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PSE CERTIFIED SECURITIES PSE CERTIFIED SECURITIES

SPECIALIST COURSE SPECIALIST COURSE

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COURSE 1: COURSE 1:
QUANTITATIVE METHODS OF QUANTITATIVE METHODS OF
FINANCE AND STATISTICS FINANCE AND STATISTICS
WHAT IS MEANT BY TIME WHAT IS MEANT BY TIME
VALUE OF MONEY? VALUE OF MONEY?
Answer: Answer: It means that as one moves FORWARD It means that as one moves FORWARD
THROUGH TIME, the VALUE of his/her THROUGH TIME, the VALUE of his/her
MONEY INCREASES OR GROWS. MONEY INCREASES OR GROWS.
the future value F of ones money is always the future value F of ones money is always
bigger than the present value P of the money; bigger than the present value P of the money;
i.e., F > P or P < F (Illustrate on the whiteboard i.e., F > P or P < F (Illustrate on the whiteboard
using a timeline!) using a timeline!)
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ACCUMULATING VS. ACCUMULATING VS.
DISCOUNTING: DISCOUNTING:
1.) The process of obtaining the future value F (using 1.) The process of obtaining the future value F (using
either the simple interest method or the simple either the simple interest method or the simple
discount method or the compound interest discount method or the compound interest
method) is called ACCUMULATING. method) is called ACCUMULATING.
2.) The process of getting the present value P (using 2.) The process of getting the present value P (using
either the simple interest method or the simple either the simple interest method or the simple
discount method or the compound interest discount method or the compound interest
method) is called DISCOUNTING. method) is called DISCOUNTING.
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HOW DO WE ACCUMULATE OR HOW DO WE ACCUMULATE OR
DISCOUNT UNDER THE COMPOUND DISCOUNT UNDER THE COMPOUND
INTEREST METHOD? INTEREST METHOD?
( )
( )
discount to v F
i 1
F
P equation the Use b.)
accumulate to i 1 P F equation the Use a.)
n
n
=
+
=
+ =
n
4
( )
i 1
1
, F P equation in the that Note N.B.
d)! whiteboar on the ity compatibil his (explain t
COMPATIBLE n of and i of units the make
formulas, or equations above the using Before : CAUTION
i 1
n
+
= =
+

n
ILLUSTRATIVE EXERCISES ON ILLUSTRATIVE EXERCISES ON
ACCUMULATING AND DISCOUNTING: ACCUMULATING AND DISCOUNTING:
1.) Accumulate 1.) Accumulate Php Php 100,000 for 5 years at an 100,000 for 5 years at an
interest rate of 15% interest rate of 15% p.a.c.m p.a.c.m. .
2.) Discount 2.) Discount Php Php 500,000 over a period of 8 years 500,000 over a period of 8 years
at an interest rate of 16% at an interest rate of 16% p.a.c.q p.a.c.q. .
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ILLUSTRATIVE PROBLEMS ON ILLUSTRATIVE PROBLEMS ON
DISCOUNTING: DISCOUNTING:
11..)) The The common common stocks stocks of of ABC ABC Company Company are are projected projected to to give give
annual annual per per share share dividends dividends of of Php Php 55,, Php Php 66,, Php Php 66..50 50,, Php Php 88,,
and and Php Php 10 10 during during the the next next one one year, year, 22 years, years, 33 years, years, 44 years years
and and 55 years, years, respectively respectively.. It It is is also also projected projected that that by by the the end end of of
five five years, years, the the price price of of these these stocks stocks would would be be Php Php 80 80 per per share share.. five five years, years, the the price price of of these these stocks stocks would would be be Php Php 80 80 per per share share..
Using Using an an interest interest rate rate of of 20 20%% p p..a a.. effective effective (i (i..ee..,, 20 20%% p p..a a..cc..a a..), ),
determine determine the the intrinsic intrinsic value value of of these these stocks stocks.. (answer (answer:: Php Php
52 52..12 12))
(N (N..BB.: .: a a..)) Do Do this this exercise exercise without without using using vv !!
b b..)) In In determining determining the the intrinsic intrinsic value value of of a a common common stock, stock, one one
may may also also use use the the investors investors target target rate rate of of return return or or the the
companys companys ROE ROE..))
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ILLUSTRATIVE PROBLEMS ILLUSTRATIVE PROBLEMS
ON DISCOUNTING: ON DISCOUNTING:
2.) The projected annual yearend operating free cash flows (OFCF) 2.) The projected annual yearend operating free cash flows (OFCF)
of XYZ Corporation are as follows: of XYZ Corporation are as follows:
Year Year Yearend OFCF Yearend OFCF
11 Php Php 100 M 100 M
22 Php Php 115 M 115 M 22 Php Php 115 M 115 M
33 Php Php 138 M 138 M
44 Php Php 149 M 149 M
55 Php Php 170 M 170 M
Discount (i.e., find the total of the present values of) these cash Discount (i.e., find the total of the present values of) these cash
flows using XYZs weighted average cost of capital (WACC) of flows using XYZs weighted average cost of capital (WACC) of
15% p.a. effective (i.e., 15% 15% p.a. effective (i.e., 15% p.a.c.a p.a.c.a.). (answer: .). (answer: Php Php 434.362 M) 434.362 M)
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WHAT IS STATISTICS? WHAT IS STATISTICS?
A science which deals with the A science which deals with the
collection, organization, analysis, collection, organization, analysis,
interpretation and presentation of interpretation and presentation of
quantitative data in order to extract quantitative data in order to extract
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quantitative data in order to extract quantitative data in order to extract
information and/or conclusions that information and/or conclusions that
help in the decision help in the decision--making process making process..
DIVISIONS OF STATISTICS: DIVISIONS OF STATISTICS:
1.) DESCRIPTIVE STATISTICS: 1.) DESCRIPTIVE STATISTICS:
Covers the procedures for organizing, Covers the procedures for organizing,
summarizing, describing and presenting quantitative summarizing, describing and presenting quantitative
data as well as the computation of statistical or data as well as the computation of statistical or
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data as well as the computation of statistical or data as well as the computation of statistical or
numerical measures such as: numerical measures such as:
1.1) Measures of Central Location 1.1) Measures of Central Location
1.2) Measures of Relative Location 1.2) Measures of Relative Location
1.3) Measures of Variability 1.3) Measures of Variability
1.4) Measures of Relationship Between/Among 1.4) Measures of Relationship Between/Among
Variables Variables
DIVISIONS OF STATISTICS: DIVISIONS OF STATISTICS:
2.) INFERENTIAL STATISTICS: 2.) INFERENTIAL STATISTICS:
Dwells on drawing out conclusions about the Dwells on drawing out conclusions about the
characteristics of a population by applying the characteristics of a population by applying the
appropriate statistical techniques and methods on appropriate statistical techniques and methods on
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appropriate statistical techniques and methods on appropriate statistical techniques and methods on
quantitative data from samples that were randomly quantitative data from samples that were randomly
taken from the population. taken from the population.
KEY STATISTICAL CONCEPTS: KEY STATISTICAL CONCEPTS:
1.) POPULATION or UNIVERSE 1.) POPULATION or UNIVERSE
2.) SAMPLE 2.) SAMPLE
3.) PARAMETER 3.) PARAMETER
x
) ( the and the
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3.) PARAMETER 3.) PARAMETER
4.) STATISTIC 4.) STATISTIC
5.) RANDOM VARIABLE 5.) RANDOM VARIABLE
) ( the and the
) ( s the and x the
TYPES OF DATA: TYPES OF DATA:
1.) CATEGORICAL DATA 1.) CATEGORICAL DATA
1.1) Yes or No or Dont Know 1.1) Yes or No or Dont Know
1.2) Equity or Fixed 1.2) Equity or Fixed--Income or Balanced Income or Balanced
1.3) Banks and Financial Services, Telecom, 1.3) Banks and Financial Services, Telecom,
Property, Holding, Manufacturing, Oil, Property, Holding, Manufacturing, Oil, Mining Mining
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Property, Holding, Manufacturing, Oil, Property, Holding, Manufacturing, Oil, Mining Mining
1.4) Freshman, Sophomore, Junior, Senior 1.4) Freshman, Sophomore, Junior, Senior
1.5) S, M , L, XL, XXL, XXXL, XXXXL 1.5) S, M , L, XL, XXL, XXXL, XXXXL
1.6) Rural, Thrift, Commercial, Universal 1.6) Rural, Thrift, Commercial, Universal
1.7) AAA, AA, A, BBB, BB, B, CCC, CC, C 1.7) AAA, AA, A, BBB, BB, B, CCC, CC, C
TYPES OF DATA: TYPES OF DATA:
2.) NUMERICAL DATA: 2.) NUMERICAL DATA:
2.1) 2.1) DISCRETE DATA: DISCRETE DATA: age, income, expenses, age, income, expenses,
sales volume, production sales volume, production
output, no. of telephone calls output, no. of telephone calls
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output, no. of telephone calls output, no. of telephone calls
per month per month
2.2) 2.2) CONTINUOUS DATA: CONTINUOUS DATA: height, IQ, Rate of height, IQ, Rate of
Return, waiting time from Return, waiting time from
arrival up to time of being arrival up to time of being
fluorescent bulb fluorescent bulb
MEASURES OF CENTRAL MEASURES OF CENTRAL
LOCATION / TENDENCY: LOCATION / TENDENCY:
1.) Arithmetic Mean 1.) Arithmetic Mean
(or simply, Mean) (or simply, Mean)
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(or simply, Mean) (or simply, Mean)
2.) Median 2.) Median
3.) Mode 3.) Mode
CHARACTERISTICS OF THE CHARACTERISTICS OF THE
MEAN MEAN
1.) Most commonly used 1.) Most commonly used
2.) Easy to compute 2.) Easy to compute
3.) Its value is AFFECTED by extremely big or 3.) Its value is AFFECTED by extremely big or
extremely small values or observations extremely small values or observations
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extremely small values or observations extremely small values or observations
N.B.: These extreme values are referred to as N.B.: These extreme values are referred to as
outliers outliers
4.) Appropriate to use when values or observations 4.) Appropriate to use when values or observations
are taken from a HOMOGENEOUS population are taken from a HOMOGENEOUS population
HOW TO COMPUTE THE HOW TO COMPUTE THE
MEAN MEAN
N
X
N
i
i

