C. 97.4%
D. 97.5%
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Answer
Answer: C Let the probability of not defaulting in 1 quarter is (nd). Then the probability of not defaulting for a full year is (nd)4. This implies that the probability of defaulting within 1 year time is {1 given as 10%. 1-(nd)4=0.1 which implies (nd)=0.91/4
= 97.4%
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Question
A corporate bond will mature in 3 years. The marginal probability of default in year one is 0.03%. The marginal probability of default in year 2 is 0.04%. The marginal probability of default in year 3 is 0.06%. What is the cumulative probability that default will occur during the 3 year period? A. 0.1247%
B. 0.1276% C. 0.1299%
D. 0.1355%
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Answer
Answer: C The cumulative probability of default= 1-{Product of marginal probabilities of not defaulting} =1-{(1-0.0003)*(1-.0004)*(1-0.0006)} =0.001299 Therefore the cumulative probability of default is 0.1299%
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Poisson Distribution
Assumptions: The probability of observing a single event over a small interval is of that interval. The probability of an event within a certain interval The probability of an event in one interval is independent interval which is not overlapping.
Poisson distribution is a special case of Binomial distribution when the probability of success(p) becomes very small and the number of events(n) becomes very large in such a way that the product of both gives a constant(). Fix the expectation =np Number of trials n A Binomial distribution will become a Poisson distribution
E[X] = , Var(X) =
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Plots of Poisson Distribution
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Question
When can you use the Normal distribution to approximate the Poisson distribution, assuming you have "n" independent trials each with a probability of success of "p"? When the mean of the Poisson distribution is very small. When the variance of the Poisson distribution is very small. When the number of observations is very large and the success rate is close to 1.
When the number of observations is very large and the success rate is close to 0.
As sample size gets large (typically > 30) Sampling distribution becomes almost normal regardless of shape of population
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Answer
Answer: C The Normal distribution can approximate the distribution of a Poisson random variable with a large lambda parameter (). This will be the case when both the number observations (n) is very large and the success rate (p) is close to 1 since = n*p. INCORRECT: A, The mean of a Poisson distribution must be large to allow approximation with a Normal distribution. INCORRECT: B, The variance of a Poisson distribution must be large to allow approximation with a Normal distribution. INCORRECT: D, The Normal distribution can approximate the distribution of a Poisson random variable with a large lambda parameter (). But since = n*p, where n is the number observations and p is the success rate, will not be large if p is close to 0.
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Example
A. The number of false fire alarms in a suburb of Houston averages 2.1 per day. What is the (approximate) probability that there would be 4 false alarms on 1 day?
A. 1
B. 0.1 0.5
C.
D. 0
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Solution
Answer: B Use Poisson distribution P(X = x) = [x *e-]/ ! Is there any other intuitive way as well???
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Uniform distribution
The simplest continuous distribution function is the uniform distribution. This is defined over a range of values for x, a x b.
The density function is, f (x) =1 /(b a) , a x b
Its mean and variance are given by

E(X) =(a + b)/ 2 V(X) = (b a)2 /12
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Question
Assume we use continuous uniform distribution U(0,10) to generate a series of random numbers. Which of the following statements is Correct?
A. The number 5 is likely to be observed much more often than any other number.
B. Numbers between 4 and 6 are more likely to occur than the number between 6 and 10, because the first interval is closer to the center of the distribution. C. Numbers between 1 and 3 are as likely as the number between 4 and 6. D. Numbers between 1 and 3 are less likely than the number between 4 and 6, due to skewness of the distribution.
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Solution
Answer: C
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Standard Normal Distribution
The standard normal distribution has mean = 0 and standard deviation sigma=1
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Normal (Gaussian) Distribution

The normal distribution is defined by first two moments, mean() and variance(2) The probability density function P(x) of normally distributed variable is given by:
The probability of the value lying between a and b is given by:
The expected value of a normally distributed variable: E[X]= , The variance of normally distributed variable: Var(X)= 2
If two variables are individually normally distributed, then the linear combination of the both is also normally distributed.
Lets take an example of two variable X1 and X2 which are normally distributed such that: X1~N(1,1) and X2~N(2,2)
Then X= a.X1+ b.X2 is also normally distributed.
The skewness of normal distribution is = 0 and the kurtosis is =3

