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Lecture 3
Introduction
Life is uncertain, we are not sure
what the future will bring Risk and probability is a part of our daily lives Probability is a numerical statement about the likelihood that an event will occur
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Fundamental Concepts
1. The probability, P, of any event or state of nature occurring is greater than or equal to 0 and less than or equal to 1. That is:
0 P (event) 1
2. The sum of the simple probabilities for all possible outcomes of an activity must equal 1
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and Supply has always been either 0, 1, 2, 3, or 4 gallons per day Over the past 200 days, the owner has observed the following frequencies of demand
QUANTITY DEMANDED 0 1 2 3 4 NUMBER OF DAYS 40 80 50 20 10 Total 200 PROBABILITY
0.20 (= 40/200) 0.40 (= 80/200) 0.25 (= 50/200) 0.10 (= 20/200) 0.05 (= 10/200) Total 1.00 (= 200/200)
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and the individual probabilities Notice Supply has always been either 0, 1, 2, 3, or 4 gallons per day are all between 0 and 1 Over the past 200 days, the owner has observed 0 P (event) 1 the following frequencies of demand And the total of all event QUANTITY probabilities equals 1 NUMBER OF DAYS PROBABILITY
DEMANDED 0 P (event) = 1.00 40 1 80 2 50 3 20 4 10 Total 200 0.20 (= 40/200) 0.40 (= 80/200) 0.25 (= 50/200) 0.10 (= 20/200) 0.05 (= 10/200) Total 1.00 (= 200/200)
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Types of Probability
Determining objective probability Relative frequency
Typically based on historical data
Number of occurrences of the event P (event) = Total number of trials or outcomes
Types of Probability
Subjective probability is based on the experience and judgment of the person making the estimate Opinion polls Judgment of experts Delphi method
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tails as possible outcomes of coin flips All six possible outcomes of the roll of a die
OUTCOME OF ROLL 1 2 3 4 5 6
PROBABILITY
1/ 1/ 1/ 1/ 1/ 1/ 6 6 6 6 6 6
Total 1
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Venn Diagrams
P (A and B)
P (A)
P (B)
P (A)
P (B)
P (A or B) = P (A) + P (B)
Figure 2.1
of one event has no effect on the probability of occurrence of the second event
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events occurring and is the product of their marginal probabilities for independent events P (AB) = P (A) x P (B)
Conditional probability is the probability of event
B given that event A has occurred P (B | A) = P (B) Or the probability of event A given that event B has occurred P (A | B) = P (A)
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Independent Events
A bucket contains 3 black balls and 7 green balls We draw a ball from the bucket, replace it, and draw a second ball
1. 2.
A black ball drawn on first draw P (B) = 0.30 (a marginal probability) Two green balls drawn P (GG) = P (G) x P (G) = 0.7 x 0.7 = 0.49
(a joint probability for two independent events)
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Independent Events
A bucket contains 3 black balls and 7 green balls We draw a ball from the bucket, replace it, and draw a second ball
3.
A black ball drawn on second draw if the first draw is green P (B | G) = P (B) = 0.30
(a conditional probability but equal to the marginal because the two draws are independent events)
4.
A green ball is drawn on the second if the first draw was green P (G | G) = P (G) = 0.70
(a conditional probability as in event 3)
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Random Variables
A random variable assigns a real number to every possible outcome or event in an experiment
X = number of refrigerators sold during the day
Discrete random variables can assume only a finite or limited set of values
Continuous random variables can assume any one of an infinite set of values
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Stock 50 Christmas trees Inspect 600 items Send out 5,000 sales letters Build an apartment building Test the lifetime of a lightbulb (minutes)
Table 2.4
Number of Christmas trees sold Number of acceptable items Number of people responding to the letters Percent of building completed after 4 months Length of time the bulb lasts up to 80,000 minutes
X Y Z
0 R 100
0 S 80,000
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Strongly agree (SA) Agree (A) Neutral (N) Disagree (D) Strongly disagree (SD)
Defective Not defective Good Average Poor Y=
X=
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Agree
Neutral Disagree Strongly disagree
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3 2 1
20
30 30 10 Total 100
0.2 = 20/100
0.3 = 30/100 0.3 = 30/100 0.1 = 10/100 1.0 = 100/100
Table 2.6
0.3
P (X)
0.2
0.1
0 |
Figure 2.5
| 1 2
| 3 X
| 4
| 5
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0.3
Central tendency of the distribution is the mean or expected value Amount of variability or spread is the variance
P (X)
0.2
0.1
0 |
Figure 2.5
| 1 2
| 3 X
| 4
| 5
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X 1 P X 1 X 2 P ( X 2 ) ... X n P ( X n )
where
possible values = summation sign indicating we are adding all n possible values i 1 E ( X ) = expected value or mean of the random sample
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where
X i = random variables possible values E ( X ) = expected value of the random variable [ X i E ( X )]= difference between each value of the random
variable and the expected mean P ( X i ) = probability of each possible value of the random sample
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variance (5 2.9)2 (0.1) ( 4 2.9)2 (0.2) (3 2.9)2 (0.3) (2 2.9)2 (0.3) (1 2.9)2 (0.1)
Variance
where
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Variance
where
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s=
S ( Ri - R )2 i=1 (n)
Note, this is for a continuous distribution where the distribution is for a population. R represents the population mean in this example.
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continuous distribution of population returns for a particular investment (even though there are only 10 returns).
9.6%, -15.4%, 26.7%, -0.2%, 20.9%,
28.3%, -5.9%, 3.3%, 12.2%, 10.5% Calculate the Expected Return and Standard Deviation for the population assuming a continuous distribution.
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