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L1R8 - Quantitative Methods - IR

This document provides definitions and concepts related to probability. It discusses key terms like random variable, outcome, event, mutually exclusive events, and empirical, subjective, and a priori probability. It also covers odds, unconditional and conditional probability, the addition rule, multiplication rule, and total probability rule. Expected value, variance, standard deviation, covariance, and correlation are defined. Examples are provided to illustrate various probability concepts.

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0% found this document useful (0 votes)
66 views26 pages

L1R8 - Quantitative Methods - IR

This document provides definitions and concepts related to probability. It discusses key terms like random variable, outcome, event, mutually exclusive events, and empirical, subjective, and a priori probability. It also covers odds, unconditional and conditional probability, the addition rule, multiplication rule, and total probability rule. Expected value, variance, standard deviation, covariance, and correlation are defined. Examples are provided to illustrate various probability concepts.

Uploaded by

Juan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Reading 8: Probability

Concepts
Reading 8 - LOSs
• LOSs Covered
• 8b, 8c, 8d, 8e, 8f, 8g, 8h, 8i, 8j, 8k, 8l,
8m, 8n
• LOSs Not Covered
• 8o
Definitions
Random Variable : uncertain quantity

Outcome : observed value of a random variable

Event : single outcome or a set of outcomes

Mutually exclusive events : cannot both happen.

Exhaustive events : includes all possible outcomes.


Properties, Types of Probability R

For any event E, P(E) is between zero and one:


0  P E   1
For any collection of mutually exclusive and exhaustive
events Ei,
 Ei  1
Empirical probability is based on an analysis of data.

Subjective probability is based on personal perception


and biases.(e.g. 70% that CB lowers rates)

A priori probability is based on reasoning in the absence


of data.(e.g. 50% head and 50% tail when throwing a coin)
Odds R

Odds are alternative way of expressing probabilities.


They represent the payoff on a fair bet (one where the expected payoff
is zero); given the probability of an event P(E),

Odds for (or in favor of) E: P(E) / (1 – P(E))


Odds against E: (1 – P(E)) / P(E)

Example: Suppose that the probability of A is 25%. Then the odds in


favor of A (or odds for) are 25% / 75%, or 1/3 (sometimes written
1:3), and the odds against A are 75% / 25% or 3/1 (or 3:1, reciprocal).

Expected profit = 25% (3) + 75% (-1) = 0  fair bet


A
If the odds in favor of an event, E, are A:B, then: P E  
AB

B
If the odds against an event, E, are A:B, then: P E  
AB
Practice Question 8-1
Analysts have quoted the odds against Syzygy Unlimited
meeting its quarterly earnings target at 2:3. The analysts’
estimate of the probability that Syzygy meets its earnings
target is closest to:

A. 40%
B. 60%
C. 67%
Unconditional & Conditional Probability
The unconditional probability of A – P(A) – is the probability of A
irrespective of the outcome of other events (or without the knowledge
of the outcome of other events).

Example: the probability that the economy will expand by more than
2%.

The conditional probability of A given B – P(A|B) – is the probability


of A knowing that event B has occurred.

Example: the probability that the economy will expand by more than
2% given that the Fed has reduced interest rates by 50 basis points.

Two events A and B are independent if:

P(A|B) = P(A) and P(B|A) = P(B)


Rules for Probability – I
Addition Rule

P(A or B) = P(A) + P(B) – P(AB)

A AB B

Multiplication Rule

P(AB) = P(A|B) × P(B) = P(B|A) × P(A)

For independent events:

P(AB) = P(A) × P(B)


Rules for Probability – II
Total Probability Rule
If S1, S2, . . ., Sn are mutually exclusive and exhaustive
events (scenarios), then,
P(A) = P(AS1) + P(AS2) + . . . + P(ASn)
= P(A|S1)P(S1) + P(A|S2)P(S2) + . . . + P(A|Sn)P(Sn)
Sn
A ASn S1
AS1
AS2
S2
AS3
AS4
S3
S4
Rules for Probability – III
Example: The probability of an increase in interest rates is 70%. If
interest rates increase, the probability that the economy grows is 30%,
while if interest rates don’t increase, the probability that the economy
grows is 60%. What is the (unconditional) probability that the economy
grows?

