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RANDOM VARIABLES ............................................................................................................. 9-3 Graphs of Random Variables............................................................................................ 9-4 Random Variables as Models ........................................................................................... 9-5 PROPERTIES OF RANDOM VARIABLES .................................................................................... 9-6 Mean of a Random Variable ............................................................................................. 9-6 Expected Value.................................................................................................................. 9-7 Variance and Standard Deviation .................................................................................... 9-9 PROPERTIES OF EXPECTED VALUES ..................................................................................... 9-12 Adding and Subtracting .................................................................................................. 9-12 Multiplying by a Constant............................................................................................... 9-13 Example........................................................................................................................... 9-14 COMPARING RANDOM VARIABLES ....................................................................................... 9-14 Sharpe Ratio.................................................................................................................... 9-15 SUMMARY ............................................................................................................................ 9-17

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Japanese homemaker Yuka Yamamoto got bored watching television. After seeing an ad on TV, she took $2,000 in savings and started trading stocks fromm home. Within a year, she turned the initial $2,000 into $1 million and became a celebrity in Japan. Her success as a day trader made her into a popular speaker and contributor to books. Twenty-year-old student Yuta Mimura found similar success as a day trader on the Tokyo Stock Exchange. His first investment turned out to be a great choice. He happily watched shares that he bought for $0.25 jump to $0.45 in two days. His parents were not happy with his new hobby, at least not until he fixed up their home with $100,000 earned trading!1 Day traders guess when the price of a stock is headed up or down. To do this, theyve invented many rules for deciding when to buy and sell stocks, such as the rule suggested in this chart. A big valley in the sequence of prices followed by a small valley, the cup and handle in the figure, signals a change in the trend of these prices of stock in Walt Disney if you believe the rule. The underlying objective of these trading rules is simple: Enable the trader to consistently buy at a low price, then sell at a higher price. If you know a stock is going up, then buy the shares now. Sell them after the price has risen and make a profit. Day traders need to be right more often than wrong. Theyd like it if these trading rules always worked, but thats asking for too much. Sometimes the price of stock that they bought stays the same or goes down. This chapter defines a concise language for describing probabilities. Whether were anticipating the price of a stock, deciding among strategic plans, scheduling shipments, or forecasting economic trends, the ideas in this chapter allow us to describe the possibilities and evaluate the alternatives.

See In Japan, Day-Trading Like Its 1999, The New York Times, Feb 19, 2006. 9-2

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Random Variables

Well start with a day trader who has a simple description of what she expects to happen to a stock. This day trader is looking at stock in IBM. She can buy one share in IBM for $100 at the close of the stock market today. The stock market tomorrow determines whether she makes money. To simplify the arithmetic, well restrict what can happen to three possible outcomes. The price of the stock at the close of the market tomorrow will either go up to $105, stay at $100, or fall to $95. If she buys one share, she might make $5, break even, or lose $5. To decide if IBM is a good investment, she needs to assign probabilities to these outcomes. Probability provides a way to express what is known today about the price tomorrow. With only three possible outcomes, we could use probability trees or tables, but taking this route would miss an opportunity. This setting provides a simple context for introducing concepts that are essential for more complex and realistic problems. Key among these concepts is the notion of a random variable. A random variable describes the probabilities for an uncertain future numerical outcome of a random process. For a day trader who is considering stock in IBM, the random variable is the unknown change in the price of IBM stock. We cant be sure today how activity in the market tomorrow will impact the price of IBM stock. Following convention, we use a capital letter X to denote the random variable that represents the change in the price of IBM stock. It takes some getting used to, but you have to remember that X does not stand for a number, as in algebra. A random variable represents the collection of all of the possibilities and their chances. To define a random variable, you have to list every possible outcome along with its probability. Lets convert the opinions of the day trader into a random variable. Most of the time, the day trader expects the price to stay the same; she assigns this event probability 0.80. She divides the rest of the probability almost equally between going up (with probability 0.11) and going down (with probability 0.09). Theres a slight edge in favor of an increase. Because one of these outcomes has to happen, the probabilities add to 1. The basic rules of probability still apply. This table summarizes the outcomes and probabilities. Stock Price Increases Stays same Decreases Change x $5 0 $5 Probability P(X = x) 0.11 0.80 0.09

random variable A symbol representing the correspondence between outcomes and probabilities, often shown as a table or graph.