= == =
= == =
1
: MEAN POPULATION . 1
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n
X
x MEAN SAMPLE
N
n
i
i

= == =
= == =
1
: . 2
ILLUSTRATION : COMPUTING THE MEAN ILLUSTRATION : COMPUTING THE MEAN
On On August August 28 28,, 2007 2007,, the the closing closing share share prices prices of of
banks banks in in the the local local stock stock market market were were as as follows follows::
Asiatrust Asiatrust Dev. Bank Dev. Bank : P9.5 : P9.5 Security Bank : P73 Security Bank : P73
BDO / EPCI BDO / EPCI : 57.5 PB : 57.5 PB Comm Comm : 52 : 52
BPI BPI : 58.5 PNB : 46.5 : 58.5 PNB : 46.5
China Bank China Bank : 820.0* PSB : 63.5 : 820.0* PSB : 63.5
Chinatrust Chinatrust Phil Phil : 30 Phil. Trust Co. : 54.5 : 30 Phil. Trust Co. : 54.5
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Chinatrust Chinatrust Phil Phil : 30 Phil. Trust Co. : 54.5 : 30 Phil. Trust Co. : 54.5
Citystate Citystate Savings : 23 RCBC : 25 Savings : 23 RCBC : 25
EIB EIB : 0.4* Union Bank : 55 : 0.4* Union Bank : 55
Metrobank Metrobank : 55 : 55
1.) What is the mean of these share prices? 1.) What is the mean of these share prices?
2.) Calculate the mean excluding the outliers China Bank and EIB 2.) Calculate the mean excluding the outliers China Bank and EIB
2.) P46.38 2.) P46.38
THE WEIGHTED MEAN: THE WEIGHTED MEAN:
N.B.: The weights W N.B.: The weights W
i i
s can be integers or fractions or decimal numbers. s can be integers or fractions or decimal numbers.

= == =
= == =
= == =
n
i
i
n
i
i i
w
W
X W
X
1
1
: MEAN WEIGHTED
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N.B.: The weights W N.B.: The weights W
i i
s can be integers or fractions or decimal numbers. s can be integers or fractions or decimal numbers.
ILLUSTRATION: A student obtained the following grades (in %) in ILLUSTRATION: A student obtained the following grades (in %) in
subjects A, B, C, D, and E subjects A, B, C, D, and E
A (5 units) A (5 units) : 75 : 75
B (3 units) B (3 units) : 78 : 78
C (4 units) C (4 units) : 56 : 56
D (3 units) D (3 units) : 80 : 80
E (1 unit) E (1 unit) : 95 : 95
Calculate the students GPA.( Answer : 73% ) Calculate the students GPA.( Answer : 73% )
MEAN OR EXPECTED VALUE MEAN OR EXPECTED VALUE
OF A RANDOM VARIABLE OF A RANDOM VARIABLE
W
X W
X
n
i
n
i
i i
w

=
=
=
1
, formula the In
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X p
X
X
i
n
i
i
w
i

=
=
= =
1
i
1
E(X) X OF VALUE EXPECTED is, that
; X V. R. the of VALUE EXPECTED the becomes then
s p VALUES Y PROBABILIT are s Wi weights the and
(R.V.) VARIABLE RANDOM a is if
ILLUSTRATION: EXPECTED VALUE ILLUSTRATION: EXPECTED VALUE
OF A RANDOM VARIABLE: OF A RANDOM VARIABLE:
Within the next 3 months, the probable rate of return on two Within the next 3 months, the probable rate of return on two
assets A and B (stocks, for example) are as follows: assets A and B (stocks, for example) are as follows:
RATE OF RETURN RATE OF RETURN
Probability Probability ASSET A ASSET A ASSET B ASSET B
0.6 0.6 0.15 0.15 0.06 0.06
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0.6 0.6 0.15 0.15 0.06 0.06
0.3 0.3 0.12 0.12 0.23 0.23
0.1 0.1 0.05 0.05 0.10 0.10
Determine: 1.) The expected rate of return on Asset A. Determine: 1.) The expected rate of return on Asset A.
2.) The expected rate return on Asset B 2.) The expected rate return on Asset B
TIME TIME- -WEIGHTED AVERAGE RATE OF RETURN WEIGHTED AVERAGE RATE OF RETURN
OR GEOMETRIC MEAN RATE OF RETURN: OR GEOMETRIC MEAN RATE OF RETURN:
ILLUSTRATION: ILLUSTRATION:
During a certain 5 month period, a stock or issue had During a certain 5 month period, a stock or issue had
the following monthly rates of return: the following monthly rates of return:
n ... 3, 2, 1, i i, period the during return of rate the :
1 ) 1 ...( ) 1 )( 1 (
2 1
= == = = == =
+ ++ + + ++ + + ++ + = == =
i
n
p
n
p p p T
R where
R R R R
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the following monthly rates of return: the following monthly rates of return:
Month 1 Month 1 : 15% : 15%
Month 2 Month 2 : 12% : 12%
Month 3 Month 3 : : - -5% 5%
Month 4 Month 4 : : - -10% 10%
Month 5 Month 5 : 8% : 8%
What was the time What was the time- -weighted average monthly rate of return weighted average monthly rate of return
during the entire 5 during the entire 5- -month period? (answer: 3.53%) month period? (answer: 3.53%)
CHARACTERISTICS OF THE CHARACTERISTICS OF THE
MEDIAN MEDIAN
1.) The value or observation compared to which 50% 1.) The value or observation compared to which 50%
of the total number of observations are SMALLER of the total number of observations are SMALLER
and 50% are BIGGER. and 50% are BIGGER.
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2.) Not affected by extremely big or extremely small 2.) Not affected by extremely big or extremely small
values/ observations values/ observations
3.) Finds application when the population is NOT 3.) Finds application when the population is NOT
HOMOGENEOUS. HOMOGENEOUS.
HOW TO DETERMINE THE HOW TO DETERMINE THE
MEDIAN MEDIAN
STEPS: STEPS:
1.) Arrange the values / observations in ASCENDING order. 1.) Arrange the values / observations in ASCENDING order.
2.) Apply the following RULES: 2.) Apply the following RULES:
RULE 1: If there is an ODD number of observations RULE 1: If there is an ODD number of observations
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RULE 1: If there is an ODD number of observations RULE 1: If there is an ODD number of observations
(i.e. (i.e. n n = no. of observations = an odd number) = no. of observations = an odd number)
n observatio
n
the M MEDIAN
th
d
|

\
|
+
=
2
1
:
n observatio
n
the and
n observatio
n
the of AVERAGE the MEDIAN
number EVEN an is n If RULE
th
th
|

