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Lecture 3

Introduction

Life is uncertain, we are not sure

what the future will bring Risk and probability is a part of our daily lives Probability is a numerical statement about the likelihood that an event will occur

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Fundamental Concepts

1. The probability, P, of any event or state of nature occurring is greater than or equal to 0 and less than or equal to 1. That is:

0 P (event) 1

2. The sum of the simple probabilities for all possible outcomes of an activity must equal 1

2008 Prentice-Hall, Inc. 23

Demand for white latex paint at Diversey Paint

and Supply has always been either 0, 1, 2, 3, or 4 gallons per day Over the past 200 days, the owner has observed the following frequencies of demand

QUANTITY DEMANDED 0 1 2 3 4 NUMBER OF DAYS 40 80 50 20 10 Total 200 PROBABILITY

0.20 (= 40/200) 0.40 (= 80/200) 0.25 (= 50/200) 0.10 (= 20/200) 0.05 (= 10/200) Total 1.00 (= 200/200)

2008 Prentice-Hall, Inc. 24

Demand for white latex paint at Diversey Paint

and the individual probabilities Notice Supply has always been either 0, 1, 2, 3, or 4 gallons per day are all between 0 and 1 Over the past 200 days, the owner has observed 0 P (event) 1 the following frequencies of demand And the total of all event QUANTITY probabilities equals 1 NUMBER OF DAYS PROBABILITY

DEMANDED 0 P (event) = 1.00 40 1 80 2 50 3 20 4 10 Total 200 0.20 (= 40/200) 0.40 (= 80/200) 0.25 (= 50/200) 0.10 (= 20/200) 0.05 (= 10/200) Total 1.00 (= 200/200)

2008 Prentice-Hall, Inc. 25

Types of Probability

Determining objective probability Relative frequency

Typically based on historical data

Number of occurrences of the event P (event) = Total number of trials or outcomes

1 P (head) = 2 Number of ways of getting a head Number of possible outcomes (head or tail)

2008 Prentice-Hall, Inc. 26

Types of Probability

Subjective probability is based on the experience and judgment of the person making the estimate Opinion polls Judgment of experts Delphi method

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Events are said to be mutually exclusive if only one of the events can occur on any one trial

Tossing a coin will result

Rolling a die will result in

2008 Prentice-Hall, Inc. 28

Events are said to be collectively exhaustive if the list of outcomes includes every possible outcome

Both heads and

tails as possible outcomes of coin flips All six possible outcomes of the roll of a die

OUTCOME OF ROLL 1 2 3 4 5 6

PROBABILITY

1/ 1/ 1/ 1/ 1/ 1/ 6 6 6 6 6 6

Total 1

2008 Prentice-Hall, Inc. 29

We often want to know whether one or a second event will occur When two events are mutually exclusive, the law of addition is

P (event A or event B) = P (event A) + P (event B) P (spade or club) = P (spade) + P (club) = 13/52 + 13/52

2008 Prentice-Hall, Inc. 2 10

The equation must be modified to account for double counting The probability is reduced by subtracting the chance of both events occurring together

P (event A or event B) = P (event A) + P (event B) P (event A and event B both occurring) P (A or B) = P (A) + P (B) P (A and B) P(five or diamond) = P(five) + P(diamond) P(five and diamond) = 4/52 + 13/52 1/52 = 16/52 = 4/13

2008 Prentice-Hall, Inc. 2 11

Venn Diagrams

P (A and B)

P (A)

P (B)

P (A)

P (B)

P (A or B) = P (A) + P (B)

Figure 2.1

Figure 2.2

2008 Prentice-Hall, Inc. 2 12

Events may be either independent or dependent

For independent events, the occurrence

of one event has no effect on the probability of occurrence of the second event

2 13

Marginal (or simple) probability is just the

Joint probability is the probability of two or more

events occurring and is the product of their marginal probabilities for independent events P (AB) = P (A) x P (B)

Conditional probability is the probability of event

B given that event A has occurred P (B | A) = P (B) Or the probability of event A given that event B has occurred P (A | B) = P (A)

2008 Prentice-Hall, Inc. 2 14

The probability of tossing a 6 on the first roll of the die and a 2 on the second roll

P (6 on first and 2 on second) = P (tossing a 6) x P (tossing a 2) = 1/6 x 1/6 = 1/36 = 0.028

2 15

Independent Events

A bucket contains 3 black balls and 7 green balls We draw a ball from the bucket, replace it, and draw a second ball

1. 2.