Table 9-1. The random variable X.

This table is the random variable X. It lists the possible outcomes ($5, 0, and -$5) and their probabilities. Because we can list all of the outcomes,
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discrete random variable A random variable that can take on one of a list of possible values. Discrete random variables are typically counts.

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X is a discrete random variable. Otherwise, the random variable is continuous or a mixture of the two. We will see continuous random variables in Chapter 12. The notation in Table 9-1 illustrates that we denote possible outcomes, or realizations, of a random variable by the corresponding lower-case letter. Since were talking about the random variable X, we use x. This convention produces possibly confusing statements, such as P(X = x) in the heading of the third column. The first time you see this, it might seem as though were saying something as useless as P(1=1). That is not what is meant, and you have to pay close attention to the capitalization. The statement P(X=x) is shorthand for the probability of any one of the possible outcomes. The possible values of X are x = 5, 0, and -5, so P(X = x) is a generic expression for any of the three probabilities: P(X = 5), P(X = 0), or P(X = -5). Tables work well for random variables that have few outcomes, but plots are better when there are more outcomes. Table 9-1 would be huge if we allowed the random variable to take on all possible changes in the price of IBM stock. Well have to handle these situations eventually, so to prepare we need to get comfortable with plots now. How do we plot a random variable? Think about the plot that you would choose if you had data that gave the changes in price of IBM. Imagine that we had 100 observed changes in the price. What plot would you use to describe these daily changes? If the timeplot of the changes lacks a pattern, we would create a histogram. We need a comparable display for a random variable. Theres a big difference, however, between the histogram of data and the display of a random variable. A histogram shows relative frequencies of what happened in the past. The equivalent display for a random variable shows probabilities assigned to events that have yet to happen.

continuous random variable A random variable that takes on any value in a range rather than discrete choices.

Graphs of Random Variables

probability distribution The probability distribution of a random variable is a function that assigns probabilities to each possible value of the random variable.

This graph of a random variable shows its probability distributionwhich is also is known as a probability density function, probability distribution function, or probability mass function. The probability distribution of a random variable is often abbreviated as p(x) = P(X=x) The name reminds you that the graph shows probabilities, not relative frequencies in data. Whereas a histogram sets the heights of the bars by counting data, the heights of the probability distribution p(x) are probabilities. The following figure shows a graph of p(x).

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Figure 9-1. Plot of the probability distribution of X.

This graph defines the random variable X because it shows all of the relevant information. It shows every possible outcome and its probability. Strictly speaking, the gray vertical lines that connect p(x) to the x-axis are not part of the probability distribution. We show them for discrete random variables to make it easier to identify the values.

Random Variables as Models

A random variable is a type of statistical model. For now, think of a model as a simplified or idealized view of reality. When the day trader uses the random variable X to describe what she thinks will happen to IBM tomorrow, she hopes that her probabilities match reality. Later in this chapter well see that even though X limits the possibilities to three outcomes, this random variable mimics several properties of the real stock. Data affect the choice of a probability distribution for a random variable. Experiences in the past affect what we expect to happen in the future. If a stock has always gone up or down by $5 and never stayed the same, this random variable wouldnt be a good description of what is likely to happen. This model suggests that it is common to see no change in the value of the stock. If her model for the probabilities is right, youd expect to find 80% of the future changes at zero, 11% at $5, and 9% at $5. The histogram that accumulates the outcomes in the future should eventually match her probability distribution in the long run if shes right. That is how we defined probability in Chapter 7: a probability is a longrun frequency. When we say that X is a random variable with these probabilities, we claim to know the chances for what will happen tomorrow and the days that follow. We cannot say which outcome will happen tomorrow any more than we can say whether a coin will land on heads or tails, but we can describe what will happen for lots of tomorrows. In this sense, a random variable describes the histogram of possibilities rather than a histogram of data.

Are You There?