\
|
+
|

\
|
=
1
2
2
, : 2
ILLUSTRATION: OBTAINING ILLUSTRATION: OBTAINING
THE MEDIAN THE MEDIAN
Obtain the median of each of the following Obtain the median of each of the following
sets of observations: sets of observations:
1.) 20%, 18%, 22%, 8%, 10%,12%, 5%, 11%, 14% 1.) 20%, 18%, 22%, 8%, 10%,12%, 5%, 11%, 14%
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1.) 20%, 18%, 22%, 8%, 10%,12%, 5%, 11%, 14% 1.) 20%, 18%, 22%, 8%, 10%,12%, 5%, 11%, 14%
2.) 1.9%, 1.8%, 1.6%, 2.1%, 1.5%, 1.7%, 2.0%, 2.) 1.9%, 1.8%, 1.6%, 2.1%, 1.5%, 1.7%, 2.0%,
1.8% 1.8%
CHARACTERISTICS OF THE MODE: CHARACTERISTICS OF THE MODE:
1.) It is the observation that appears 1.) It is the observation that appears
MOST MOST frequently frequently
2.) Not affected by extremely big or 2.) Not affected by extremely big or
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2.) Not affected by extremely big or 2.) Not affected by extremely big or
extremely small values extremely small values
3.) May not be unique 3.) May not be unique
4.) May not exist 4.) May not exist
ILLUSTRATION: OBTAINING THE MODE ILLUSTRATION: OBTAINING THE MODE
Find the mode of the following sets of values: Find the mode of the following sets of values:
1.) 20%, 18%, 22%, 11%, 10%, 12%, 5%, 11%, 1.) 20%, 18%, 22%, 11%, 10%, 12%, 5%, 11%,
14% 14%
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14% 14%
2.) 1.9, 1.8, 1.5, 2.1, 1.5, 1.7, 2.0, 1.8 2.) 1.9, 1.8, 1.5, 2.1, 1.5, 1.7, 2.0, 1.8
MEASURES OF RELATIVE MEASURES OF RELATIVE
POSITION / LOCATION: POSITION / LOCATION:
1.) 1.) QUARTILES: QUARTILES: measures that divide the measures that divide the
distribution of the ordered data into four (4) distribution of the ordered data into four (4)
2.) 2.)DECILES: DECILES: measures that divide the measures that divide the
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2.) 2.)DECILES: DECILES: measures that divide the measures that divide the
distribution of ordered data into ten (10) distribution of ordered data into ten (10)
3.) 3.)PERCENTILES: PERCENTILES: measures that divide the measures that divide the
distribution of ordered data into 100 distribution of ordered data into 100
THE QUARTILES: THE QUARTILES:
FIRST QUARTILE FIRST QUARTILE = = QQ
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= the observation compared to which = the observation compared to which
25% of the total no. of observations are SMALLER and 75% are 25% of the total no. of observations are SMALLER and 75% are
BIGGER. BIGGER.
==
SECOND QUARTILE SECOND QUARTILE = Q = Q
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= the observation compared to which = the observation compared to which
50% of the total no of observations are SMALLER and 50% are 50% of the total no of observations are SMALLER and 50% are
t arrangemen ordered the in n observatio
n
the
th
|

\
|
+
4
1
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SECOND QUARTILE SECOND QUARTILE = Q = Q
22
= the observation compared to which = the observation compared to which
50% of the total no of observations are SMALLER and 50% are 50% of the total no of observations are SMALLER and 50% are
BIGGER. BIGGER.
= =
THIRD QUARTILE THIRD QUARTILE = = QQ
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= the observation compared to which = the observation compared to which
75% of the total no. of observations are SMALLER and 25% are 75% of the total no. of observations are SMALLER and 25% are
BIGGER . BIGGER .
== t arrangemen ordered the in n observatio n
th
|

\
|
+ ) 1 (
4
3
Median the
HOW TO OBTAIN HOW TO OBTAIN
QUARTILES QUARTILES
STEPS: STEPS:
1.) Arrange the observations in ASCENDING order 1.) Arrange the observations in ASCENDING order
RULE 1: if the resulting positioning point (i.e., the value of or of ) is RULE 1: if the resulting positioning point (i.e., the value of or of ) is
an INTEGER, the an INTEGER, the observation corresponding to that positioning point observation corresponding to that positioning point
is chosen as the quartile. is chosen as the quartile.
4
1 + n
4
) 1 ( 3 + n
29
is chosen as the quartile. is chosen as the quartile.
RULE 2: If or is HALFWAY BETWEEN TWO INTEGERS, RULE 2: If or is HALFWAY BETWEEN TWO INTEGERS,
the quartile is the AVERAGE of their corresponding observations. the quartile is the AVERAGE of their corresponding observations.
RULE 3: If or is NEITHER AN RULE 3: If or is NEITHER AN INTEGER NOR INTEGER NOR
HALFWAY BETWEEN TWO INTEGERS, round off to the NEAREST HALFWAY BETWEEN TWO INTEGERS, round off to the NEAREST
INTEGER and select the value of the corresponding observation as the INTEGER and select the value of the corresponding observation as the
quartile. quartile.
4
) 1 ( 3 + n
4
1 + n
4
) 1 ( 3 + n
4
1 + n
ILLUSTRATION 1: OBTAINING ILLUSTRATION 1: OBTAINING
THE QUARTILES THE QUARTILES
Obtain Q Obtain Q
11
, Q , Q
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, and the median for the following , and the median for the following
observations: observations:
1.4, 1.5, 1.6, 1.7, 1.8, 1.8, 1.9, 2.0, 2.0, 2.0, 2.1, 2.1, 2.2, 2.2, 2.3 1.4, 1.5, 1.6, 1.7, 1.8, 1.8, 1.9, 2.0, 2.0, 2.0, 2.1, 2.1, 2.2, 2.2, 2.3
: Solution
30
0 . 2 8
1 . 2 12
12
4
) 1 15 ( 3
4
) 1 ( 3
7 . 1 4
4
4
1 15
4
1
:
2
3
1
= == = = == = = == =
= == = = == =
= == =
( (( (

( (( (

+ ++ +
= == =
( (( (

( (( (

+ ++ +
= == =
= == = = == =
= == =
| || |

| || |

\ \\ \
| || |
+ ++ +
= == =
| || |

| || |

\ \\ \
| || |
+ ++ +
= == =
n observatio the Q Median
n observatio the
n observatio the n observatio the n observatio
n
the Q
n observatio the
n observatio the n observatio the n observatio
n
the Q
Solution
th
th
th
th th
th
th
th th
ILLUSTRATION 2: OBTAINING ILLUSTRATION 2: OBTAINING
THE QUARTILES THE QUARTILES
Obtain Q Obtain Q
11
, Q , Q
33
, and the median for the following , and the median for the following
observations: observations:
1.4, 1.5, 1.6, 1.7, 1.8, 1.8, 1.9, 2.0, 2.0, 2.1, 2.1, 2.2, 2.2, 2.3 1.4, 1.5, 1.6, 1.7, 1.8, 1.8, 1.9, 2.0, 2.0, 2.1, 2.1, 2.2, 2.2, 2.3
: Solution
31
95 . 1 8 7
1 . 2 11
) 25 . 11 (
4
) 1 14 ( 3
4
) 1 ( 3
7 . 1 4
) 75 . 3 (
4
1 14
4
1
:
2
3
1
= = =
= =
=
(

+
=
(

+
=
= =
=
|

\
|
+
=
|

\
|
+
=
ns observatio and the of average Q Median
n observatio the
n observatio the n observatio the n observatio
n
the Q
n observatio the
n observatio the n observatio the n observatio
n
the Q
Solution
th th
th
th
th th
th
th
th th
THE 5 THE 5- -NUMBER SUMMARY NUMBER SUMMARY
A summary consisting of the following 5 A summary consisting of the following 5
numbers or values: numbers or values:
XX
smallest smallest
, Q , Q
1 1
, Median, Q , Median, Q
3 3
, , XX
biggest biggest
32
This summary helps to determine if the This summary helps to determine if the
distribution of a given set of observations is distribution of a given set of observations is
symmetric or right symmetric or right- - skewed or left skewed or left- -skewed. skewed.
USING THE 5 USING THE 5- -NUMBER SUMARY TO NUMBER SUMARY TO
RECOGNIZE DATA SYMMETRY: RECOGNIZE DATA SYMMETRY:
1.) The distance from 1.) The distance from xx
smallest smallest
to the Median = to the Median =
the distance from the Median to the distance from the Median to xx
biggest biggest
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2.) The distance from 2.) The distance from xx
smallest smallest
to Q to Q
1
= =
the distance from Q the distance from Q
33
to to xx
biggest biggest
USING THE 5 USING THE 5- -NUMBER SUMMARY NUMBER SUMMARY
TO RECOGNIZE DATA SKEWNESS: TO RECOGNIZE DATA SKEWNESS:
1.) RIGHT 1.) RIGHT- -SKEWED DISTRIBUTION OF DATA: SKEWED DISTRIBUTION OF DATA:
1.1) Distance from median to x 1.1) Distance from median to x
biggest biggest
> distance from > distance from
x x
smallest smallest
to median to median
1.2) Distance from Q 1.2) Distance from Q
33
to x to x
biggest biggest
> distance from x > distance from x
smallest smallest
to Q to Q
11
34
to Q to Q
11
2.) 2.) LEFT LEFT- -SKEWED DISTRIBUTION OF DATA: SKEWED DISTRIBUTION OF DATA:
2.1) Distance from x 2.1) Distance from x
smallest smallest
to Median > distance from to Median > distance from
Median to x Median to x
biggest biggest
2.2) Distance from x 2.2) Distance from x
smallest smallest
to Q to Q
11
> distance from > distance from
QQ
33
to x to x
biggest biggest
THE BOX THE BOX- -AND AND- -WHISKER PLOT WHISKER PLOT
(or simply, BOX PLOT) (or simply, BOX PLOT)
A graphical representation of the A graphical representation of the
distribution of a given set of data based on distribution of a given set of data based on
the 5 the 5- -NUMBER SUMMARY. (Please see NUMBER SUMMARY. (Please see
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the 5 the 5- -NUMBER SUMMARY. (Please see NUMBER SUMMARY. (Please see
illustration on the white board) illustration on the white board)
MEASURES OF VARIABILITY OR MEASURES OF VARIABILITY OR
VARIATION VARIATION
1.) The RANGE: Range = 1.) The RANGE: Range = XX
biggest biggest
XX
smallest smallest
2.) The VARIANCE and the STANDARD 2.) The VARIANCE and the STANDARD
DEVIATION DEVIATION
36
DEVIATION DEVIATION
3.) The COEFFICIENT OF VARIATION 3.) The COEFFICIENT OF VARIATION
THE VARIANCE AND THE THE VARIANCE AND THE
STANDARD DEVIATION STANDARD DEVIATION
) (
:
2
1
2
2
variance Deviation Standard
N
X
Variance
POPULATION A FOR
N
i
i

