Review of Probability Theory

AMATH 540/ECON 424

Sunmer 2012
Eric Zivot
Updated: June 26, 2012

Eric Zivot 2011

Discrete Distribution

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Annual Return on Microsoft

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0.5

return

>
>
>
+
>

r.msft = c(-0.3, 0, 0.1, 0.2, 0.5)

prob.vals = c(0.05, 0.20, 0.50, 0.20, 0.05)
barplot(prob.vals, names.arg = as.character(r.msft),
xlab="return")
title("Annual Return on Microsoft")
Eric Zivot 2011

0.4

Probability Curve for Continuous RV

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pdf

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Pr(( 2 X 1))

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-2

Eric Zivot 2011

CDF of Discrete Distribution

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cdf

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1.0

F X ( x ) Pr( X x )

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x.vals

Eric Zivot 2011

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pdf

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Standard Normal Distribution

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> x.vals = seq(-4, 4, length=150)

> plot(x.vals, dnorm(x.vals), type="l", lwd=2, col="blue",
+
xlab="x", ylab="pdf")
Eric Zivot 2011

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CDF

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Standard Normal CDF

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x
> x.vals = seq(-4, 4, length=150)
> plot(x.vals, pnorm(x.vals), type="l", lwd=2, col="blue",
+
xlab="x", ylab="CDF")

Eric Zivot 2011

SD as a Measure of Risk
Amazon
Boeing

RB ~ N(0.01,(0.05)2 )

pdf

RA ~ N(0.02,(0.10)2 )

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Eric Zivot 2011

Normal vs. Log-Normal Distribution for Returns

rt ~ N (0.05, (0.5)2 )
Rt ~ lognormal(0.05, (0.5)2 ) 1

Eric Zivot 2011

v=1
v=5
v=10
v=60

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pdf

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Students t Distribution

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Eric Zivot 2011

Return and Wealth Distributions

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0

pdf

R(t) ~ N(0.05,(.10)^2)

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12000

13000

2e-04
0e+00

pdf

4e-04
4

W1 ~ N(10,500,(1,000)^2)

8000

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10000

11000
W1

Eric Zivot 2011

5% Value-at-Risk

Area = 5%

pdf

R(t) ~ N(0.05,(.10)^2)

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2000

3000

2e-04
0e+00

pdf

4e-04

R*W0 ~ N(500,(1,000)^2)

-2000

-1000

1000
W0*R

Eric Zivot 2011

Bivariate Standard Normal

> pmvnorm(lower=c(-1, -1), upper=c(1, 1))

[1] 0.4661
Eric Zivot 2011

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Simulated Data from Bivariate Standard Normal

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Eric Zivot 2011

Probability Scatterplots
(b)

y
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x

(c)

(d)

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y
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(e)

(f)

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0
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-1.5 -0.5 0.5

-0.5
-1.5

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1.5

(a)

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-1.0

-0.5

0.0

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1.0

1.5

Eric Zivot 2011

Cov(x, y) > 0

QII
x x 0
y y 0

QII
x x 0
y y 0

QIV
x x 0
y y 0

0
-1
-2

y y

QI
x x 0
y y 0

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-1

x x

Eric Zivot 2011

Bivariate Normal
X Y 1, X Y 1, XY 0.5

Eric Zivot 2011

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Simulated Data from Bivariate Normal

-1

Eric Zivot 2011