Customers who buy tires at an auto service center purchase one tire, two tires, three tires, or a full set of four tires. The probability of buying 1 tire is , the probability of buying two is , and the probability of buying three is 1/16. The random variable Y denotes the number of tires purchased by a customer.
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(a) What is P(Y = 4)?2 (b) What is P(Y > 1)?3 (c) Graph the probability distribution of Y.4

Properties of Random Variables

parameter A characteristic of a random variable, such as its mean or standard deviation. Parameters are typically denoted by Greek letters.

A random variable conveys information that resembles what we might obtain in a histogram. This similarity allows us to exploit what we have learned about histograms to summarize random variables. For example, the mean x and standard deviation s are two important summaries of the data in a histogram. Analogous measures summarize a random variable.

similarly can, however, cause confusion. Do not to confuse the This characteristics of a random variable, called parameters, with statistics computed from data. To distinguish parameters from statistics, well use Greek symbols to denote the parameters of a model.
The probability distribution of a random variable determines its mean. Even though the mean of the random variable is not an average of data, its definition is similar. Imagine that we have data whose relative frequencies match the probabilities for X. We have n = 100 observed changes in the price of IBM stock. Of these, the price fell on 9 days by $5, stayed the same 80 times, and increased by $5 on 11 days. The histogram of these 100 changes matches the probability distribution of X in Figure 9-1. What is the mean of these imagined data? Because of the repetition, this is an easy calculation: 9 80 11 (5) + + (5) + 0 + + 0 + 5 + + 5 x= 100 5(9) + 0 (80) + 5(11) = 100 = 5 ( 0.09 ) + 0 ( 0.80 ) + 5 ( 0.11)

Mean of a Random Variable

= $0.10 The average of these 100 changes is $0.10.

mean of a random variable The mean of a random variable is the weighted sum of possible values, with the probabilities as weights.

We define the mean of a random variable in just this way, but replace the imaginary data with probabilities. The mean of the random variable X is a weighted average of the possible outcomes, with the probabilities p(x) for the weights. The most common symbol for the mean of a random variable is the Greek letter (mu, pronounced mew). The mean of the random variable X is
Since the probability distribution must sum to 1, P(Y=4) = 1 - (0.5+0.25+0.0625) = 0.1875 = 3/16. P(Y > 1) = 1 - P(Y=1) = . 4 The graph should show the points (1,1/2), (2,1/4), (3,1/16), and (4,3/16), possibly connected by vertical lines down to the x axis. 9-6
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= 5 p(5) + 0 p(0) + 5 p(5)

= 5 0.09 + 0 0.80 + 5 0.11

) (

) (

= $0.10 The mean of X matches the average of the imagined data. In general, the mean of a discrete random variable X that has k possible values x1, x2, xk is written like this = x1 p( x1 ) + x2 p( x2 ) + + xk p( xk )
The sum includes all of the possible outcomes of the random variable. The mean reveals the same things about the random variable X that x the data in a histogram. In both cases, the mean is the tells us about balance point. To balance the probability distribution of a random variable on a seesaw, you locate the fulcrum at . Heres the probability distribution of the random variable X with a fulcrum added at .

[locate triangle at 0.1]

Figure 9-2. The mean balances the probability distribution.

The mean tells us that the day trader expects on average to make 10 cents on every share of IBM she buys. The mean is positive because there is more probability to the right of zero than to the left. According to this model, the stock is more likely to increase in value than decrease. These gains seem small until you think about what happens over time. Each share costs $100, so a gain of $0.10 amounts to an increase of 0.10/100 = 0.1% daily. If you had a savings account that paid 0.1% daily, that would pile up more than 44% interest annually!

Expected Value
The mean of a random variable is a special case of a more general concept. A weighed average of outcomes based on probabilities is known as an expected value. Because the mean of a random variable is a weighted average of the possible values of the random variable, the mean of X is also known as the expected value of X. It is written in this notation as E X = = x1 p( x1 ) + x2 p( x2 ) + + xk p( xk )

expected value A weighted average that uses probabilities to weight the possible outcomes.