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Question
Let X be a uniformly distributed random variable between minus one and one so that the standard deviation of X is 0.577. What percentage of the distributions will be less than 1.96 standard deviations above the mean: A. 100%
B. 97.5% C. 95%
D. Insufficient information provided.
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Answer
Answer: A The answer requires understanding of distributions and standard deviation. The key is that every distribution has a standard deviation. However the number of standard deviations associated with different probabilities are different for each distribution. In this case 1.96 standard deviation represent a move of 1.12 or less. As the total distribution is defined as falling between minus one and one the correct answer is a.
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Question
For the standard normal distribution, calculate the value of P(-1.87 Z 1.23) or P(|Z| 1.6)? 0.5683 0.8794 0.7831 0.9145
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Solution
Answer: D In the diagram given below, the area representing the region P(-1.87 Z 1.23) or P(|Z| 1.6) is shown below. The area will be from Z = -1.87 to Z = 1.6 and common area is from Z = 1.6 to Z = 1.23. P(-1.87 Z 1.23) or P(|Z| 1.6) = P(Z 1.87) + P(Z 1.6) = 0.4693 + 0.4452 = 0.9145 Hence option D is correct.
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Agenda
Appendix
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Appendix: Example FRM EXAM

Assume you have empirical data showing historical returns (v) for a given financial variable (e.g.: Forex rate), how could you perform a quick test of the validity of the power law Prob(v > x) = K.x-a where x is large, as a good model of the tail of the distribution?
A. Plot the probability of v exceeding x standard deviations against x B. Plot the probability of v exceeding x standard deviations against Log of x C. Plot the Log of the probability of v exceeding x standard deviations against x D. Plot the Log of the probability of v exceeding x standard deviations against the Log of x
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Solution
Answer: D The mathematical relationship in the question can be rewritten (by taking the logs on both sides): Log(Prob(v > x)) = Log(K) - aLog(x), i.e. the plot of the Log of the probability of v exceeding x standard deviations against the log of x should be a straight (decreasing) line if the relationship strictly holds. The intercept is an estimate of Log of K and the slope of the line yields the parameter a.
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Appendix: Sum Rule & Bayes Theorem

Jack has 3 white balls and 2 red balls in his box while his friend Andrew has 4 white and 5 red balls. Andrew took 1 white ball from jack and gave him 1 red ball in compensation. Now calculate the probability of picking a red ball from Andrews box. After the exchange, Tom stole a ball from one of the boxes and found that its white. If you have to tell who lost his white ball, what should be your say?
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Solution
Initially Jack has 3 white balls and 2 red balls in his box while his friend Andrew has 4 white and 5 red balls. After the exchange Jack has 2 white and 3 red balls, and Andrew has 5 white and 4 red balls. Therefore the probability of picking a red ball from Andrews box is: P(RAndrew)=4/(5+4)=4/9 Now Tom stole a white ball from one of the two boxes. To make a calculated guess about who lost 1 white ball, we need to calculate the conditional probabilities. P(Jacks box/If the balls is White)= Probability of white balls in Jacks box/(Probability of white ball in Jacks box +Probability of white ball in Andrews box)
Similarly, P(Andrews box/White)
Point to note here is that the white ball can come from 2 boxes only, so the sum of conditional probabilities of the boxes, given the ball is white should sum to 1, which is (18/43+25/43) =1 in our case.
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Appendix: Question
There are 10 sprinters in the Olympic finals. How many ways can the gold, silver, and bronze medals be awarded? A. 120
B. 720 C. 1,440 D. 604,800
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Solution
Answer: B
10P 3
= 720
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Bayes Theorem Problem

