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Questions & Answers:

300.1. Assume the probability density function (pdf) of a zero-coupon bond with a notional value
of $10.00 is given by f(x) = x/8 - 0.75 on the domain [6,10] where x is the price of the bond:

=
f(x) 8 − 0.75 s.t. 6 ≤ x ≤ 10 where x = bond price
What is the probability that the price of the bond is between $8.00 and $9.00?

a) 25.750%
b) 28.300%
c) 31.250%
d) 44.667%

300.2. Assume the probability density function (pdf) of the final value (at maturity) of a zero
coupon bond with a notional value of $5.00 is given by f(x) = (3/125)*x^2 on the domain [0,5]
where x is the price of the bond:
3
f(x) = 125 s.t. 0 ≤ x ≤ 5 where x = bond price
Although the mean of this distribution is $3.75,assume the expected final payoff is a return of
the full par of $5.00.If we apply the inverse cumulative distribution function and find the price of
the bond (i.e.,the value of x) such that 5.0% of the distribution is less than or equal to (x),let this
price be represented by q(0.05); in other words,a 5% quantile function.If the 95.0% VaR is given
by -[q(0.05) - 5] or [5 - q(0.05)],which is nearest to this 95.0% VaR?
a) $1.379
b) $2.842
c) $2.704
d) $3.158

301.1. A random variable is given by the discrete probability function f(x) = P[X = x(i)] = a*X^3
such that x(i) is a member of {1, 2, 3} and (a) is a constant. That is, X has only three discrete
outcomes. What is the probability that X will be greater than its mean? (bonus: what is the
distribution's variance?)

() = ∈ {1,2,3}

a) 45.8%
b) 50.0%
c) 62.3%
d) 75.0%

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301.2. A credit asset has a principal value of $6.0 with probability of default (PD) of
3.0% and a loss given default (LGD) characterized by the following continuous
probability density function (pdf): f(x) = x/18 such that 0 ≤ x ≤ $6. Let expected
loss (EL) = E[PD*LGD]. If PD and LGD are independent, what is the asset's
expected loss? (note: why does independence matter?)

=
() 18 0 ≤ ≤ 6

a) $0.120
b) $0.282
c) $0.606
d) $1.125

302.1. There is a prior (unconditional) probability of 20.0% that the Fed will initiate Quantitative
Easing 4 (QE 4). If the Fed announces QE 4, then Macro Hedge Fund will outperform the
market with a 70% probability. If the Fed does not announce QE 4, there is only a 40%
probability that Macro will outperform (and a 60% that Acme will under-perform; like the Fed's
announcement, there are only two outcomes). If we observe that Macro outperforms the market,
which is nearest to the posterior probability that the Fed announced QE 4?
a) 20.0%
b) 27.9%
c) 30.4%
d) 41.6%

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 The definition of a random sample is technical: the draws (or trials) are independent and
identically distributed (i.i.d.)
o Identical: same distribution
 o Independence: no correlation (in a time series, no autocorrelation)

 The assumption of i.i.d. is a precondition for:

o Law of large numbers
o Central limit theorem (CLT)
o Square root rule (SRR) for scaling volatility; e.g., we typically scales a daily
volatility of (V) to an annual volatility with V*SQRT(250). Please note that i.i.d.
returns is the unrealistic precondition.

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Probabilities (Miller Chapter 2)

P1.T2.300. Probability functions (Miller)
P1.T2.301. Miller's probability matrix
P1.T2.300. Probability functions (Miller)
AIMs: Describe the concept of probability. Describe and distinguish between continuous and
discrete random variables. Define and distinguish between the probability density function, the
cumulative distribution function and the inverse cumulative distribution function, and calculate
probabilities based on each of these functions.

300.1. Assume the probability density function (pdf) of a zero-coupon bond with a notional value
of $10.00 is given by f(x) = x/8 - 0.75 on the domain [6,10] where x is the price of the bond:

What is the probability that the price of the bond is between $8.00 and $9.00?

a) 25.750%
b) 28.300%
c) 31.250%
d) 44.667%

300.2. Assume the probability density function (pdf) of a zero-coupon bond with a notional value
of $5.00 is given by f(x) = (3/125)*x^2 on the domain [0,5] where x is the price of the bond:

Although the mean of this distribution is $3.75, assume the expected final payoff is a return of
the full par of $5.00. If we apply the inverse cumulative distribution function and find the price of
the bond (i.e., the value of x) such that 5.0% of the distribution is less than or equal to (x), let
this price be represented by q(0.05); in other words, a 5% quantile function. If the 95.0% VaR is
given by -[q(0.05) - 5] or [5 - q(0.05)], which is nearest to this 95.0% VaR?