P(I) = 70%, P(IC) = 1 – 70% = 30%

P(G|I) = 30%, P(G|IC) = 60%

P(G) = P(GI) + P(GIC) = P(G|I)P(I) + P(G|IC)P(IC)

= (0.3 × 0.7) + (0.6 ×0.3)

= 0.21 + 0.18 = 0.39 = 39%


Tree Diagram
Whether interest rates decrease or EPS = $3.50
increase, company performance P = 0.14
can be good or poor P = 0.20

Interest Rates
P=
Decrease 0.80 EPS = $3.10
P = 0.70 P = 0.56
E(EPS) =
$3.11
P = 0.30 EPS = $3.00
P=
Interest Rates 0.90
P = 0.27
Increase
E(EPS) = 0.14($3.50) + 0.56($3.10) P = 0.10

+ 0.27($3.00) + 0.03($2.60) EPS = $2.60


= $3.11 P = 0.03
Expected Value, Variance, Std. Dev. – I
Given a set of (numerical) outcomes {X1, X2, . . ., Xn}, and
probabilities P(Xi) for each of those outcomes, the
expected value of X is:
n
E  X    P  Xi  Xi
i 1

The variance of X is:


n
   P  X i   X i  E  X  
2 2
X
i 1

The standard deviation of X is:


n

 P  X   X  E  X  
2
X   2
X  i i
i 1
Expected Value, Variance, Std. Dev. – II
Example: You’re given the following data:
Xi P(Xi)
4% 0.10
3% 0.20
-1% 0.30
2% 0.40
E(X) = 0.1(4%) + 0.2(3%) + 0.3(-1%) + 0.4(2%) = 1.5%

σ2X = 0.1(4% – 1.5%) + 0.2(3% – 1.5%)

+ 0.3(-1% – 1.5%) + 0.4(2% – 1.5%)

= 0.000305

σX = √0.000305 = 1.746%
Covariance – I
Given a population of pairs of observations {(X1, Y1), . . .,
(Xn, Yn)}, and mean values μX, μY for the Xs and Ys,
respectively, the covariance of X and Y is:
n

 X i   X Yi  Y 
Cov  X ,Y   i 1
n
If the observations form a sample, the covariance is:
 X  
n

i  X Yi  Y
Cov  X ,Y   i 1
n 1
If there is a probability P(Xi, Yi) for each observation, the
covariance is:
n
Cov  X ,Y    P  X i ,Yi  X i   X Yi  Y 
i 1
Covariance – II
Example: You’re given the following data:
(Xi, Yi) P(Xi, Yi)
(4%, 2%) 0.10
(3%, -2%) 0.20
(-1%, 4%) 0.30
(2%, 3%) 0.40
μX = 0.1(4%) + 0.2(3%) + 0.3(-1%) + 0.4(2%) = 1.5%

μY = 0.1(2%) + 0.2(-2%) + 0.3(4%) + 0.4(3%) = 2.2%

Cov(X,Y) = 0.1(4% – 1.5%)(2% – 2.2%) + 0.2(3% – 1.5%)(-2% – 2.2%)

+ 0.3(-1% – 1.5%)(4% – 2.2%) + 0.4(2% – 1.5%)(3% – 2.2%)

= -0.00025
Covariance – III
Example: You’re given the following table of joint probabilities for all possible
pairs of returns r1 and r2:
Returns r2 = 2% r2 = 4% r2 = 7% Sum
r1 = 5% 0.10 0.05 0.15 0.30
r1 = 7% 0.05 0.20 0.10 0.35
r1 = 9% 0.15 0.15 0.05 0.35
Sum 0.30 0.40 0.30
E(r1) = 0.30(5%) + 0.35(7%) + 0.35(9%) = 7.1%
E(r2) = 0.30(2%) + 0.40(4%) + 0.30(7%) = 4.3%
Cov(r1,r2) = 0.10(5% – 7.1%)(2% – 4.3%) + . . .
+ 0.05(9% – 7.1%)(7% – 4.3%) = -0.000083
σ2(r1) = 0.30(5% – 7.1%)2 + 0.35(7% – 7.1%)2 + 0.35(9% – 7.1%)2 = 0.000259
σ(r1) = √0.000259 = 1.609%
σ2(r2) = 0.30(2% – 4.3%)2 + 0.40(4% – 4.3%)2 + 0.30(7% – 4.3%)2 = 0.000381
σ(r2) = √0.000381 = 1.952%
ρ(r1, r2) = -0.000083 / [(1.609%)(1.952%)]
= -0.2642
Covariance – IV
Properties of covariance:
• Values can range from -∞ to +∞.
• Positive values suggest that when X is above its mean,
Y is above its mean, and when X is below its mean, Y is
below its mean.
• Negative values suggest that when X is above its mean,
Y is below its mean, and when X is below its mean, Y is
above its mean.
• The units are the product of the units on X and the units
on Y; e.g., if X is interest rate and Y is EPS, then the
units on Cov(X,Y) are % × $/share.
Correlation – I
The correlation of two variables X and Y is:
Cov  X ,Y 
Corr  X ,Y  
 XY
Properties of correlation:
• Measures the strength of the linear relationship of X, Y.
• Values can range from -1 to +1.
• Positive values suggest that X and Y are above their
means together, or below their means together.
• Negative values suggest that when X is above its mean,
Y is below its mean, and vice-versa.
• Correlation is just a number; it has no units.
• Population correlation is denoted by ρ, sample
correlation by r; r is always equal to ρ.
Correlation – II
Example: You’re given the following data:
(Xi, Yi) P(Xi, Yi)
(4%, 2%) 0.10
(3%, -2%) 0.20
(-1%, 4%) 0.30
(2%, 3%) 0.40
μX = 1.5%, μY = 2.2%