( )

tip

The name expected value can be confusing. For the stock, the expected value of X is not one of the possible outcomes. The price of the stock either stays the same or changes by five dollars. It never changes by 10 cents. The expected value of a random variable may not match one of the possible outcomes. Only when we see the results of many future outcomes
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does the expected value emerge: The expected value is the average of these future outcomes. The expected value is a way of thinking about long-run averages of anything. Usually anything involves a random variable, as in the following illustration. A company uses free giveaways to increase the number of shoppers who regularly visit its retail stores. Four prize-winning tickets are hidden in randomly chosen items. Some of these are not claimed by the end of most contests. Based on prior promotions, the following table describes the distribution of the random variable W that denotes the number of winners in the current promotion. Number of winners 1 2 3 4 P(W=w) 10% 25% 50% 15%

Table 9-2. Distribution of the number of winners in the current contest.

The mean, or expected value, of W is slightly less than 3:

= E(W) = 1 (0.10) + 2 (0.25) + 3 (0.50) + 4 (0.15) = 2.7

This figure shows the probability distribution of W with a triangle locating .

[locate triangle at 2.7]

Figure 9-3. Plot of the probability distribution of W.

The amount won by those who discover a winning ticket depends on the number of customers who claim winning prizes. The total prize of $30,000 is split among the winners. What is E(30000/W), the expected value of the amount won? Lets organize the calculations. The first column in the following table lists the possible values of the random variable W. The second column shows the amount won in case that many customers claim prizes. The third column gives the probabilities, and the last column uses these to
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weight the outcomes. The sum of the values in the fourth column is the expected value of the amount won.
Number of Winners w 1 2 3 4 Amount Won 25000/w 30000 15000 10000 7500 Probability P (W = w ) 0.10 0.25 0.50 0.15 Sum
Table 9-3 Calculations for the expected amount won.

Amount P (W = w ) 3000 3750 5000 1125 12875

If you find a winning ticket in your package, you win on average $12,875. Notice that the average prize is larger than you might expect given that an average of 2.7 = E(W) winners share the prize. The expected value E(30000/W) is larger than 30000/E(W).

Are You There?

People who play the carnival game Lucky Ducks pick a plastic duck from among those floating in a small pool. Each duck has a value written on the bottom that determines the prize. Most say Sorry, try again! Otherwise, 25% pay $1, 15% pay $5, and 5% pay $20. The rest pay nothing. Let the random variable Y denote the winnings from picking a duck at random. (a) Graph the probability distribution of Y.5 (b) Estimate the mean of Y from the graph of its probability distribution.6 (c) Find the expected value of Y. Whats your interpretation of the mean if the carnival charges $2 to play this game?7

Variance and Standard Deviation

Day traders have to understand more about their choices than the expected value. Day traders, and anyone else who has to make decisions, also need to appreciate the variation in what might happen. The mean change in the model for IBM stock is positive, E(X) = $0.10. The fact that the mean is positive does not imply her investment goes up in value every day. On average, she does well, but she could lose money. The price might go down. The same goes for players of the Lucky Ducks carnival game. The expected payoff ($2) matches the cost of the game, but few break even. The variance and standard deviation of a random variable summarize the uncertainty among the outcomes. The variance of a random variable
Your graph should have 4 points. p(0) = 0.55, p(1) = 0.25, p(5) = 0.15, and p(20) = 0.05. The skewness of the probabilities ought to suggest that the mean is larger than $1 or $2, but probably not larger than $5. 7 The mean is 0*0.55 + 1*0.25 + 5*0.15 + 20*0.05 = $2. This is a so-called fair game. On average customers win as much as they spend. Dont expect to find games like this at a real carnival; the proprietor has to make a living, you know. 9-9
5 6

variance and SD The variance of a random variable X is the expected value of the squared deviation from its mean 2 = E(X-)2 The SD of a random variable is the square root of its variance.