a) $1.379
b) $2.842
c) $2.704
d) $3.158

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300.3. Assume a loss severity given by (x) can be characterized by a probability density
function (pdf) on the domain [1, e^5]. For example, the minimum loss severity = $1 and the
maximum possible loss severity = exp(5) ~= $148.41. The pdf is given by f(x) = c/x as follows:
What is the 95.0% value at risk (VaR); i.e., given that losses are expressed in positive values, at
what loss severity value (x) is only 5.0% of the distribution greater than (x)?

a) $54.42
b) $97.26
c) $115.58
d) $139.04

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P1.T2.301. Miller's probability matrix

AIMs: Calculate the probability of an event given a discrete probability function. Distinguish
between independent and mutually exclusive events. Define joint probability, describe a
probability matrix and calculate joint probabilities using probability matrices.

301.1. A random variable is given by the discrete probability function f(x) = P[X = x(i)] = a*X^3
such that x(i) is a member of {1, 2, 3} and (a) is a constant. That is, X has only three discrete
outcomes. What is the probability that X will be greater than its mean? (bonus: what is the
distribution's variance?)
 a) 45.8%
b) 50.0%
c) 62.3%
d) 75.0%

301.2. A credit asset has a principal value of $6.0 with probability of default (PD) of
3.0% and a loss given default (LGD) characterized by the following continuous
probability density function (pdf): f(x) = x/18 such that 0 ≤ x ≤ $6. Let expected
loss (EL) = E[PD*LGD]. If PD and LGD are independent, what is the asset's
expected loss? (note: why does independence matter?)

a) $0.120
b) $0.282
c) $0.606
d) $1.125

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301.3. In analyzing a company, Analyst Sam prepared a probability matrix which is a joint (aka,
bivariate) probability mass function that characterizes two discrete variables, equity
performance versus a benchmark (over or under) and bond rating change.

The company's equity performance will result in one of three mutually exclusive outcomes:
under-perform, track the benchmark, or over-perform. The company's bond will either be
upgraded, downgraded, or remain unchanged.

Unfortunately, before Sam could share his probability matrix, he spilled coffee on it, and
unfortunately some cells are not visible.
Two questions: what is the joint Prob [equity over-performs, bond has no change]; and are the
two discrete variables independent?

a) 7.0%, yes
b) 12.0%, yes
c) 19.0%, no
d) 22.0%, no

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Probabilities (Stock & Watson Chapter 2)

P1.T2.201. Random variables
P1.T2.202. Variance of sum of random variables
P1.T2.203. Skew and kurtosis (Stock & Watson)
P1.T2.204. Joint, marginal, and conditional probability functions
P1.T2.205. Sampling distributions (Stock & Watson)
P1.T2.206. Variance of sample average
P1.T2.207. Law of large numbers and Central Limit Theorem (CLT)

P1.T2.201. Random variables

Define random variables, and distinguish between continuous and discrete random
variables. Define the probability of an event. Define, calculate, and interpret the mean,
standard deviation, and variance of a random variable.

201.1. Which of the following is most likely to be characterized by a DISCRETE random

variable, and consequently, a discrete probability distribution (aka, probability mass function,
PMF) and/or a discrete CDF?

a) The future price of a stock under the lognormal assumption (geometric Brownian motion,
GBM) that underlies the Black-Scholes-Merton (BSM)
b) The extreme loss tail under extreme value theory (EVT; i.e., GEV or GPD) c) The
empirical losses under the simple historical simulation (HS) approach to value at risk
(VaR)
d) The sampling distribution of the sample variance
201.2. A model of the frequency of losses (L) per day, for a certain key operational process,
assumes the following discrete distribution: zero loss (events per day) with probability (p) =
20%; one loss with p = 30%; two losses with p = 30%; three losses with p = 10%; and four
losses with p = 10%. What are, respectively, the expected (average) number of loss events per
day, E(L), and the standard deviation of the number of loss events per day, StdDev(L)?

a) E(L) = 1.20 and StdDev(L) = 1.44

b) E(L) = 1.60 and StdDev(L) = 1.20
c) E(L) = 1.80 and StdDev(L) = 2.33
d) E(L) = 2.20 and StdDev(L) = 9.60

