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Probability Concepts and Applications

Lecture 3

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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
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Diversey Paint Example


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)
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Diversey Paint Example


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)
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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

Classical or logical method Logically determine probabilities without trials


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


Events are said to be mutually exclusive if only one of the events can occur on any one trial
Tossing a coin will result

in either a head or a tail


Rolling a die will result in

only one of six possible outcomes


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Collectively Exhaustive Events


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
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Adding Mutually Exclusive Events


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

= 26/52 = 1/2 = 0.50 = 50%


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Adding Not Mutually Exclusive Events


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
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Venn Diagrams
P (A and B)

P (A)

P (B)

P (A)

P (B)

Events that are mutually exclusive

Events that are not mutually exclusive

P (A or B) = P (A) + P (B)
Figure 2.1

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


Figure 2.2
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Statistically Independent Events


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

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Three Types of Probabilities


Marginal (or simple) probability is just the

probability of an event occurring P (A)


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)
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Joint Probability Example


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

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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
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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Random Variables Numbers


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, 1, 2,, 50 0, 1, 2,, 600 0, 1, 2,, 5,000

0 R 100

0 S 80,000

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Random Variables Not Numbers


EXPERIMENT OUTCOME RANDOM VARIABLES RANGE OF RANDOM VARIABLES

Students respond to a questionnaire

Strongly agree (SA) Agree (A) Neutral (N) Disagree (D) Strongly disagree (SD)
Defective Not defective Good Average Poor Y=

X=

5 if SA 1, 2, 3, 4, 5 4 if A.. 3 if N.. 2 if D.. 1 if SD

One machine is inspected Consumers respond to how they like a product


Table 2.5

0 if defective 0, 1 1 if not defective Z= 3 if good. 1, 2, 3 2 if average 1 if poor..

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Probability Distribution of a Discrete Random Variable


Selecting the right probability distribution is important
For discrete random variables a

probability is assigned to each event


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

5. Strongly agree 4. Agree 3. Neutral 2. Disagree 1. Strongly disagree

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Probability Distribution of a Discrete Random Variable


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

Distribution follows all three rules


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
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Probability Distribution for Dr. Shannons Class


0.4

0.3

P (X)

0.2

0.1

0 |
Figure 2.5

| 1 2

| 3 X

| 4

| 5

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Probability Distribution for Dr. Shannons Class


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

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Expected Value of a Discrete Probability Distribution


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

X i = random variables possible values P ( X i ) = probability of each of the random variables

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

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Variance of a Discrete Probability Distribution


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

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Variance of a Discrete Probability Distribution


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)

0.441 0.242 0.003 0.243 0.361 1.29


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Variance of a Discrete Probability Distribution


A related measure of dispersion is the standard deviation

Variance
where

= square root = standard deviation

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Variance of a Discrete Probability Distribution


A related measure of dispersion is the standard deviation

Variance
where

= square root textbook question For the = standard deviation

Variance 1.29 1.14

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Determining Expected Return (Continuous Dist.)


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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Determining Standard Deviation (Risk Measure)

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.
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Continuous Distribution Problem


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.
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