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is the expected value of the squared deviation from . We will explain this step by step. Because it is an expected value, the variance of a random variable is a weighted sum. The possible values are the squared deviations from the mean, (x )2. The variance of a random variable is another parameter, and so we denote it by a Greek symbol 2 (pronounced sigma-squared). To avoid the Greek, we often write Var(X) for the variance of the random variable X. Heres the formula: 2 = Var( X)
=E X

2 2 2

= x1 p( x1 ) + x2 p( x2 ) + + xk p( xk )

As an example, well use the day traders random variable. With data, we calculate s2 by subtracting x from each value, squaring these deviations, adding them up, and dividing by n - 1. A sequence of similar steps produces the variance. First, find the deviation of each outcome from , then square the deviations, as in this table. Change in Price x $5 0 $5 Deviation x 5 0.10 = -5.1 0 0.10 = - 0.1 5 0.10 = 4.9 Squared Deviation (x )2 (5.1)2 (-0.1)2 (4.9)2 Probability p(x) 0.09 0.80 0.11

Table 9-4 Calculating the variance.

Next, multiply the squared deviations by the corresponding probabilities. Finally, add the weighted squared deviations. The variance of the day traders random variable is then 2 = Var( X)

= 5 0.10 = 4.99

) (0.09) + (0 0.10) (0.80) + (5 0.10) (0.11)

The variance is the expected value of the squared deviation from , implying that the units of the variance are the squares of the units of data. That makes the variance hard to interpret.
standard deviation The square root of the variance, whether from data or probabilities.

Well remedy this problem for random variables as we did for data: take the square root. The standard deviation of a random variable is the square root of its variance:

= SD( X) = Var( X)
= 4.99 $2.23 The expected daily change in the random variable for the price of IBM stock is = $0.10 with standard deviation = $2.23.

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Example 9.1 Computer Shipments and Quality

Motivation

state the question

CheapO Computers promptly shipped 2 servers to its biggest client. The company profits $5,000 on each one of these big systems. Executives are horrified, though, to learn that someone restocked 4 refurbished computers among the 11 new systems in the warehouse. The guys in shipping randomly selected the systems that were delivered from the 15 computers in stock. If the client gets 2 new servers, CheapO earns $10,000 profit. If the client gets a refurbished computer, its coming back for replacement and CheapO must pay the $400 shipping fee. That still leaves $9,600 profit. If both servers that were shipped are refurbished, however, the client will return both and cancel the order. CheapO will be out any profit and left with $800 in shipping costs. What are the expected value and the standard deviation of its profits?

Method

describe the data and select an approach

Begin by identifying the relevant random variable. In this example, the random variable is the amount of profit earned on this order. The probabilities for the alternatives come directly from the statement of the problem. Well arrange the information as a tree. (You could use a table as well.)

Mechanics

do the analysis

This tree identifies the possible outcomes and the probability for each. Notice that two paths lead to one refurbished computer and one new computer. The probability that the second system is refurbished depends on whether the first is refurbished. If X denotes the profit earned on the shipment, then the table that describes X is (a table of values and probabilities)

Outcome Both refurbished One refurbished New/New

x -800 9600 10000

p(x) P(RR) = 12/210 P(NR or RN) = 88/210 P(NN) = 110/210

The expected value of X is a weighted sum of the possible profits, with the probabilities defining the weights.
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E(X)=10000 110/210+9600 88/210-800 12/210 = $9,215 The variance is expected squared deviation of the profit from the mean, Var(X) = (-800 9215)2 12/210 + (9600 9215)2 88/210 + (10000 9215) 2 110/210 = 6,116,340 Taking the square root gets the standard deviation, which is in units of dollars.
SD( X) = Var( X) = 6,116, 340 $2, 473

Message

summarize the results

This is a very profitable deal on average, unless both systems that were shipped are refurbished units. The expected value of the sale is $9,215. The large SD ($2,500) is a reminder that the profits are wiped out if both systems are refurbished.

Properties of Expected Values

We often have to add a constant to a random variable or multiply a random variable by a constant. For example, consider the computer shipper in the previous example. Suppose this company also has to pay out of its profits a fixed delivery fee of, say, $400 for shipping both computers in the first place. In this case the net profits are not X dollars, but X $400. Similarly, we often multiply random variables by constants. The car shop that sells tires makes a sale of Y tires to a customer. If the shop profits $25 on each tire, then the profit from a sale of Y tires is 25 Y. What are the mean and standard deviation of these quantities? We could start over: Define new random variables in each case and find their expected values. Theres an easier approach, however. Lets start with the effect of adding (or subtracting) a constant.