= = =

= =

=
37
etc. liters, squared years, squared pesos, squared i.e., units,
SQUARED in measured are and that note Please : N.B.
1
) (
:
2 2
2
1
2
2
s
s variance s Deviation Standard
n
x x
s Variance
SAMPLE A FOR
n
i
i

= = =

= =

=
ILLUSTRATIVE EXERCISE ILLUSTRATIVE EXERCISE
Determine the variance and the standard Determine the variance and the standard
deviation of the following SAMPLE data: deviation of the following SAMPLE data:
1.4, 1.5, 1.6, 1.7, 1.8, 1.8,1.9, 2.0, 2.0, 2.1, 2.1, 1.4, 1.5, 1.6, 1.7, 1.8, 1.8,1.9, 2.0, 2.0, 2.1, 2.1,
38
1.4, 1.5, 1.6, 1.7, 1.8, 1.8,1.9, 2.0, 2.0, 2.1, 2.1, 1.4, 1.5, 1.6, 1.7, 1.8, 1.8,1.9, 2.0, 2.0, 2.1, 2.1,
2.2, 2.2, 2.3 2.2, 2.2, 2.3
22
= 0.076923; s = 0.277350) = 0.076923; s = 0.277350)
SIGNIFICANCE OF THE SIGNIFICANCE OF THE
STANDARD DEVIATION: STANDARD DEVIATION:
i.e.,
MEAN; the from data the of
NESS SCATTERED OR DISPERSION THE MEASURES 1.
; x or d from e disperse s are mor the x or s bigger
i
39
stocks of portfolio a or stock a of return
of rate expected the achieve to able being not of RISK the
ANALYSIS, PORTFOLIO INVESTMENT IN 2.
.
i.e.,
=

x or d from s disperse s are les the x or s er less

; x or d from e disperse s are mor the x or s bigger
i
i
THE COEFFICIENT OF THE COEFFICIENT OF
VARIATION OR CV: VARIATION OR CV:
: SAMPLE A FOR
100
: POPULATION A FOR
s
x CV =

40
units. different in measured
data of sets more or two comparing in useful is CV The 2.
mean. the of unit value per data of ess scatteredn
or dispersion the measures CV The 1.
: N.B.
100 x
x
s
CV =
MEASURES OF LINEAR MEASURES OF LINEAR
RELATIONSHIP: RELATIONSHIP:

sample). a (for r by or
) population a (for by denoted is it Y; and X variables random two
between ip relationsh linear the of strength the of measure
: N CORRELATIO LINEAR OF T COEFFICIEN 1.

41
X. R.V. T INDEPENDEN
the of values with the ip relationsh linear by the explained or for
accounted be can that Y R.V. DEPENDENT the of values in the
ty variabili the of percentage or proportion the measures
: ) r or ( ION DETERMINAT OF T COEFFICIEN 2.
2 2

COMMENTS ON THE VALUES OF r COMMENTS ON THE VALUES OF r

AND r : AND r :
1.) 1.) --1 r 1 1 r 1
2.) r = o there is no linear relationship between 2.) r = o there is no linear relationship between
the values of the R.V.s X and Y the values of the R.V.s X and Y
r = 1 the values of the R.V.s X and Y are r = 1 the values of the R.V.s X and Y are
PERFECTLY POSITIVELY PERFECTLY POSITIVELY
42
PERFECTLY POSITIVELY PERFECTLY POSITIVELY
CORRELATED CORRELATED
r = r = --1 the values of the R.V.s X and Y are 1 the values of the R.V.s X and Y are
PERFECTLY NEGATIVELY PERFECTLY NEGATIVELY
CORRELATED CORRELATED..
3.) The value of r 3.) The value of r
22
is always positive and is expressed as a is always positive and is expressed as a
percentage. percentage.
DETERMINING r FROM DETERMINING r FROM
HISTORICAL DATA: HISTORICAL DATA:
] ) ( ) ( ][ ) ( ) ( [
) )( ( ) (
2 2 2 2

=
Y Y n X X n
Y X XY n
r
43
Y) (X, NS OBSERVATIO PAIRED of number the : = n where
WORKSHEET FOR COMPUTING r: WORKSHEET FOR COMPUTING r:
XX Y Y XY XY X X Y Y
XX
11
Y Y
11
XX
11
Y Y
11
XX
11
Y Y
11

XX
22
Y Y
22
XX
22
Y Y
22
XX
22
Y Y
22

44
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
XX
n n
Y Y
n n
XX
n n
Y Y
n n
XX
n n
Y Y
n n

XX Y Y (XY) (XY) (X) (X) (Y) (Y)