σX = 1.746%, σ Y = 2.182%

Cov(X,Y) = -0.00025

Cov  X ,Y  0.00025
 X ,Y    0.6561
 XY 1.746% 2.182%
Practice Question 8-2
Given the variance of X is 1.4, the variance of Y is 2.1, and
the covariance of X and Y is -0.429, the correlation of X
and Y is closest to:

A. -0.250
B. -0.146
C. -0.050
Portfolio Returns
Given a portfolio with two assets having weights w1 and w2
(w1 + w2 = 1), expected returns r1 and r2, standard
deviations of returns σ1 and σ2, respectively, and
correlation of returns ρ1,2, the expected portfolio return is:
E  rport   w1r1  w 2r2

The expected variance of portfolio returns is:


 r2  w12 12  w 22 22  2w1w 2 1,2 1 2
port

 w12 12  w 22 22  2w1w 2Cov  r1, r2 

The expected standard deviation of portfolio returns is:


rport
  r2port  w12 12  w 22 22  2w1w 2 1,2 1 2

 w12 12  w 22 22  2w1w 2Cov  r1, r2 


Practice Question 8-3
A portfolio comprises 70% security A and 30% security B. A’s expected
return is 5% while B’s is 9%. A’s standard deviation of returns is 4%,
B’s is 12%, and the correlation of returns between A and B is +0.4.
The expected return and standard deviation of returns for the portfolio
are closest to:

E(rp) σ(rp)
A. 6.20% 5.37%
B. 6.20% 8.95%
C. 7.80% 8.95%
Bayes’ Formula – I
For any events A and B:
P B | A P  A
P  A | B 
P B 
This is a straightforward consequence of the rules for
conditional probability:
P  A | B  P  B   P  AB   P  B | A  P  A 
Simply divide each side by P(B).

Problems that can be solved using Bayes’ formula are


often easier to solve using a tree diagram.
Bayes’ Formula – II
Example: You’re given the following information:
• D = Decrease in interest rates
• E = Economic expansion
• P(D) = 60%
• P(E|D) = 90%
• P(EC|DC) = 80%

What is the probability that interest rates decreased, given an


economic expansion?

P(E) = P(E|D)P(D) + P(E|DC)P(DC)

= (0.90)(0.60) + (0.20)(0.40) = 0.62

P E | D  P D   0.90  0.60 
P D | E     87.1%
P E  0.62
Bayes’ Formula – III
Economy
Expands P = 0.60 × 0.90 = 0.54
Interest Rates
Decrease
Economy
P = 0.60 × 0.10 = 0.06
Contracts

Economy
P = 0.40 × 0.20 = 0.08
Expands
Interest Rates
Increase
Economy
P = 0.40 × 0.80 = 0.32
Contracts

0.54
P D | E    87.1%
0.54  0.08
Practice Question 8-4
Alpha Beta Gamma (ΑΒΓ) Corporation hopes to sign a large contract
in a new market it’s been pursuing; ΑΒΓ puts the probability of signing
at 75%. If they’re successful, there’s an 80% chance they’ll meet next
quarter’s earnings goal, while if they fail there’s only a 15% chance of
meeting the goal. If they meet the goal, the probability that they signed
the contract is closest to:

A. 60%
B. 75%
C. 94%

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