Adding and Subtracting

Adding or subtracting a constant from a random variable shifts every possible value of the random variable, changing the expected value by this amount. If c is any constant, then E(X c) = E(X) E(c) = E(X) c The expected value of a constant is the constant. Hence, the expected net profit to the computer shipper after paying the initial shipping fee of $400 is E(X 400) = E(X) $400 = $9,215 - $400 = $8,815

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tip

Notice that capital letters denote random variables whereas lower-case letters like a, b or c identify constants. When you see a capital letter, think random. When you see a small letter, think 2 or 3.14. What about the standard deviation? How does shifting the outcomes affect the standard deviation? With data, adding or subtracting a constant doesnt change the variance or standard deviation. The same holds for random variables. A shift has no effect on the variance of a random variable: Var(X c) = Var(X)

Multiplying by a Constant
Multiplying the value of a random variable by a constant changes both the expected value as well the variance. Recall from Chapter 4 that multiplying or dividing every data value by a constant changes the mean and the standard deviation by that factor. Variance, being the square of standard deviation, changes by the square of the constant. The same is true for random variables. Multiplying a random variable by a constant c multiplies the mean and standard deviation by c: E(c X) = c E(X) SD(c X) = c SD(X) Because it has squared units, multiplying by a constant changes the variance by the square of c. Var(c X) = c2 Var(X) For example, the car shop sells on average E(Y) = 10.5 + 20.25 + 30.0625 + 40.1875 = 1.9375 tires per sale. A similar calculation shows that SD(Y) 1.144 tires. Since it profits $25 per tire, the expected profit is E(25 Y) = 25 E(Y) $48.4 with standard deviation SD(25 Y) = 25 SD(Y) $28.6. Let do another example, returning to the day trader. Suppose rather than buy one share of stock, she buys two. By investing $200 and buying two shares, the day trader doubles and . With c = 2, the expected change in the value of her investment is twice what we found previously: E(2 X) = 2 E(X) = 2 0.10 = $0.20 with standard deviation SD(2 X) = 2 SD(X) = $4.46 She expects to earn twice as much on average, but she also doubles the standard deviation. The variance increases more, growing by a factor of 4: Var(2 X) = 22 Var(X) = 4 4.99 = 19.96 $2
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The measurement units of the variance are unusual, so we wrote them in this odd style as a reminder. The measurement units of a variance are the square of the units of the random variable.

Example
In this example, the random variable S denotes the number of windows shipped daily by a manufacturer of building materials. Some days the plant produces more and other days, less. The mean of S is 2,500 windows with standard deviation 500 windows. Each window has 8 panes of glass. What is the expected number of panes of glass shipped each day and its standard deviation? We must use the rules for expected values to find the answer in the this example since we dont know the underlying probabilities. The mean number of panes is E(8 S) = 8 2,500 = 20,000 panes with standard deviation SD(8 S) = 8 500 = 4,000 panes. The following equations summarize the rules for finding expected values and variances when constants are mixed with random variables. Lower case letters denote constants. Rules for Expected Values. If a and b are constants and X is a random variable, then E(a + b X) = a + b E(X) SD(a + b X) = b SD(X) Var(a + b X) = b2 Var(X) Expected values of sums are sums of expected values, the expected value of a constant is that constant, and constants factor out (with squares for the variance).

Are You There?

(a) If the day trader has to pay $0.10 for each trade of a share of stock, what is the expected change in the value of her investment? In general, what is E(X - )? (Hint: The mean is a constant.)8 (b) Suppose the day trader prefers to track the value of her investments in cents rather than dollars. What are the mean and variance of 100 X?9

Comparing Random Variables

Expressions that combine random variables with constants often arise when comparing random variables. In such cases, comparison requires transforming the initial random variables into new random variables that have a common scale or more useful scale. Consider the following example.