INDIVIDUAL HOMEWORK INDIVIDUAL HOMEWORK
(To be submitted next meeting): (To be submitted next meeting):
DETERMINING r AND r: DETERMINING r AND r:
Compute and interpret the coefficient of linear Compute and interpret the coefficient of linear
correlation and the coefficient of determination correlation and the coefficient of determination
for the following SAMPLE data: for the following SAMPLE data:
45
for the following SAMPLE data: for the following SAMPLE data:
XX 44 55 99 14 14 18 18 22 22 24 24
Y Y 16 16 22 22 11 11 16 16 77 33 17 17
STATISTICAL EXPERIMENT, STATISTICAL EXPERIMENT,
SAMPLE SPACE AND EVENTS: SAMPLE SPACE AND EVENTS:
STATISTICAL EXPERIMENT STATISTICAL EXPERIMENT: process of generating random : process of generating random
outcomes or data outcomes or data
Examples: Examples: drawing a card from a well drawing a card from a well--shuffled deck; shuffled deck;
tossing a pair of dice tossing a pair of dice
SAMPLE SPACE: SAMPLE SPACE: set of all possible outcomes of a statistical set of all possible outcomes of a statistical
46
SAMPLE SPACE: SAMPLE SPACE: set of all possible outcomes of a statistical set of all possible outcomes of a statistical
experiment experiment
SAMPLE POINTS: SAMPLE POINTS: the elements of a sample space the elements of a sample space
EVENT: EVENT: a subset of a sample space a subset of a sample space
NULL SPACE OR EMPTY SPACE: NULL SPACE OR EMPTY SPACE: subset of the sample space; subset of the sample space;
has no elements; denoted by has no elements; denoted by o o
VENN DIAGRAM: VENN DIAGRAM: pictorial representation of a sample space and pictorial representation of a sample space and
the events in this sample space the events in this sample space
ASSIGNING PROBABILITY ASSIGNING PROBABILITY
WEIGHTS TO THE ELEMENTS OF A WEIGHTS TO THE ELEMENTS OF A
SAMPLE SPACE: SAMPLE SPACE:
1.) Drawing one card from a well 1.) Drawing one card from a well- -shuffled deck shuffled deck
2.) Tossing a FAIR DIE once 2.) Tossing a FAIR DIE once
47
2.) Tossing a FAIR DIE once 2.) Tossing a FAIR DIE once
3.) Tossing a LOADED DIE once (the die is 3.) Tossing a LOADED DIE once (the die is
loaded such that the even numbers are loaded such that the even numbers are
THRICE as likely to turn up as the odd THRICE as likely to turn up as the odd
numbers) numbers)
PROBABILITY OF AN EVENT A PROBABILITY OF AN EVENT A
(MARGINAL PROBABILITY OF A): (MARGINAL PROBABILITY OF A):
P(A) = sum of the probability weights of those P(A) = sum of the probability weights of those
sample points belonging to event A sample points belonging to event A
N.B.: 0 P(an Event) 1; N.B.: 0 P(an Event) 1;
If P(an Event) = 1, the event is certain to If P(an Event) = 1, the event is certain to
occur occur
48
occur occur
If P(an Event) = 0, it is an impossible If P(an Event) = 0, it is an impossible
event event
Example: A die is loaded such that the number 1 is Example: A die is loaded such that the number 1 is
thrice as likely to turn up as the other thrice as likely to turn up as the other
numbers. If the die is tossed, find: numbers. If the die is tossed, find:
1.) P(getting a 1) 1.) P(getting a 1)
2.) P(getting a number less than 4) 2.) P(getting a number less than 4)
CLASSICAL DEFINITION OF CLASSICAL DEFINITION OF
PROBABILITY OF AN EVENT: PROBABILITY OF AN EVENT:
If an experiment can result in any one of N If an experiment can result in any one of N
different EQUALLY LIKELY OUTCOMES, and if different EQUALLY LIKELY OUTCOMES, and if
exactly n of these outcomes correspond to event A, exactly n of these outcomes correspond to event A,
then then
n
A P = == = ) (
49
Example: If a card is drawn from a well Example: If a card is drawn from a well--shuffled shuffled
deck, what is the probability of drawing deck, what is the probability of drawing
a.) a face card? a.) a face card?
b.) an ace? b.) an ace?
N
n
A P = == = ) (
PROBABILITY RULES: PROBABILITY RULES:
1.) 1.) ADDITIVE RULE: ADDITIVE RULE: For any two events A and B, For any two events A and B,
P(A U B) = P(A) + P(B) P(A U B) = P(A) + P(B) P(A B) P(A B)
N.B.: a.) Illustrate using the N.B.: a.) Illustrate using the VENN DIAGRAM VENN DIAGRAM
b.) b.) P( A B) P( A B) = joint probability of A and B = joint probability of A and B
50
= the probability that events A and B will = the probability that events A and B will
both occur both occur
2.) If A and B are 2.) If A and B are MUTUALLY EXCLUSIVE MUTUALLY EXCLUSIVE events (i.e., events which events (i.e., events which
have no sample point in common, or events that can not occur have no sample point in common, or events that can not occur
jointly), then jointly), then
P (A U B) = P(A) + P(B) P (A U B) = P(A) + P(B)
COMPLEMENT OF AN EVENT A: COMPLEMENT OF AN EVENT A:
The complement of an event A with respect The complement of an event A with respect
to some sample space S is the set of all the to some sample space S is the set of all the
elements or sample points in S that are not in A. elements or sample points in S that are not in A.
The complement of A is denoted by A. The complement of A is denoted by A.
51
The complement of A is denoted by A. The complement of A is denoted by A.
N.B.: note that N.B.: note that P(A) + P(A) = 1 P(A) + P(A) = 1
P(A) = 1 P(A) = 1 P(A) P(A)
ILLUSTRATION: DETERMINING ILLUSTRATION: DETERMINING
PROBABILITIES: PROBABILITIES:
From past experiences, a stockbroker believes From past experiences, a stockbroker believes
that under present economic conditions a customer that under present economic conditions a customer
will invest in bonds with a probability of 0.45, will will invest in bonds with a probability of 0.45, will
invest in mutual funds with a probability of 0.5, will invest in mutual funds with a probability of 0.5, will
52
invest in mutual funds with a probability of 0.5, will invest in mutual funds with a probability of 0.5, will
invest in both bonds and mutual funds with a invest in both bonds and mutual funds with a
probability of 0.15. At this time, find the probability probability of 0.15. At this time, find the probability
that a customer will invest that a customer will invest
a.) in either bonds or mutual funds; a.) in either bonds or mutual funds;
b.) in neither bonds nor mutual funds. b.) in neither bonds nor mutual funds.
CONDITIONAL PROBABILITY: CONDITIONAL PROBABILITY:
The The CONDITIONAL PROBABILITY CONDITIONAL PROBABILITY of an event A, given that of an event A, given that
another event B has occurred, denoted by P(A|B), is defined as: another event B has occurred, denoted by P(A|B), is defined as:
P(A|B) = P(A B), P(A|B) = P(A B), provided that provided that P(B) 0 P(B) 0
P(B) P(B)
the the JOINT PROBABILITY JOINT PROBABILITY that both events A and B that both events A and B
occur is: occur is:
53
occur is: occur is:
P(A B) = P(B) P(A|B) P(A B) = P(B) P(A|B)
N.B.: N.B.: 1) Since it does not matter which one of the two events is called 1) Since it does not matter which one of the two events is called
A and which one is called B, we can interchange A and B in the A and which one is called B, we can interchange A and B in the
above equation; above equation; i,.e i,.e., .,
P(B|A) = P(B A) P(B A) = P(A) P(B|A) P(B|A) = P(B A) P(B A) = P(A) P(B|A)
P(A) P(A)
2) 2) P(A B) = P(B A) P(B) P(A|B) = P(A) P(B|A) P(A B) = P(B A) P(B) P(A|B) = P(A) P(B|A)
ILLUSTRATION: DETERMINING ILLUSTRATION: DETERMINING
CONDITIONAL PROBABILITIES: CONDITIONAL PROBABILITIES:
A random sample of 100 call center employees, all college A random sample of 100 call center employees, all college
graduates, are classified below according to sex and college degree. graduates, are classified below according to sex and college degree.
MALE MALE FEMALE FEMALE
PSYCHOLOGY PSYCHOLOGY 77 12 12
54
If a person is chosen at random from this group of employees, find the If a person is chosen at random from this group of employees, find the
probability that probability that
a.) The person is a male, given that the person has a degree in a.) The person is a male, given that the person has a degree in
Education Education
b.) The person is a non b.) The person is a non--psychology degree holder, given that the psychology degree holder, given that the
person is a female. person is a female.
EDUCATION EDUCATION 18 18 20 20
COMMERCE COMMERCE 15 15 28 28
INDEPENDENT EVENTS: INDEPENDENT EVENTS:
Events A and B are INDEPENDENT if either Events A and B are INDEPENDENT if either
P(A|B) = P(A) or P(B|A) = P(B) P(A|B) = P(A) or P(B|A) = P(B)
Otherwise, A and B are dependent. Otherwise, A and B are dependent.
55
Otherwise, A and B are dependent. Otherwise, A and B are dependent.
JOINT PROBABILITY OF JOINT PROBABILITY OF
INDEPENDENT EVENTS: INDEPENDENT EVENTS:
1.) If A and B are INDEPENDENT events: 1.) If A and B are INDEPENDENT events:
P(A B) = P(B A) = P(A) P(B) P(A B) = P(B A) = P(A) P(B)
2.) In general, if there are 2.) In general, if there are kk INDEPENDENT INDEPENDENT
EVENTS A EVENTS A , A , A ,, A A ,, A A , their JOINT , their JOINT
56
EVENTS A EVENTS A
1 1
, A , A
2 2
,, A A
3 3
,, A A
kk
, their JOINT , their JOINT
PROBABILITY is PROBABILITY is
P(A P(A
1 1
A A
2 2
A A
3 3
A A
kk
) = ) =
P(A P(A
11
) P(A ) P(A
22
) P(A ) P(A
33
) P(A ) P(A
kk
))
TOTAL PROBABILITY TOTAL PROBABILITY
THEOREM: THEOREM:
If the events B If the events B
1 1
, B , B
2 2
,, BB
3 3
,, BB
kk
constitute a PARTITION constitute a PARTITION
of the sample space S such that P(B of the sample space S such that P(B
i i
)) 0 for 0 for i i = 1, 2, = 1, 2,
kk, then for any event A in S , then for any event A in S
P(A) = P(B P(A) = P(B
1 1
A) A) + P(B + P(B
2 2
A) + A) +PP(B (B
3 3
A) + + P A) + + P ((BB
kk
A A))
57
1 1 2 2 3 3 kk
= P(B = P(B
11
) P(A|B ) P(A|B
11
) + P(B ) + P(B
22
) P(A|B ) P(A|B
22
) + + P( ) + + P(BB
kk
) P(A| ) P(A| BB
kk
))
N.B.: Illustrate the theorem using the VENN N.B.: Illustrate the theorem using the VENN
DIAGRAM, first with DIAGRAM, first with kk = 2 and then with = 2 and then with kk = 3. = 3.
ILLUSTRATION: APPLICATION OF ILLUSTRATION: APPLICATION OF
THE TOTAL PROBABILITY THE TOTAL PROBABILITY
THEOREM: THEOREM:
ABC Corporation is aiming to close a P500M sales ABC Corporation is aiming to close a P500M sales
transaction with XYZ Company. ABC has three topnotch transaction with XYZ Company. ABC has three topnotch
sales executives who could negotiate with XYZ: Peter, Paul sales executives who could negotiate with XYZ: Peter, Paul
and Mary. Their probabilities of being selected to broker and Mary. Their probabilities of being selected to broker
58
and Mary. Their probabilities of being selected to broker and Mary. Their probabilities of being selected to broker
the deal are 0.5, 0.2 and 0.3, respectively. If ABC chooses the deal are 0.5, 0.2 and 0.3, respectively. If ABC chooses
Peter, the probability of closing the deal is 0.8; if Paul were Peter, the probability of closing the deal is 0.8; if Paul were
chosen, ABCs probability of closing the deal is 0.6 while if chosen, ABCs probability of closing the deal is 0.6 while if
Mary were selected, the probability that ABC will get the Mary were selected, the probability that ABC will get the
deal is 0.7. What is the probability that ABC will close the deal is 0.7. What is the probability that ABC will close the
BAYES RULE: BAYES RULE:
If the events B If the events B
1 1
, B , B
2 2
,, BB
3 3
,, BB
kk
constitute a constitute a
PARTITION of the sample space S where P(B PARTITION of the sample space S where P(B
i i
) 0 ) 0
for i = 1, 2, , for i = 1, 2, , kk, then for any event A in S such , then for any event A in S such
that P(A) 0, that P(A) 0,
59
that P(A) 0, that P(A) 0,
P( P(BB
r r
|A |A) = P(B ) = P(B
r r
) P( ) P(A|B A|B
r r
))
P(B P(B
11
) P(A|B ) P(A|B
11
) + P(B ) + P(B
22
) P(A|B ) P(A|B
22
) ++ P( ) ++ P(BB
kk
) P( ) P(A|B A|B
kk
) )
for r = 1, 2, 3, for r = 1, 2, 3, kk..
N.B.: Note that the denominator is equal to P(A) according to the N.B.: Note that the denominator is equal to P(A) according to the
Total Probability Theorem (please go back to slide no. 56) Total Probability Theorem (please go back to slide no. 56)
ILLUSTRATION: APPLICATION ILLUSTRATION: APPLICATION
OF BAYES RULE: OF BAYES RULE:
Let us go back to the illustration of slide no. 58. Let us go back to the illustration of slide no. 58.
If it is known that ABC Corporation was able If it is known that ABC Corporation was able
60
If it is known that ABC Corporation was able If it is known that ABC Corporation was able
to close the deal, what is the probability that Mary to close the deal, what is the probability that Mary
was chosen to broker the deal? was chosen to broker the deal?
INDIVIDUAL HOMEWORK: Please refer to handout. INDIVIDUAL HOMEWORK: Please refer to handout.
APPLICATION: DETERMINING APPLICATION: DETERMINING
ASSET RISK AND PORTFOLIO RISK: ASSET RISK AND PORTFOLIO RISK:
1.) MEASURE OF RISK = 1.) MEASURE OF RISK = = variance = = variance =
2.) 2.)
where: p where: p
i i
= the probability that outcome = the probability that outcome i i will will
occur occur
E(R)] [Ri pi
n
1 i
2 2