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201.3. A volatile portfolio produced the following daily returns over the prior five days (in
percentage terms, %, for convenience): +5.0, -3.0, +6.0, -1.0, +3.0. Although this is a tiny
sample, we have two ways to calculate the daily volatility. The first is to compute a technically
proper daily volatility as an unbiased sample standard deviation. The second, a common
practice for short-period/daily returns, is to make two simplifying assumptions: assume the
mean return is zero since these are daily periods, and divide the sum of squared returns by (n)
rather than (n-1). For this sample of only five daily returns, what is respectively (i) the sample
daily volatility and (ii) the simplified daily volatility?

a) 1.65 (sample) and 2.55 (simplified)

b) 2.96 (sample) and 3.00 (simplified)
c) 4.11 (sample) and 3.65 (simplified)
d) 3.87 (sample) and 4.00 (simplified)

201.4. Consider the following five random variables:

 A standard normal random variable; no parameters needed.
 A student's t distribution with 10 degrees of freedom; df = 10.
 A Bernoulli variable that characterizes the probability of default (PD), where PD = 4%; p
= 0.040
 A Poisson distribution that characterizes the frequency of operational losses during the
day, where lambda = 5.0
 A binomial variable that characterizes the number of defaults in a basket credit default
swap (CDS) of 50 bonds, each with PD = 2%; n = 50, p = 2%
Which of the above has, respectively, the lowest value and highest value as its variance among
the set?
 a) Standard normal (lowest) and Bernoulli (highest)
b) Binomial (lowest) and Student's t (highest)
c) Bernoulli (lowest) and Poisson (highest)
d) Poisson (lowest) and Binomial (highest)

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P1.T2.202. Variance of sum of random variables

AIM: Calculate the mean and variance of sums of random variables.

202.1. A high growth stock has a daily return volatility of 1.60%. The returns are positively
autocorrelated such that the correlation between consecutive daily returns is +0.30. What is the
two-day volatility of the stock?

a) 1.800%
b) 2.263%
c) 2.580%
d) 3.200%

202.2. A three-bond portfolio contains three par $100 junk bonds with respective default
probabilities of 4%, 8% and 12%. Each bond either defaults or repays in full (three Bernoulli
variables). The bonds are independent; their default correlation is zero. Finally, for convenience,
recovery is assumed to be zero (LGD = 100%). What is, respectively, the mean value of the
three-bond portfolio and the standard deviation of the portfolio's value?

a) mean $276.00 and StdDev $46.65

b) mean $276.00 and StdDev $139.94
c) mean $276.00 and StdDev $2,176.45
d) mean $313.00 and StdDev $94.25

202.3. Assume two random variables X and Y. The variance of Y = 49 and the correlation
between X and Y is 0.50. If the variance[2X - 4Y] = 652, which is a solution for the standard
deviation of X?

a) 2.0
 b) 3.0
c) 6.0
d) 9.0

202.4 A risky bond has a (Bernoulli) probability of default (PD) of 7.0% with loss given default
(LGD) of 60.0%. The LGD has a standard deviation of 40.0%. The correlation between LGD and
PD is 0.50. What is the bond's expected loss, E[L] = E[PD * LGD]?

a) 3.1%
b) 4.2%
c) 7.5%
d) 9.3%

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202.5. Portfolio (P) is equally-weighted in two positions: a 50% position in StableCo (S) plus a
50% position in GrowthCo (G). Volatility of (S) is 9.0% and volatility of (G) is 19.0%. Correlation
between (S) and (G) is 0.20. The beta of GrowthCo (G) with respect to the portfolio--denoted
Beta (G, P)--is given by the covariance(G,P)/variance(P) where P = 0.5*G + 0.5*S. What is
beta(G, P)?

a) 0.45
b) 0.88
c) 1.39
d) 1.55

202.6. Two extremely risky bonds have unconditional probabilities of default (Bernoulli PDs) of
10% and 20%. Their (linear) correlation is 0.35. What is the probability that both bonds
default?

a) 2.0%
b) 4.6%
c) 6.2%
d) 9.7%
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P1.T2.203. Skew and kurtosis (Stock & Watson)

AIM: Define, calculate, and interpret the skewness, and kurtosis of a distribution

203.1. Let random variable W be distributed normally as N(0,10). What are, respectively, the
following: i. The fourth moment of W, E[W^4]; and ii. The kurtosis of W?

a) 30.0 (4th moment) and zero (kurtosis)

b) 100.0 and 3.0
c) 300.0 and zero
d) 300.0 and 3.0

203.2. A random variable (X) has three possible outcomes: 90.0 with 40% probability; 100.0
with 50% probability; and 110.0 with 10% probability. What is the skewness of the variable's
distribution?

