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The document covers various probability concepts and calculations related to financial scenarios, including buy limit orders, equity fund performance, BankCorp's EPS changes, mutual fund portfolio analysis, default rates on high-yield debt, and criteria for evaluating distressed credits. It presents problems requiring the calculation of probabilities, expected returns, covariance, and the effectiveness of tests for predicting company survival. The document serves as a comprehensive guide for applying quantitative methods in finance.

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4 views4 pages

Q4

The document covers various probability concepts and calculations related to financial scenarios, including buy limit orders, equity fund performance, BankCorp's EPS changes, mutual fund portfolio analysis, default rates on high-yield debt, and criteria for evaluating distressed credits. It presents problems requiring the calculation of probabilities, expected returns, covariance, and the effectiveness of tests for predicting company survival. The document serves as a comprehensive guide for applying quantitative methods in finance.

Uploaded by

j3172711
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Quantitative Methods Module 4 Probability Concepts

1. Suppose you have two buy limit orders outstanding on the same stock. One
buy order (Order 1) was placed at a price limit of $10. The probability that it
will execute within one hour is 0.35.
The second buy order (Order 2) was placed at a price limit of $9.75; it has a
0.25 probability of executing within the same one-hour time frame.
A. What is the probability that either Order 1 or Order 2 will execute?
B. What is the probability that Order 2 executes, given that Order 1
executes?

2. Suppose an analyst wants to study whether historical performance predicts


future performance for a sample of 500 equity funds. The top 50% of funds
are categorized as winners and the bottom 50% are categorized as losers in
each year.
Period 2 Winner Period 2 Loser
Period 1 Winner 140 110
Period 1 Loser 90 160
Answer the following questions:
A. State the four events needed to define the four conditional probabilities.
B. Illustrate the problem using a tree diagram.
C. State the four entries of the table as conditional probabilities using the
form P(this event | that event) = number.
D. Using the information in the table, calculate the probability of the event a
fund is a loser in both Period 1 and Period 2
E. Judge whether or not the period 1 and period 2 performance are
independent.

1
Quantitative Methods Module 4 Probability Concepts

3. A banking industry analyst studies BankCorp. The historical record shows


that in 55% of recent quarters BankCorp’s EPS has increased sequentially,
and in 45% of quarters EPS has decreased or remained unchanged.
A. Assuming the changes in sequential EPS are independent.
a. What is the probability of 3Q:2014 will be larger than 2Q:2014 (a
positive change in sequential EPS)?
b. What is the probability that EPS decreases or remains unchanged in
the next two quarters?
B. Suppose 𝑃(𝐴|𝑆 ) = 0.40. Write the statement in probability notation:
the probability that the change in sequential EPS is positive next quarter,
given that the change in sequential EPS is positive in prior quarter and
calculate it.
Event Probability

A=change in sequential EPS is positive next quarter 0.55


AC=change in sequential EPS is 0 or negative next quarter 0.45
S=change in sequential EPS is positive in prior quarter 0.55
SC=change in sequential EPS is 0 or negative in prior quarter 0.45

4. Suppose the BankCorp’s estimated operating cost is 𝑌 = 12.5 + 0.65𝑋, with


X the # of branch offices.

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Quantitative Methods Module 4 Probability Concepts

5. You have a portfolio of two mutual funds, A and B, 75% invested in A, as


shown in the table below.
Fund A B

Expected return 𝐸(𝑅 ) = 20% 𝐸(𝑅 ) = 12%

Covariance Matrix 𝐴 𝐵

A 625 120

B 120 196
A. Calculate the expected return of the portfolio.
B. Calculate the correlation matrix for this problem.
C. Compute portfolio standard deviation of return.

6. A report form Fitch data service states the following two facts:
 In 2002, the volume of defaulted US high-yield debt was $109.8 billion. The
average market size of the high-yield bond market during 2002 was $669.5
billion.
 The average recovery rate for defaulted US high-yield bonds in 2002
(defined as average price one month after default) was $0.22 on the dollar.
Address the following three tasks:
A. On the basis of the first fact given above, calculate the default rate on US
high-yield debt in 2002. Interpret this default rate as a probability.
B. State the probability computed in Part A as an odds against default.
C. The quantity 1 minus the recovery rate given in the second fact above is
the expected loss per $1 of principal value, given that default has
occurred. Suppose you are told that an institution held a diversified high-
yield bond portfolio in 2002. Using the information in both facts, what
was the institution’s expected loss in 2002, per $1 of principal value of
the bond portfolio?

3
Quantitative Methods Module 4 Probability Concepts

7. Suppose we have the expected daily returns (in terms of US dollars),


standard deviations, and correlations shown in the table below.
US Dollar Daily Returns in Percent US Bonds German Bonds Italian Bonds
Expected Return 0.029 0.021 0.073
Standard Deviation 0.409 0.606 0.635
Correlation Matrix US Bonds German Bonds Italian Bonds
US Bonds 1 0.09 0.10
German Bonds 1 0.70
Italian Bonds 1
A. Using the data given above, construct a covariance matrix for the daily
returns on US,
German, and Italian bonds.
B. State the expected return and variance of return on a portfolio 70 percent
invested in
US bonds, 20 percent in German bonds, and 10 percent in Italian bonds.
C. Calculate the standard deviation of return for the portfolio in Part B.

8. Calculate the covariance of the returns on Bedolf Corporation (RB) with the
returns on Zedock Corporation (RZ), using the following data.
𝑅 = 15% 𝑅 = 10% 𝑅 = 5%
𝑅 = 30% 0.25 0 0
𝑅 = 15% 0 0.50 0
𝑅 = 10% 0 0 0.25

9. You have developed a set of criteria for evaluating distressed credits.


Companies that do not receive a passing score are classed as likely to go
bankrupt within 12 months. You gathered the following information when
validating the criteria:
 Forty percent of the companies to which the test is administered will go
bankrupt within 12 months: P(nonsurvivor) = 0.40.
 Fifty-five percent of the companies to which the test is administered pass
it: P(pass test) =0.55.
 The probability that a company will pass the test given that it will
subsequently survive 12 months, is 0.85: P(pass test | survivor) = 0.85.
A. What is P(pass test | nonsurvivor)?
B. Using Bayes’ formula, calculate the probability that a company is a
survivor, given that it passes the test; that is, calculate P(survivor | pass test).
C. What is the probability that a company is a nonsurvivor, given that it fails
the test?
D. Is the test effective?

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