There is a city which hosts two taxi-cab companies, the Blue are blue and Green cabs are green; they are otherwise identical. 70 percent of the cabs in the city are Blue cabs, and 30 percent of the cabs in the city are cabs have been involved in 70% of all traffic accidents in the city that involved cabs, and have been involved in 30% of all traffic accidents in the city that involved cabs. One night, there is a traffic accident involving a taxi-cab in the city, to which there is one witness. Authorities perform extensive tests on the witness, and determine that his ability to recognize cabs by their color at night is approximately 80 percent accurate and 20 percent inaccurate (meaning that when he is wrong he does not say he doesnt know, but rather misidentifies it as being of the other color). The witness says the taxi accident was 'blue.' On these facts, and strictly assuming the taxi is the approximate probability that the taxi-cab involved in the accident belonged to the Blue Cab Co. and the Green Cab Co. Blue cabs Green cabs. Moreover, historically speaking, Blue Green cabs taxi-cab involved in the taxi-cab was not from some other city, what Cab Co.
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Solution
Let P(R) be the probability of witness being accurate. Then P(R) = 0.8 which implies P(W) = 0.2 i.e. probability of witness being wrong. Let P(B/R) = Probability of accident by a blue car, conditional on the fact that the statement is a right statement. Then P(B/R) = 0.7 Also P(B/W)=0.3, Similarly P(G/R) = 0.3 Here we need to find P(R/B) i.e. If the witness has said that it was a blue car, then what's the probability that it was actually blue. Applying Bayes Theorem now: P(R/B) = P(B/R) * P(R)/P(B) Here we know all except P(B):
P(B) = P(B/R)*P(R) +P(B/W)*P(W)

= 0.7*0.8 + 0.3*0.2 = 0.56 + 0.06 Therefore: P(R/B) = 0.7*0.8/0.62 = 0.903
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Understanding Bayes Theorem
Therefore the probability of the car being actually blue, when the witness identified it as blue equals: (0.56/0.62)=0.903
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FRM Exam 2006

Which of the following statements is the most accurate about the relationship between a normal distribution and a Students t-distribution that have the same mean and standard deviation? A. They have the same skewness and the same kurtosis.
B. The Students t-distribution has larger skewness and larger kurtosis. C. The kurtosis of a Students t -distribution converges to that of the normal distribution as the number of degrees of freedom increases.
D. The normal distribution is a good approximation for the Students t-distribution when the number of degrees of freedom is small.
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Answer
Answer: C The skewness of both distributions is zero and the kurtosis of the Students t distribution converges to that of the normal distribution as the number of degrees of freedom increases.
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Quantitative Analysis I

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Quantitative Analysis

Moments (1 hr) Probability distributions (2 hr)

Number of ways of giving r objects to n people, such that repetition is allowed

B. 700 C. 1,716 D. 100,800

Trial: Roll the die once

Conditional & Joint Probability

Which reads the joint probability of X and Y.

IBM stock may go up or go down

Conditional & Joint Probability

Conditional and Unconditional Probabilities

Some definitions and properties of Probability

Some Properties of Probability

Sum Rule & Bayes Theorem

We know that P(AB) = P(B/A).P(A)

Also P(BA)= P(A/B).P(B)

Continuous & Discrete Probability Distributions

otherwise, it is called a discrete variable

Binomial probability distribution, Poisson probability distribution

A continuous probability distribution cannot be expressed in tabular form.

There are 4 moments:

The graph shows the mean of 3 different distributions.

Variance & Standard deviation

Covariance and Correlation

Similarly correlation measures the linear relationship between two variable.

Correlation() is actually the normalized form of covariance.

Some Properties of Variance

Variance of a constant = 0 Covariance between same variables is also their variance

For independent or uncorrelated variables, covariance or correlation = 0

Skewness can be negative or positive.

+ (11-5.67)2 + (2-5.67)2 + (11-5.67)2] / 6 = 45.22 (%2)

The standard deviation is the square root of the variance:

FRM Exam 2009

B. A leptokurtic distribution with a kurtosis of 8. C. A normal distribution.

The expected number of successes E[X] = n.p

Plots of Poisson Distribution

The density function is, f (x) =1 /(b a) , a x b

Its mean and variance are given by

Standard Normal Distribution

Normal (Gaussian) Distribution

The probability of the value lying between a and b is given by:

Then X= a.X1+ b.X2 is also normally distributed.

The skewness of normal distribution is = 0 and the kurtosis is =3

D. Insufficient information provided.

Appendix: Example FRM EXAM

Appendix: Sum Rule & Bayes Theorem

Similarly, P(Andrews box/White)

B. 720 C. 1,440 D. 604,800

Bayes Theorem Problem

P(B) = P(B/R)*P(R) +P(B/W)*P(W)

Understanding Bayes Theorem

FRM Exam 2006

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P(B) = P(B/R)P(R) +P(B/W)P(W)