a) -1.82
b) -0.95
c) 0.37
d) 0.74

203.3. An analyst gather information about the return distribution for two portfolios during the
same period: Portfolio A shows skewness of 0.9 and kurtosis of 3.7; Portfolio B shows
skewness of 1.3 and kurtosis of 2.1. The analyst asserts "Portfolio A is more peaked--that is,
has a higher peak--than a normal distribution and Portfolio B has a long right tail."

a) The analyst is correct about both portfolios

b) The analyst is correct about A but incorrect about B
c) The analyst is correct about B but incorrect about A
d) The analyst is wrong about both portfolios

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P1.T2.204. Joint, marginal, and conditional probability functions AIM:
Describe Joint, marginal, and conditional probability functions
204.1. X and Y are discrete random variables with the following joint distribution; e.g., Pr (X = 4,
Y = 30) = 0.07.

What is the conditional standard deviation of Y given X = 7; i.e., Standard Deviation(Y) | X = 7?

a) 10.3
b) 14.7
c) 21.2
d) 29.4

204.2. Sally's commute (C) is either long (L) or short (S). While commuting, it either rains (R =
Y) or it does not (R = N). Today, the marginal (aka, unconditional) probability of no rain is 75%;
P(R = N) = 75%. The joint probability of rain and a short commute is 10%; i.e., P(R = Y, C = S)
= 10%. What is the probability of a short commute conditional on it being rainy, P (C = S | R =
Y)?

a) 10%
b) 25%
c) 40%
d) 68%

204.3. Economists predict the economy has a 40% of experiencing a recession in 2012;
marginal P(R) = 40% and therefore the marginal probability of no recession P(R') = 60%. Let
P(S) be the probability the S&P 500 index ends the year above 1400, such that P(S') is the
probability the index does not end the year above 1400. If there is a recession, the probability of
the index ending the year above 1400 is only 30%; P(S|R) = 30%. If there is not a recession, the
probability of the index ending above 1400 is 50%; P(S|R') = 50%. Bayes' Theorem tells us that
the conditional probability, P(R|S), is equal to the joint probability P(R,S) divided by the marginal
probability, P(S). At the end of the year, the index does end above 1400, such that we observe
(S) not (S'). What is the probability of a recession conditional on the index ending above 1400;
i.e., P(R|S)?

a) 12.0%
b) 28.6%
c) 40.0%
d) 42.0%

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P1.T2.205. Sampling distributions (Stock & Watson)

AIM: Describe the key properties of the normal, standard normal, multivariate normal, Chi-
squared, Student t, and F distributions.
205.1. Two variables each have a normal distribution: X = N(20,4) and Y = N(40,9). The
correlation between X and Y is 0.20. Let the (J) be a bivariate normal distribution such that J =
20*X + 28*Y. What is the Pr(1,355 < J < 1,753)?

a) 90.0%
b) 93.0%
c) 94.0%
d) 96.0%

205.2. Each of the following is true about the student t distribution EXCEPT:

a) The student t distribution has skew equal to zero; variance equal to df/(df - 2) where (df)
is degrees of freedom; and kurtosis greater than 3.0 (leptokurtosis with heavier tail and
higher peak compared to the normal)
b) To test of significance of a single partial slope coefficient in a (sample) multiple
regression with three independent variables (aka, regressors), we use a critical t with
degrees of freedom (d.f) equal to the sample size minus four (n - 4)
c) The student's t distribution is the distribution of the ratio of a standard normal random
variable divided by the square root of an independently distributed chi-squared random
variable with (m) degrees of freedom divided by (m)
d) For asset returns involving large sample sizes (for example, n = 1,000), the student t
should be used to simulate heavy tails as asset returns exhibit heavy tails

205.3. Each of the following is true about the chi-square and F distributions EXCEPT:

a) The chi-square distribution is used to test a hypothesis about a sample variance; i.e.,
given an observed sample variance, is the true population variance different than a
specified value?
b) As degrees of freedom increase, the chi-square approaches a lognormal distribution and
the F distribution approaches a gamma distribution
c) The F distribution is used to test the joint hypothesis that the partial slope coefficients in
a multiple regression are significant; i.e., is the overall multiple regression significant? d)
Given a computed F ratio, where F ratio = (ESS/df)/(SSR/df), and sample size (n), we can
compute the coefficient of determination (R^2) in a multiple regression with (k)
independent variables (regressors)

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P1.T2.206. Variance of sample average