=
=
61
occur occur
n = the no. of possible outcomes n = the no. of possible outcomes
RR
i i
= the rate of return on the asset if outcome = the rate of return on the asset if outcome i i occurs occurs
E(R) = the expected rate of return on the asset E(R) = the expected rate of return on the asset
==
i
n
i
i
R p .
1

= == =
ILLUSTRATION: ILLUSTRATION:
DETERMINING ASSET RISK: DETERMINING ASSET RISK:
The probable rates of return on Assets A, B, C are as follows: The probable rates of return on Assets A, B, C are as follows:
Probability Probability
RATE OF RETURN RATE OF RETURN
on Asset A on Asset A
(R (R
A A
) )
on Asset B on Asset B
(R (R
B B
) )
on Asset C on Asset C
(R (R
C C
) )
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
62
Find: a.) the expected rate of return on each asset Find: a.) the expected rate of return on each asset
b.) the risk on each asset b.) the risk on each asset
N.B.: 1.) show the solution on the whiteboard for Asset A N.B.: 1.) show the solution on the whiteboard for Asset A
2.) Individual homework for Asset B and Asset C 2.) Individual homework for Asset B and Asset C
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
0.50 0.50 0.12 0.12 0.11 0.11 0.14 0.14
028355 . 0 017321 . 0
134 . 0 ) E(R 11 . 0 ) E(R : answers
C B
= =
= =
C B
R R

ILLUSTRATION: DETERMINING ILLUSTRATION: DETERMINING
PORTFOLIO RISK: PORTFOLIO RISK:
The probable rates of return on Assets A, B, and C are as follows: The probable rates of return on Assets A, B, and C are as follows:
Probability Probability
RATE OF RETURN RATE OF RETURN
on Asset A on Asset A
(R (R
A A
))
on Asset B on Asset B
(R (R
BB
))
on Asset C on Asset C
(R (R
C C
))
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
63
Determine: a.) the expected rate of return and the risk on PORTFOLIO 1 composed Determine: a.) the expected rate of return and the risk on PORTFOLIO 1 composed
of 30% A, 30% B and 40% C. of 30% A, 30% B and 40% C.
b.) the expected rate of return and the risk on PORTFOLIO 2 composed b.) the expected rate of return and the risk on PORTFOLIO 2 composed
of 30% A, 10% B, and 60% C. of 30% A, 10% B, and 60% C.
N.B.: 1.) Show the solutions for PORTFOLIO 1 on the whiteboard N.B.: 1.) Show the solutions for PORTFOLIO 1 on the whiteboard
2.) Individual homework for PORTFOLIO 2 2.) Individual homework for PORTFOLIO 2
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
0.50 0.50 0.12 0.12 0.11 0.11 0.14 0.14
019112 . 0 ; 1295 . 0 ) E(R : answers
2
2
P
= =
P
R

COVARIANCE BETWEEN ASSETS: COVARIANCE BETWEEN ASSETS:

COVARIANCE BETWEEN TWO ASSETS = COVARIANCE BETWEEN TWO ASSETS = Cov Cov(R (R
A A
,R ,R
BB
): a ): a
measure of the movements of the rates of return of two (2) assets or measure of the movements of the rates of return of two (2) assets or
securities A and B. securities A and B.
Positive Covariance R Positive Covariance R
A A
and R and R
B B
tend to move in the same tend to move in the same
direction direction
Negative Covariance R Negative Covariance R
A A
and R and R
B B
tend to move in opposite tend to move in opposite
64
Negative Covariance R Negative Covariance R
A A
and R and R
B B
tend to move in opposite tend to move in opposite
directions directions
where: p where: p
i i
= probability that outcome = probability that outcome i i will occur will occur
RR
A A
i i
= rate of return on asset A if outcome = rate of return on asset A if outcome i i occurs occurs
RR
BB
i i
= rate of return on asset B if outcome = rate of return on asset B if outcome i i occurs occurs
E(R E(R
A A
) = expected rate of return on asset A ) = expected rate of return on asset A
E(R E(R
BB
) = expected rate of return on asset B ) = expected rate of return on asset B

=
=
n
i
B B A A i B A
)]} i E(R ) ][R i E(R {[R p ) ,R Cov(R
1

ILLUSTRATION: DETERMINING COVARIANCES: ILLUSTRATION: DETERMINING COVARIANCES:
The probable rates of return on assets A, B, and C, are as follows: The probable rates of return on assets A, B, and C, are as follows:
Probability Probability
RATE OF RETURN RATE OF RETURN
on Asset A on Asset A
(R (R
A A
))
on Asset B on Asset B
(R (R
BB
))
on Asset C on Asset C
(R (R
C C
))
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
0.50 0.50 0.12 0.12 0.11 0.11 0.14 0.14
65
Determine: a.) Determine: a.) Cov Cov ((RR
A A
, , RR
BB
))
b.) b.) Cov Cov ((RR
A A
, , RR
C C
))
c.) c.) Cov Cov ((RR
BB
, , RR
C C
))
N.B.: 1.) Show on the whiteboard the solution for N.B.: 1.) Show on the whiteboard the solution for Cov Cov ((RR
A A
, , RR
BB
))
2.) 2.) INDIVIDUAL HOMEWORK for INDIVIDUAL HOMEWORK for Cov Cov ((RR
A A
, , RR
C C
) and ) and Cov Cov ((RR
BB
, , RR
C C
))
A A
, R , R
BB
) = 0.000342 ) = 0.000342
Cov Cov (R (R
BB
, R , R
C C
) = ) = -- 0.00048 0.00048
PORTFOLIO RISK ON A 2 PORTFOLIO RISK ON A 2- -ASSET ASSET
PORTFOLIO USING COVARIANCE: PORTFOLIO USING COVARIANCE:
1.) 1.)
p p
= W = W
A A

