Discrete Probability

Distributions
[Week 13]
TOPIC 7
1
Chap 7-2
Objectives
After completing this chapter, you should be
able to:
Interpret the mean and standard deviation for a
discrete probability distribution
Explain covariance and its application in finance
Use the binomial probability distribution to find
probabilities
Describe when to apply the binomial distribution
Use the hypergeometric and Poisson discrete
probability distributions to find probabilities
Chap 7-3
Introduction to Probability
Distributions
Random Variable
Represents a possible numerical value from
an uncertain event

Random
Variables
Discrete
Random Variable
Continuous
Random Variable
Chap 7-4
Discrete Random Variables
Can only assume a countable number of values

Examples:

Roll a die twice
Let X be the number of times 4 comes up
(then X could be 0, 1, or 2 times)


Toss a coin 5 times.
Let X be the number of heads
(then X = 0, 1, 2, 3, 4, or 5)

Chap 7-5
Experiment: Toss 2 Coins. Let X = # heads.
T
T
Discrete Probability Distribution
4 possible outcomes
T
T
H
H
H H
Probability Distribution
0 1 2 X
X Value Probability
0 1/4 = .25
1 2/4 = .50
2 1/4 = .25
.50
.25
P
r
o
b
a
b
i
l
i
t
y






Chap 7-6
Discrete Random Variable
Summary Measures
Expected Value (or mean) of a discrete
distribution (Weighted Average)




Example: Toss 2 coins,
X = # of heads,
compute expected value of X:
E(X) = (0 x .25) + (1 x .50) + (2 x .25)
= 1.0
X P(X)
0 .25
1 .50
2 .25

=
= =
N
1 i
i i
) X ( P X E(X)
Chap 7-7
Variance of a discrete random variable




Standard Deviation of a discrete random variable





where:


E(X) = Expected value of the discrete random variable X
X
i
= the i
th
outcome of X
P(X
i
) = Probability of the i
th
occurrence of X
Discrete Random Variable
Summary Measures

=
=
N
1 i
i
2
i
2
) P(X E(X)] [X
(continued)

=
= =
N
1 i
i
2
i
2
) P(X E(X)] [X
Chap 7-8
Example: Toss 2 coins, X = # heads,
compute standard deviation (recall E(X) = 1)
Discrete Random Variable
Summary Measures
) P(X E(X)] [X
i
2
i
=

.707 .50 (.25) 1) (2 (.50) 1) (1 (.25) 1) (0
2 2 2
= = + + =
(continued)
Possible number of heads
= 0, 1, or 2
Chap 7-9
The Covariance
The covariance measures the strength of the
linear relationship between two variables
The covariance:





) Y X ( P )] Y ( E Y )][( X ( E X [
N
1 i
i i i i XY
=
=
where: X = discrete variable X
X
i
= the i
th
outcome of X
Y = discrete variable Y
Y
i
= the i
th
outcome of Y
P(X
i
Y
i
) = probability of occurrence of the condition affecting
the i
th
outcome of X and the i
th
outcome of Y

Chap 7-10
Computing the Mean for
Investment Returns
Return per $1,000 for two types of investments
P(X
i
Y
i
) Economic condition Passive Fund X Aggressive Fund Y
.2 Recession - $ 25 - $200
.5 Stable Economy + 50 + 60
.3 Expanding Economy + 100 + 350

Investment
E(X) =
X
= (-25)(.2) +(50)(.5) + (100)(.3) = 50
E(Y) =
Y
= (-200)(.2) +(60)(.5) + (350)(.3) = 95
Chap 7-11
Computing the Standard Deviation
for Investment Returns
P(X
i
Y
i
) Economic condition Passive Fund X Aggressive Fund Y
.2 Recession - $ 25 - $200
.5 Stable Economy + 50 + 60
.3 Expanding Economy + 100 + 350

Investment
43.30
(.3) 50) (100 (.5) 50) (50 (.2) 50) (-25
2 2 2
X
=
+ + =
71 . 193
) 3 (. ) 95 350 ( ) 5 (. ) 95 60 ( ) 2 (. ) 95 200 - (
2 2 2
Y
=
+ + =
Chap 7-12
Computing the Covariance
for Investment Returns
P(X
i
Y
i
) Economic condition Passive Fund X Aggressive Fund Y
.2 Recession - $ 25 - $200
.5 Stable Economy + 50 + 60
.3 Expanding Economy + 100 + 350

Investment
8250
95)(.3) 50)(350 (100
95)(.5) 50)(60 (50 95)(.2) 200 - 50)( (-25
Y X,
=
+
+ =
Chap 7-13
Interpreting the Results for
Investment Returns
The aggressive fund has a higher expected
return, but much more risk


Y
= 95 >
X
= 50
but


Y
= 193.21 >
X
= 43.30

The Covariance of 8250 indicates that the two
investments are positively related and will vary
in the same direction
Chap 7-14
The Sum of
Two Random Variables
Expected Value of the sum of two random variables:



Variance of the sum of two random variables:



Standard deviation of the sum of two random variables:
XY
2
Y
2
X
2
Y X
2 Y) Var(X + + = = +
+
) Y ( E ) X ( E Y) E(X + = +
2
Y X Y X

+ +
=
Chap 7-15
Portfolio Expected Return
and Portfolio Risk
Portfolio expected return (weighted average
return):


Portfolio risk (weighted variability)



Where w = portion of portfolio value in asset X
(1 - w) = portion of portfolio value in asset Y
) Y ( E ) w 1 ( ) X ( E w E(P) + =
XY
2
Y
2 2
X
2
P
w) - 2w(1 ) w 1 ( w + + =
Chap 7-16
Portfolio Example
Investment X:
X
= 50
X
= 43.30
Investment Y:
Y
= 95
Y
= 193.21

XY
= 8250

Suppose 40% of the portfolio is in Investment X and
60% is in Investment Y:






The portfolio return and portfolio variability are between the values
for investments X and Y considered individually
77 ) 95 ( ) 6 (. ) 50 ( 4 . E(P) = + =
04 . 133
8250) 2(.4)(.6)( (193.21) ) 6 (. (43.30) (.4)
2 2 2 2
P
=
+ + =
Chap 7-17
Probability Distributions
Continuous
Probability
Distributions
Binomial
Poisson
Probability
Distributions
Discrete
Probability
Distributions
Normal
Uniform
Exponential
Chap 7-18
Binomial Probability Distribution
A fixed number of observations, n
e.g., 15 tosses of a coin; ten light bulbs taken from a warehouse
Two mutually exclusive and collectively exhaustive
categories
e.g., head or tail in each toss of a coin; defective or not defective
light bulb
Generally called success and failure
Probability of success is p, probability of failure is 1 p
Constant probability for each observation
e.g., Probability of getting a tail is the same each time we toss
the coin
Chap 7-19
Binomial Probability Distribution
(continued)
Observations are independent
The outcome of one observation does not affect the
outcome of the other
Two sampling methods
Infinite population without replacement
Finite population with replacement

Chap 7-20
Possible Binomial Distribution
Settings
A manufacturing plant labels items as
either defective or acceptable
A firm bidding for contracts will either get a
contract or not
A marketing research firm receives survey
responses of yes I will buy or no I will
not
New job applicants either accept the offer
or reject it
Chap 7-21
Rule of Combinations
The number of combinations of selecting X
objects out of n objects is
)! X n ( ! X
! n
X
n

=
|
|
.
|

\
|
where:
n! =n(n - 1)(n - 2) . . . (2)(1)
X! = X(X - 1)(X - 2) . . . (2)(1)
0! = 1 (by definition)
Chap 7-22
P(X) = probability of X successes in n trials,
with probability of success p on each trial

X = number of successes in sample,
(X = 0, 1, 2, ..., n)
n = sample size (number of trials
or observations)
p = probability of success
P(X)
n
X !
n X
p (1-p)
X
n
X
!
( ) !
=


Example: Flip a coin four
times, let x = # heads:
n = 4
p = 0.5
1 - p = (1 - .5) = .5
X = 0, 1, 2, 3, 4
Binomial Distribution Formula
Chap 7-23
Example:
Calculating a Binomial Probability
What is the probability of one success in five
observations if the probability of success is .1?
X = 1, n = 5, and p = .1
32805 .
) 9 )(. 1 )(. 5 (
) 1 . 1 ( ) 1 (.
)! 1 5 ( ! 1
! 5
) p 1 ( p
)! X n ( ! X
! n
) 1 X ( P
4
1 5 1
X n X
=
=

= =

Chap 7-24
n = 5 p = 0.1
n = 5 p = 0.5
Mean
0
.2
.4
.6
0 1 2 3 4 5
X
P(X)
.2
.4
.6
0 1 2 3 4 5
X
P(X)
0
Binomial Distribution
The shape of the binomial distribution depends on the
values of p and n
Here, n = 5 and p = .1
Here, n = 5 and p = .5
Chap 7-25
Binomial Distribution
Characteristics
Mean

Variance and Standard Deviation
np E(x) = =
p) - np(1
2
=
p) - np(1 =
Where n = sample size
p = probability of success
(1 p) = probability of failure
Chap 7-26
n = 5 p = 0.1
n = 5 p = 0.5
Mean
0
.2
.4
.6
0 1 2 3 4 5
X
P(X)
.2
.4
.6
0 1 2 3 4 5
X
P(X)
0
0.5 (5)(.1) np = = =
0.6708
.1) (5)(.1)(1 p) - np(1
=
= =
2.5 (5)(.5) np = = =
1.118
.5) (5)(.5)(1 p) - np(1
=
= =
Binomial Characteristics
Examples
Chap 7-27
Using Binomial Tables
n = 10
x p=.20 p=.25 p=.30 p=.35 p=.40 p=.45 p=.50
0
1
2
3
4
5
6
7
8
9
10