AIMs: Define, calculate, and interpret the mean and variance of the sample average
(Stock & Watson)

206.1. A portfolio is equally weighted among nine pairwise independent assets, each with
identical volatility of 14.0%; i.e., n = 9, sigma (i) = 14%, weight of asset (i) = 1/9, and all
correlations (i,j) = 0. If we add another independent asset with same volatility of 14.0%, such
that that (n) increases to from 9 to 10, and each asset weight dilutes to 1/10, what is absolute
change to portfolio volatility?

a) Zero
b) Reduced by 0.24% (absolute)
c) Reduced by 1.18% (absolute)
d) Reduced by 2.48% (absolute)

206.2. A stock has an expected (i.i.d.) return of 9.0% per annum and volatility of 10% per
annum. The distribution of the average (continuously compounded) rate of return has a mean of
8.5% per annual as 9.0% - 10.0%^2/2 = 8.5%; i.e., over several years, the average realized
return is expected to be 8.5% per year. Over a five-year horizon, we can be 95% confident that
the realized average (i.e. per year) per annum return will exceed what level?

a) -7.95%
b) 0.85%
c) 1.14%
d) 4.47%

206.3. A basket credit default swap (basket CDS) references one hundred (100) very risky
credits. Each credit is characterized by a random Bernoulli variable and either defaults with
probability of 9.0% or does not default. Further, the credits are uncorrelated; note these two
assumptions satisfy i.i.d. as the distributions are identical and independent. In this way, the
basket's expected average default rate is 9.0%. What is the 95% confidence interval, around
this expected mean, for basket's average default rate?

a) 3.4% < E[average default rate] < 14.6%

b) 4.3% < E[average default rate] < 13.7%
c) 5.2% < E[average default rate] < 12.6%
d) 6.1% < E[average default rate] < 11.9%

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P1.T2.207. Law of large numbers and Central Limit Theorem (CLT)

AIMs: Define and describe random sampling and what is meant by i.i.d. Describe, interpret,
and apply the Law of Large Numbers and the Central Limit Theorem (Stock & Watson)

207.1. Analyst Joe wants to apply the square root rule (SRR) to scale daily asset volatility into
monthly asset volatility. For example, if the daily volatility is (D), then the scaled monthly
volatility will be given by M = D*SQRT(20). Consider the following possible assumptions:

I. Each daily return has a normal distribution, although the mean and variance varies II.
Knowledge of today's return gives no information about tomorrows return III. Daily
returns are autocorrelated (positive serial correlation)
 IV. Each daily return is non-normal, with heavy tail, although distributional moments are
constant

Joe is informed that application of the square root rule (SRR) requires that returns are i.i.d.
Therefore, which of the above assumptions is (are) necessary to legitimately scale the
volatility?

a) I. only
b) I. and II.
c) II. and III.
d) II. and IV.

207.2. Unrealistically but somehow, Analyst Sally has determined that the true population
default rate of a single BB-rated bond is 1.0%; i.e., default is a Bernoulli with p(default) = 1.0%.
She is analyzing a collateralized debt obligation (CDO) which references a sample size of (N) of
these BB-rated bonds. She is interested in the default rate of the entire sample referenced by
the CDO. Which of the following most nearly summarizes the law of large numbers?

a) As N increases, the number of defaults (D) must also increases

b) As N increases, the CDO's default rate of D/N will exceed 1.0% with a probability that
tends toward 1.0.
c) As N increases, the CDO's default rate of D/N will converge to 1.0%, but only if bond
defaults are i.i.d.
d) As N increases, the CDO's default rate of D/N will converge to 1.0% and no assumptions
are required

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207.3 Portfolio Manager Roger is analyzing a universe of potential stocks; unrealistically, it

happens to be that each stock offers identical expected returns (mu) of 6.0% and identical
standard deviations (sigma) of 18.0%. Roger wants to invest in a sample size of (N) of the
stocks. Let (R) equal the average return of the invested sample. Roger argues that, according to
the Central Limit Theorem, as (N) increases, the distribution of [(R - 6.0%)/SQRT(18%^2/N)]
becomes increasingly well approximated by the standard normal distribution. Which of the
following best characterizes Roger's argument about the CLT?

a) Roger is correct and no further conditions are required

b) Roger is correct, but only if he can assume that the stock returns are characterized by a
normal distribution
c) Roger is correct, if he can also assume independence among returns, but the stock
returns do NOT need to be normally distributed
d) Roger is plainly incorrect, his argument is unrelated to the CLT
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