A black ball drawn on first draw P (B) = 0.30 (a marginal probability) Two green balls drawn P (GG) = P (G) x P (G) = 0.7 x 0.7 = 0.49

(a joint probability for two independent events)

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Independent Events

A bucket contains 3 black balls and 7 green balls We draw a ball from the bucket, replace it, and draw a second ball

3.

A black ball drawn on second draw if the first draw is green P (B | G) = P (B) = 0.30

(a conditional probability but equal to the marginal because the two draws are independent events)

4.

A green ball is drawn on the second if the first draw was green P (G | G) = P (G) = 0.70

(a conditional probability as in event 3)

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Random Variables

A random variable assigns a real number to every possible outcome or event in an experiment

X = number of refrigerators sold during the day

Discrete random variables can assume only a finite or limited set of values

Continuous random variables can assume any one of an infinite set of values

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EXPERIMENT OUTCOME RANDOM VARIABLES RANGE OF RANDOM VARIABLES

Stock 50 Christmas trees Inspect 600 items Send out 5,000 sales letters Build an apartment building Test the lifetime of a lightbulb (minutes)

Table 2.4

Number of Christmas trees sold Number of acceptable items Number of people responding to the letters Percent of building completed after 4 months Length of time the bulb lasts up to 80,000 minutes

X Y Z

0 R 100

0 S 80,000

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EXPERIMENT OUTCOME RANDOM VARIABLES RANGE OF RANDOM VARIABLES

Strongly agree (SA) Agree (A) Neutral (N) Disagree (D) Strongly disagree (SD)

Defective Not defective Good Average Poor Y=

X=

Table 2.5

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Selecting the right probability distribution is important

For discrete random variables a

Dr. Shannon asked students to respond to the statement, The textbook was well written and helped me acquire the necessary information.

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OUTCOME Strongly agree RANDOM NUMBER VARIABLE (X) RESPONDING 5 10 PROBABILITY P (X) 0.1 = 10/100

Agree

Neutral Disagree Strongly disagree

4

3 2 1

20

30 30 10 Total 100

0.2 = 20/100

0.3 = 30/100 0.3 = 30/100 0.1 = 10/100 1.0 = 100/100

Table 2.6

1. Events are mutually exclusive and collectively exhaustive 2. Individual probability values are between 0 and 1 3. Total of all probability values equals 1

2008 Prentice-Hall, Inc. 2 22

0.4

0.3

P (X)

0.2

0.1

0 |

Figure 2.5

| 1 2

| 3 X

| 4

| 5

2 23

0.4

0.3

Central tendency of the distribution is the mean or expected value Amount of variability or spread is the variance

P (X)

0.2

0.1

0 |

Figure 2.5

| 1 2

| 3 X

| 4

| 5

2 24

The expected value is a measure of the central tendency of the distribution and is a weighted average of the values of the random variable

EX X i PX i

i 1 n

X 1 P X 1 X 2 P ( X 2 ) ... X n P ( X n )

where

possible values = summation sign indicating we are adding all n possible values i 1 E ( X ) = expected value or mean of the random sample

2 25

For a discrete probability distribution the variance can be computed by

2 Variance [ X i E ( X )]2 P ( X i )

i 1 n

where

X i = random variables possible values E ( X ) = expected value of the random variable [ X i E ( X )]= difference between each value of the random

variable and the expected mean P ( X i ) = probability of each possible value of the random sample

2 26

For Dr. Shannons class

variance [ X i E ( X )]2 P ( X i )

i 1 5

variance (5 2.9)2 (0.1) ( 4 2.9)2 (0.2) (3 2.9)2 (0.3) (2 2.9)2 (0.3) (1 2.9)2 (0.1)

2008 Prentice-Hall, Inc. 2 27

A related measure of dispersion is the standard deviation

Variance

where

2 28

A related measure of dispersion is the standard deviation

Variance

where

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R = S ( Ri ) / ( n )

R is the expected return for the asset, Ri is the return for the ith observation, n is the total number of observations.

i=1 n

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s=

S ( Ri - R )2 i=1 (n)

Note, this is for a continuous distribution where the distribution is for a population. R represents the population mean in this example.

2008 Prentice-Hall, Inc. 2 31

Assume that the following list represents the

continuous distribution of population returns for a particular investment (even though there are only 10 returns).

9.6%, -15.4%, 26.7%, -0.2%, 20.9%,

28.3%, -5.9%, 3.3%, 12.2%, 10.5% Calculate the Expected Return and Standard Deviation for the population assuming a continuous distribution.

2008 Prentice-Hall, Inc. 2 32

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