0.1074
0.2684
0.3020
0.2013
0.0881
0.0264
0.0055
0.0008
0.0001
0.0000
0.0000
0.0563
0.1877
0.2816
0.2503
0.1460
0.0584
0.0162
0.0031
0.0004
0.0000
0.0000
0.0282
0.1211
0.2335
0.2668
0.2001
0.1029
0.0368
0.0090
0.0014
0.0001
0.0000
0.0135
0.0725
0.1757
0.2522
0.2377
0.1536
0.0689
0.0212
0.0043
0.0005
0.0000
0.0060
0.0403
0.1209
0.2150
0.2508
0.2007
0.1115
0.0425
0.0106
0.0016
0.0001
0.0025
0.0207
0.0763
0.1665
0.2384
0.2340
0.1596
0.0746
0.0229
0.0042
0.0003
0.0010
0.0098
0.0439
0.1172
0.2051
0.2461
0.2051
0.1172
0.0439
0.0098
0.0010
10
9
8
7
6
5
4
3
2
1
0
p=.80 p=.75 p=.70 p=.65 p=.60 p=.55 p=.50 x
Examples:
n = 10, p = .35, x = 3: P(x = 3|n =10, p = .35) = .2522
n = 10, p = .75, x = 2: P(x = 2|n =10, p = .75) = .0004
Chap 7-28
The Poisson Distribution
Binomial
Poisson
Probability
Distributions
Discrete
Probability
Distributions
Chap 7-29
The Poisson Distribution
Apply the Poisson Distribution when:
You wish to count the number of times an event
occurs in a given area of opportunity
The probability that an event occurs in one area of
opportunity is the same for all areas of opportunity
The number of events that occur in one area of
opportunity is independent of the number of events
that occur in the other areas of opportunity
The probability that two or more events occur in an
area of opportunity approaches zero as the area of
opportunity becomes smaller
The average number of events per unit is (lambda)
Chap 7-30
Poisson Distribution Formula
where:
X = number of successes per unit
= expected number of successes per unit
e = base of the natural logarithm system (2.71828...)


! X
e
) X ( P
x

=

Chap 7-31
Poisson Distribution
Characteristics
Mean

Variance and Standard Deviation
=

2
=
=
where = expected number of successes per unit

Chap 7-32
Using Poisson Tables


X

0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90
0
1
2
3
4
5
6
7
0.9048
0.0905
0.0045
0.0002
0.0000
0.0000
0.0000
0.0000
0.8187
0.1637
0.0164
0.0011
0.0001
0.0000
0.0000
0.0000
0.7408
0.2222
0.0333
0.0033
0.0003
0.0000
0.0000
0.0000
0.6703
0.2681
0.0536
0.0072
0.0007
0.0001
0.0000
0.0000
0.6065
0.3033
0.0758
0.0126
0.0016
0.0002
0.0000
0.0000
0.5488
0.3293
0.0988
0.0198
0.0030
0.0004
0.0000
0.0000
0.4966
0.3476
0.1217
0.0284
0.0050
0.0007
0.0001
0.0000
0.4493
0.3595
0.1438
0.0383
0.0077
0.0012
0.0002
0.0000
0.4066
0.3659
0.1647
0.0494
0.0111
0.0020
0.0003
0.0000
Example: Find P(X = 2) if = .50
.0758
2!
(0.50) e
! X
e
) 2 X ( P
2 0.50 X
= =

= =

Chap 7-33
Graph of Poisson Probabilities
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0 1 2 3 4 5 6 7
x
P
(
x
)

X
=
0.50
0
1
2
3
4
5
6
7
0.6065
0.3033
0.0758
0.0126
0.0016
0.0002
0.0000
0.0000
P(X = 2) = .0758
Graphically:
= .50
Chap 7-34
Poisson Distribution Shape
The shape of the Poisson Distribution
depends on the parameter :
0.00
0.05
0.10
0.15
0.20
0.25
1 2 3 4 5 6 7 8 9 10 11 12
x
P
(
x
)
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0 1 2 3 4 5 6 7
x
P
(
x
)
= 0.50 = 3.00
Chap 7-35
Using Poisson Distribution to
Approximate Binomial Distribution
The Poisson Distribution can be used to
approximate the Binomial Distribution when:
n is large, and
p is very small
The larger the n and the smaller the p, the better is the
approximation.
Chap 7-36
where:
P(X) = probability of X successes given the parameters n and p
n = sample size
p = true probability of success
e = mathematical constant approximated by 2.71828
X = number of successes in the sample (X = 0, 1, 2, , n)


!
) (
) (
X
np e
X P
x np
~
Using Poisson Distribution to
Approximate Binomial Distribution
Chap 7-37
Mean

Standard Deviation
np X E = = = ) (
np = =
where = expected number of successes per unit
n = sample size
p = probability of success
(1 p) = probability of failure

Using Poisson Distribution to
Approximate Binomial Distribution
Chap 7-38
Using Poisson Distribution to
Approximate Binomial Distribution
Chap 7-39
Using Poisson Distribution to
Approximate Binomial Distribution
Chap 7-40
Chap 7-41
Summary
Addressed the probability of a discrete random
variable
Defined covariance and discussed its
application in finance
Discussed the Binomial distribution
Discussed the Hypergeometric distribution
Reviewed the Poisson distribution