8 9

Zero: E(X-) = E(X)- = - = 0. Trading costs are spoilers. E(V) = E(100 X) = 100 E(X) =10; Var(V) = Var(100 X) = 1002 Var(X) = 1002 4.99 = 49,9002 9-14

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An international business based in the US is considering launching a product in two locations outside the US. One is in Europe, and the other is in India. The regional division in each location offers a random variable to express what they believe will happen if the product is launched. The division in Europe believes that the launch will produce net profits of 2.5 million euros in the first year, with standard deviation 0.75 million euros. The division in India believes that the launch will generate net profits of 125 million rupees, with standard deviation 45 million rupees. We cannot directly compare these random variable because they are measured on different scales, one in euros and one in rupees. To make these random variables comparable, as well as more familiar to managers in the US, lets convert them both into dollars, with 1 dollar converting into 0.75 euros or 40 rupees. Let X denote the random variable that models the launch in Europe, and let Y denote the model for the launch in India. To convert X into dollars we have to divide by 0.75. Hence, the mean and variance of a launch in Europe are: E(X/0.75) = 2.5/0.75 = $3.33 million; SD(X/0.75) = 0.75/0.75 = $1 million. By comparison, the mean and SD of the proposed launch in India are E(Y/40) =125/40 =$3.125 million and SD(Y/40) = 45/40 = $1.125 million. If both random variables accurately reflect the potential gains, then the launch in Europe seems the better choice. This option offers a larger mean and a smaller SD.

Sharpe Ratio
Comparisons of some random variables require adjustments even if they do have the same units. In the prior example, the launch in Europe wins on two counts: it offers larger expected sales along with smaller uncertainty. Often, however, the comparison is less straightforward. When comparing the performance of two stocks, for example, the stock with higher average return often has higher standard deviation as well. For instance, during the seven years 2000-2006, stock in Disney on average grew 0.61% monthly with standard deviation 8.3%. During this same period, stock in McDonalds grew 0.53% with SD = 7.6%. Stock in McDonalds grew at a slower average rate, but the growth was steadier. We can use these characteristics to define two random variables as models for what we expect to happen in future months. Company Disney McDonalds Random Variable D M Mean 0.61% 0.53% SD 8.3% 7.6%

Table 9-5. Random variables based on monthly returns on Disney and McDonalds.

Which random variable represents the better investment going forward? The random variables have the same units (monthly percentage
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changes), but the comparison is difficult because the one with the higher average also has the higher SD. Finance offers many ways to judge the relative size of rewards to risks. One of the most popular is the Sharpe ratio. The higher the Sharpe ratio, the better the investment. The Sharpe ratio is a fraction. The numerator of the Sharpe ratio is the mean return minus what you would earn on an investment that presents no risk (such as a savings account). The denominator of the Sharpe ratio is the standard deviation of the return on the investment. Suppose that X is a random variable measures the performance of an investment, and assume that the mean of X is and its SD is . The Sharpe ratio of X is rf S( X) = The symbol rf stands for the return on a risk-free investment (resembling the rate of interest on a savings account). to compare investing in Disney and Lets use the Sharpe ratio McDonalds. Well set the risk-free rate of interest to 0.4 % per month (about 5% annual interest). The Sharpe ratio for Disney is D rf 0.61 0.40 S(D) = = 0.0253 D 8.3 The Sharpe ratio for McDonalds is
S( M ) =

Sharpe ratio The Sharpe ratio of an investment is the ratio of its mean return minus the return on a risk-free investment to the standard deviation. This ratio was proposed by William F. Sharpe who won the Nobel Prize for Economics in 1990.

M rf M

0.53 0.40 0.0171 7.6

An investor who uses the Sharpe ratio prefers investing in Disney to investing in McDonalds because S(D) > S(M).

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9 Random Variables

Summary

A random variable represents the uncertain outcome of a random process. The probability distribution of a random variable X identifies the possible outcomes and assigns a probability to each. The probability distribution is analogous to the histogram of numerical data. An expected value is a weighted sum of the possible values of an expression that includes a random variable. The expected value of a random variable itself is the mean of the random variable, = E(X). The variance of a random variable 2 = Var(X) is the expected value of the squared deviation from the mean. The Sharpe ratio of an investment is the ratio of its net gain to its standard deviation.