RR
A A
+ W + W
BB

RR
BB
+ 2W + 2W
A A
W W
BB
Cov Cov (R (R
A A
, R , R
BB
))
where: where:
22
BB
= variance of the portfolio = variance of the portfolio
W W
A A
= weight or proportion of asset A = weight or proportion of asset A
W W = weight or proportion of asset B = weight or proportion of asset B
66
W W
B B
= weight or proportion of asset B = weight or proportion of asset B

22
RR
A A
= variance of the rates of return on Asset A = variance of the rates of return on Asset A

22
RR
BB
= variance of the rates of return on Asset B = variance of the rates of return on Asset B
Cov Cov (R (R
A A
, R , R
BB
) = covariance between R ) = covariance between R
A A
and R and R
BB
2.) PORTFOLIO RISK = 2.) PORTFOLIO RISK =
P P
= =
PP
ILLUSTRATION: DETERMINING ILLUSTRATION: DETERMINING
PORTFOLIO RISK ON A 2 PORTFOLIO RISK ON A 2- -ASSET ASSET
PORTFOLIO (USING COVARIANCE): PORTFOLIO (USING COVARIANCE):
The probable rates of return on assets A, B, and C are as follows: The probable rates of return on assets A, B, and C are as follows:
Probability Probability
RATE OF RETURN RATE OF RETURN
on Asset A on Asset A
(R (R
A A
))
on Asset B on Asset B
(R (R
BB
))
on Asset C on Asset C
(R (R
C C
))
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
67
Determine: a.) the risk on the portfolio composed of 50% B and 50% C Determine: a.) the risk on the portfolio composed of 50% B and 50% C
using covariance using covariance
b.) the risk on the portfolio composed of 30% A and 70% C b.) the risk on the portfolio composed of 30% A and 70% C
using covariance using covariance
N.B.: 1.) show on the whiteboard the solution to a.) N.B.: 1.) show on the whiteboard the solution to a.)
2.) INDIVIDUAL HOMEWORK for b.) 2.) INDIVIDUAL HOMEWORK for b.)
p p
= 0.023649 = 0.023649
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
0.50 0.50 0.12 0.12 0.11 0.11 0.14 0.14
PORTFOLIO RISK ON A 3 PORTFOLIO RISK ON A 3- -ASSET ASSET
PORTFOLIO USING COVARIANCE: PORTFOLIO USING COVARIANCE:
1.) 1.)
p p
= W = W
A A

RR
A A
+ W + W
BB

RR
BB
+ W + W
C C

RR
C C
+ 2W + 2W
A A
W W
BB
Cov Cov (R (R
A A
, R , R
BB
) )
+ 2W + 2W
A A
W W
C C
Cov Cov (R (R
A A
, R , R
C C
) + 2W ) + 2W
BB
W W
C C
Cov Cov (R (R
BB
, R , R
C C
))
2.) PORTFOLIO RISK = 2.) PORTFOLIO RISK = = =
68
2.) PORTFOLIO RISK = 2.) PORTFOLIO RISK =
P P
= =
PP
ILLUSTRATION: DETERMINING PORTFOLIO RISK ILLUSTRATION: DETERMINING PORTFOLIO RISK
ON A 3 ON A 3- -ASSET PORTFOLIO (USING COVARIANCES): ASSET PORTFOLIO (USING COVARIANCES):
The probable rates of return on assets A, B and C are as follows: The probable rates of return on assets A, B and C are as follows:
Probability Probability
RATE OF RETURN RATE OF RETURN
on Asset A on Asset A
(R (R
A A
))
on Asset B on Asset B
(R (R
BB
))
on Asset C on Asset C
(R (R
C C
))
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
69
Using Using covariances covariances, determine: , determine:
a.) a.) the risk on PORTFOLIO 1 composed of 30% A, 30% B, 40% C. the risk on PORTFOLIO 1 composed of 30% A, 30% B, 40% C.
b.) b.) the risk on PORTFOLIO 2 composed of 30% A, 10% B, 60% C. the risk on PORTFOLIO 2 composed of 30% A, 10% B, 60% C.
N.B.: 1.) show solution on the whiteboard for PORTFOLIO 1 N.B.: 1.) show solution on the whiteboard for PORTFOLIO 1
2.) INDIVIDUAL HOMEWORK: risk on PORTFOLIO 2 2.) INDIVIDUAL HOMEWORK: risk on PORTFOLIO 2
p
for Portfolio 2 = 0.019112
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
0.50 0.50 0.12 0.12 0.11 0.11 0.14 0.14
CORRELATION COEFFICIENT BETWEEN THE RATES CORRELATION COEFFICIENT BETWEEN THE RATES
OF RETURN ON TWO ASSETS A AND B: OF RETURN ON TWO ASSETS A AND B:
1.) Measures the strength or degree of dependency of the directional 1.) Measures the strength or degree of dependency of the directional
movements of the rates of return on Assets A and B movements of the rates of return on Assets A and B
2.) 2.)
3) 3) => there is a perfect positive linear correlation between R => there is a perfect positive linear correlation between R
A A
and R and R
BB
( ) 1
,
=
B A
R R
( ) 1 1
,

B A
R R
70
=> R => R
A A
and R and R
BB
move in the SAME DIRECTION all of the move in the SAME DIRECTION all of the
time time
4) 4) => => there is a perfect negative linear correlation between R there is a perfect negative linear correlation between R
A A
and R and R
BB
=> R => R
A A
and R and R
BB
move in OPPOSITE DIRECTIONS all of the move in OPPOSITE DIRECTIONS all of the
time time
5) 5) => => there is no dependency between the movements of the there is no dependency between the movements of the
values of R values of R
A A
and R and R
BB
6) 6) => R => R
A A
and R and R
BB
move in the SAME DIRECTION move in the SAME DIRECTION
80% of the time 80% of the time
( ) 1
,
=
B A
R R
( ) 0
,
=
B A
R R
( ) % 80 80 . 0
,
= =
B A
R R
Where : Cov (R
A
, R
B
) = the covariance between R
A
and R
B

R
A
= the risk on Asset A
= the standard deviation of R
A
= the risk on Asset B
COMPUTING THE CORRELATION COMPUTING THE CORRELATION
COEFFICIENT BETWEEN R COEFFICIENT BETWEEN R
A A
AND R AND R
B B
: :
( )
( )
B A
R R
B A
B A
R R Cov
R R

=
,
,
71

R
B
= the risk on Asset B
= the standard deviation of R
B
N.B: Please note that the sign of follows the sign of ( (( ( ) )) )
B A
R R
,

( )
B A
R R Cov
,
( )
( )
977328 . .)
89259 . .) :
, .
, .
: determine and 65 No. slide back to refer Please : SEATWORK INDIVIDUAL

b
R R b
R R a
C B
B A

COMPUTING THE CORRELATION COMPUTING THE CORRELATION

COEFFICIENT BETWEEN R COEFFICIENT BETWEEN R
A A
AND R AND R
B B
USING HISTORICAL DATA: USING HISTORICAL DATA:
Let the values of R Let the values of R
A A
and R and R
BB
be given by: be given by:
RR
A A
= X = X
11
, X , X
22
, X , X
33
, , XX
n n
RR
BB
= Y = Y
11
, Y , Y
22
, Y , Y
33
, , Y Y
n n
Then, as shown also in slide No. 43, the correlation coefficient Then, as shown also in slide No. 43, the correlation coefficient
72
Then, as shown also in slide No. 43, the correlation coefficient Then, as shown also in slide No. 43, the correlation coefficient
between X and Y or between R between X and Y or between R
A A
and R and R
BB
is: is:
N.B. : In obtaining , use the worksheet suggested in N.B. : In obtaining , use the worksheet suggested in
slide No. 44 for the computation of r. slide No. 44 for the computation of r.
( )
B A
R R
,