Index

expected value, 9-7 mean, 9-6 model, 9-5 parameter, 9-6 probability distribution, 9-4 random variable, 9-3

continuous, 9-4 discrete, 9-4 Sharpe ratio, 9-16 standard deviation, 9-9, 9-10 variance, 9-9, 9-10

Best Practices
Use random variables to represent uncertain outcomes. Associating a random variable with a random process forces you to become specific about what you think might happen. You have to specify the possibilities and the chances of each. Draw the random variable. Pictures provide important summaries of data, and the same applies to random variables. The plot of the probability distribution of a random variable is analogous to the histogram of data. We can guess the mean and the standard deviation from the probability distribution. Recognize that random variables represent models. The stock market is a lot more complicated and subtle than flipping coins. Well never know every possible outcome and its probability. Models can be useful, but they should not be confused with reality. Question probabilities as you would data. Keep track of the units of the random variables. As with data, the units are important. It does not make sense to compare data that have different units, and the same applies to random variables.

Pitfalls
Assuming that a model is correct. Random variables are useful ways to describe probabilities, but just because you have written down a random variable to describe the probabilities does not mean that the phenomenon (such as the gains of a stock) works that way in reality.
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9 Random Variables

Confusing x with and s with . Greek letters highlight properties of random variables. These come from weighting the outcomes by probabilities rather than from data. Thinking that a probability distribution describes data. Thats the job for a histogram. Wed like to think that the probability distribution of the random variable we propose as a model describes what will happen, but its only a model for future events. Confusing X with x. Upper case letters denote random variables, and the corresponding lower case letters reserved for indicating a generic possible value of the random variable.

Formulas and Rules

The letters a, b, and c stand for constants in the following formulas. Expected value of a random variable X Assuming that the random variable is discrete, taking on any of the k possible values x1, x2, xk:

= E( X )
= x1 p( x1 ) + x2 p( x2 ) + + xk p( xk )
k

= xi p( xi )
i=1

Variance of a random variable Assuming that the random variable is discrete, taking on any of the k possible values x1, x2, xk:

2 = Var( X)
=E X

2 2 2

= x1 p( x1 ) + x2 p( x2 ) + + xk p( xk )
k

= xi p( xi )
i=1

A short-cut formula simplifies the calculations (avoiding the need to subtract before squaring) and is useful if you have to do many of these calculations by hand:

2 = E X 2 2
2 2 = x p( x1 ) + x2 p( x2 ) + + xk p( xk ) 2 1

( )

Adding a constant to a random variable

E(X c) = E(X) c SD(X c) = SD(X), Var(X c) = Var(X) Multiplying a constant times a random variable
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9 Random Variables

E(c X ) = c E(X) SD(c X ) = c SD(X), Var(c X ) = c2 Var(X) Adding a constant and multiplying by a constant E(a + b X) = a + b E(X) Var(a + b X) = b2 Var(X) Sharpe ratio of the random variable X with mean and variance 2 rf S( X ) = The symbol rf is the corresponding risk-free rate of interest.

About the Data

The random variable in this chapter that is used to model changes in the value of stock in IBM has three possible values (-$5, 0, and $5). Even so, it is a better match to reality than you might expect. The mean and SD of X are close to those of the daily percentage change in this stock. Percentages are relevant because we set the value of the stock to $100; that way, a change of $5 is a 5% change. The following histogram summarizes percentage changes in the price of IBM stock for 2,771 trading days from 1994 through the end of 2004.

Figure 9-4. Daily percentage changes in IBM stock.

The figure includes a boxplot to convince you that theres a reason for the axes to extend so far from zero. Some data fall near the edges of the plot. IBMs stock rose or fell by close to 15% on several days during these 10 years. The mean and standard deviation of X approximate the mean and standard deviation of these data. The average percentage change in IBM over these 10 years is 0.097% per day. The mean of the random variable X is = 0.100%. The variation is also similar. The SD of these daily returns is s = 2.22%, close to = 2.23% in the example.

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