( )
( ) ( ) ( )
( ) ( ) [ ] ( ) ( ) [ ]
2
2
2
2
,

=
Y Y n X X n
Y X XY n
R R
B A

INDIVIDUAL HOMEWORK: COMPUTING THE CORRELATION INDIVIDUAL HOMEWORK: COMPUTING THE CORRELATION
COEFFICIENT BETWEEN R COEFFICIENT BETWEEN R
A A
AND R AND R
B B
USING HISTORICAL DATA USING HISTORICAL DATA
During a certain year, the monthly rates of return (in %) on Stocks A and B are tabulated below: During a certain year, the monthly rates of return (in %) on Stocks A and B are tabulated below:
Month R
A
or X R
B
or Y
1 7.2 7.3
2 - 6.1 - 8.6
3 - 10.2 1.4
4 4.5 8.4
73
4 4.5 8.4
5 - 2.8 8.6
6 2.1 1.8
7 2.8 6.8
8 2.9 - 5.0
9 - 6.7 - 0.5
10 - 8.2 - 7.2
11 - 1.4 3.4
12 - 3.6 5.1
5 decimal places.
FURTHER APPLICATIONS OF FURTHER APPLICATIONS OF
STATISTICS IN PORTFOLIO STATISTICS IN PORTFOLIO
ANALYSIS ANALYSIS
1. 1. Determination of the Determination of the and the and the of a stock of a stock
2. 2. = measure of the UNSYSTEMATIC = measure of the UNSYSTEMATIC
RISK (or DIVERSIFIABLE RISK) on RISK (or DIVERSIFIABLE RISK) on
74
RISK (or DIVERSIFIABLE RISK) on RISK (or DIVERSIFIABLE RISK) on
a stock a stock
3. 3. = measure of the SYSTEMATIC RISK = measure of the SYSTEMATIC RISK
(or UNDIVERSIFIABLE RISK) on a (or UNDIVERSIFIABLE RISK) on a
stock stock
DETERMINATION OF THE DETERMINATION OF THE OF A OF A
STOCK USING COVARIANCE: STOCK USING COVARIANCE:
index market on the return of rates R
stock on the return of rates R : where
) , (
M
2

=
=
=
M
R
M
R R Cov
75
1! is index market the of the
1
) , (

becomes for equation above the , R by replaced is R When N.B.
index market on the return of rates the of variance the
index market on the return of rates R
2
2
2
M
2
M

=>
= = =
=
=
M
M
M
M
R
R
R
M M
R
R R Cov
ILLUSTRATION: DETERMINATION OF ILLUSTRATION: DETERMINATION OF
USING COVARIANCE USING COVARIANCE
The probable rates of return on stocks A, B and C and The probable rates of return on stocks A, B and C and
on the market index are as follows: on the market index are as follows:
Probability Probability RR
A A
RR
B B
RR
C C
RR
MM
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08 0.18 0.18
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16 0.12 0.12
76
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16 0.12 0.12
0.50 0.50 0.12 0.12 0.11 0.11 0.20 0.20 0.10 0.10
Determine the of : a.) Stock B of : a.) Stock B
b.) Stock C b.) Stock C
N.B.: 1.) Show solution for a.) ( N.B.: 1.) Show solution for a.) ( of stock B) on the whiteboard of stock B) on the whiteboard
2.) 2.) INDIVIDUAL HOMEWORK INDIVIDUAL HOMEWORK for b.) ( for b.) ( of stock C) of stock C)
answer: answer: of stock C = of stock C = - - 1.49345 1.49345
DETERMINATION OF DETERMINATION OF AND AND
FROM HISTORICAL DATA: FROM HISTORICAL DATA:
PROCEDURE: PROCEDURE: Linear Regression based on the equation Linear Regression based on the equation
Y = Y = + + XX
Where: Y = R Where: Y = R
t t
= the stocks rate of return during the period t = the stocks rate of return during the period t
77
X = R X = R
MM
t t
= the markets rate of return during the period t = the markets rate of return during the period t
= diversifiable risk on the stock or asset = diversifiable risk on the stock or asset
= undiversifiable risk on the stock or asset = undiversifiable risk on the stock or asset
FORMULA FOR ALPHA: FORMULA FOR ALPHA:
( )( ) ( )( )
( ) ( )
2
2
2

=
X X n
XY X X Y

Where: n = the no. of observation periods in days,

or weeks, or months, or years
78
N.B.: 1.) is also referred to as the company is also referred to as the company--specific risk on the stock. specific risk on the stock.
2.) 2.) = = RR
actual actual
RR
expected expected
= = RR
actual actual
E(R) E(R)
2.1) 2.1) > 0 => the stock performed better than expected => > 0 => the stock performed better than expected =>
stock is stock is UNDERVALUED UNDERVALUED
2.2) 2.2) < 0 < 0 => the stock did not perform as expected =>
stock is OVERVALUED
2.3) = 0 = 0 => the stock is efficiently or properly valued
FORMULA FOR BETA: FORMULA FOR BETA:
( ) ( )( )
( ) ( )
2
2

=
X X n
Y X XY n

79
( ) ( )
2

X X n
SUGGESTED WORKSHEET FOR SUGGESTED WORKSHEET FOR
DETERMINING DETERMINING AND AND ::
t Y = R
t
X = R
Mt
X
2
XY
1
2
3
:
:
80
:
:
n
Y X X
2
XY
N.B. : R
M
= the rate of return on the market index (i.e., the PSEi)
ANOTHER INTERPRETATION ANOTHER INTERPRETATION
OF THE VALUE OF OF THE VALUE OF
measures the measures the SENSITIVITY SENSITIVITY or or RESPONSIVENESS RESPONSIVENESS of the market price of the market price
(or the rate of return) of a stock to the directional movement of the market (or the rate of return) of a stock to the directional movement of the market
index. It can be positive or negative. index. It can be positive or negative.
1.) 1.) Positive Positive = the market price of the stock moves in the SAME direction as = the market price of the stock moves in the SAME direction as
the market index the market index
81
the market index the market index
2.) 2.) Negative Negative = the market price of the stock moves in the OPPOSITE = the market price of the stock moves in the OPPOSITE
direction as the market index direction as the market index
3.) 3.) = 0 = 0 => => the market price of the stock is NOT RESPONSIVE to the the market price of the stock is NOT RESPONSIVE to the
movement of the market index movement of the market index
4.) 4.) = = +1 +1 => => if the market index GOES UP (or DOWN) by say 10%, the if the market index GOES UP (or DOWN) by say 10%, the
market price of the stock GOES UP (or DOWN) by also 10% market price of the stock GOES UP (or DOWN) by also 10%
INTERPRETATION OF THE INTERPRETATION OF THE
VALUE OF VALUE OF : (continuation) : (continuation)
5.) 5.) = = --11 => => if the market index GOES UP (or DOWN) by say 10%, the if the market index GOES UP (or DOWN) by say 10%, the
market price of the stock GOES DOWN (or UP) by also 10% market price of the stock GOES DOWN (or UP) by also 10%
6.) 6.) = + 1.5 = + 1.5 = = if the market index GOES UP (or DOWN) by say 10%, if the market index GOES UP (or DOWN) by say 10%,
the market price of the stock GOES UP (or DOWN) BY 15% the market price of the stock GOES UP (or DOWN) BY 15%
7.) 7.) = = -- 1.5 1.5 = = if the market index GOES UP (or DOWN) by say 10%, if the market index GOES UP (or DOWN) by say 10%,
82
7.) 7.) = = -- 1.5 1.5 = = if the market index GOES UP (or DOWN) by say 10%, if the market index GOES UP (or DOWN) by say 10%,
the market price of the stock GOES DOWN (or UP) BY 15% the market price of the stock GOES DOWN (or UP) BY 15%
QUERIES: QUERIES:
1.) If the 1.) If the of a stock is of a stock is - -2.0 and the index goes UP by 5%, what 2.0 and the index goes UP by 5%, what
happens to the market price of the stock? happens to the market price of the stock?
2.) If the 2.) If the of a stock is + 0.8 and the index goes DOWN by 3%, what of a stock is + 0.8 and the index goes DOWN by 3%, what
happens to the market price of the stock? happens to the market price of the stock?
INDIVIDUAL HOMEWORK: DETERMINING THE INDIVIDUAL HOMEWORK: DETERMINING THE AND THE AND THE OF A OF A
STOCK FROM HISTORICAL DATA (To be submitted on March 26, 2011): STOCK FROM HISTORICAL DATA (To be submitted on March 26, 2011):
During a certain year, the monthly rates of return on stock A (R During a certain year, the monthly rates of return on stock A (R
A A
) and the monthly rates ) and the monthly rates
of return on the stock market index (R of return on the stock market index (R
MM
), all expressed in %, are tabulated below: ), all expressed in %, are tabulated below:
Month Month
(t) (t)
Y = R Y = R
A A
X = R X = R
MM
11 7.2 7.2 6.8 6.8
22 - -6.1 6.1 7.5 7.5
33 - -10.2 10.2 9.2 9.2
44 4.5 4.5 6.5 6.5
1.) Determine the and the and the of of
stock A. stock A.
83
44 4.5 4.5 6.5 6.5
55 - -2.8 2.8 - -5.6 5.6
66 2.1 2.1 - -1.8 1.8
77 2.8 2.8 8.8 8.8
88 2.9 2.9 8.3 8.3
99 - -6.7 6.7 8.5 8.5
10 10 - -8.2 8.2 7.3 7.3
11 11 - -1.4 1.4 - -2.5 2.5
12 12 - -3.6 3.6 - -5.5 5.5
2.) Interpret the values of the 2.) Interpret the values of the
and the and the that you obtained. that you obtained.