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Chapter 5

5-

Day 4

Session-

I

PROBABILITY DISTRIBUTIONS

Learning Objectives

The properties of a probability distribution To calculate the expected value and variance of a probability distribution To calculate the covariance and its use in finance To calculate probabilities from binomial and Poisson distributions How to use the binomial and Poisson distributions to solve business problems

Chapter 5

5-

Introduction to Probability Distributions

Frequency Distribution Listing of the observed frequencies of all the outcomes of an experiment that actually occurred when the experiment was done. Probability Distribution Listing of the probabilities of all the possible outcomes that could result if the experiment were done.

Defining a Random Variable A value is random if it takes different values as a result of the outcomes of a random experiment Or it represents a possible numerical value from an uncertain event.

Introduction to Probability Distributions
Number of Cars
sold per day (X)
Frequency of
Occurance
100
1
101
7
103
5
104
3
105
4

Table 1 illustrates the number of cars sold per day during the last 20 days. The table gives a Frequency Distribution. Number of cars sold daily during 20 days. We can use this historical record to assign a probability to each possible number of cars and find a Probability distribution (Table- 2). This has been accomplished by normalizing the observed frequency distribution.

 Value of the random variable (X) Probability that the random variable will take on this value 100 1/20 =.05 101 7/20 =.35 103 5/20 =.25 104 3/20 =.15 105 4/20= .20 Total 1.00

Chapter 5

5-

Introduction to Probability Distributions
Discrete Random Variable
If a random variable is allowed to take on only a limited
number of values, which can be listed, it is a discrete random
variable.
Continuous Random Variable
If it allowed to assume any value within a given range, it is a
continuous random variable.
Random
Variables
Discrete
Random Variable
Continuous
Random Variable
Discrete Random Variables
Can only assume a countable number of values

Examples:

Roll a die twice Let X be the number of times 4 comes up (then X could be 0, 1, or 2 times)

Toss a coin 5 times.

Let X be the number of heads

(then X

= 0, 1, 2, 3, 4, or 5)

Chapter 5

5-

Discrete Probability Distribution

Experiment: Toss 2 Coins.

4 possible outcomes
Probability Distribution
T
T
X Value
Probability
0 1/4 = 0.25
T
H
1 2/4 = 0.50
2 1/4 = 0.25
H
T
0.50
0.25
H
H
0
1
2
X
Probability
Discrete Random Variable
Summary Measures
Expected Value (or mean) of a discrete distribution
(Weighted Average) we multiply each value that the random
variable can assume by the probability of occurrence of that
value and sum these products.
N
µ =
E(X)
=
X P(X )
i
i
i
= 1
X
P(X)
Example: Toss 2 coins,
0
0.25
compute expected value of X:
1
0.50
2
0.25
E(X) = (0 x 0.25) + (1 x 0.50) + (2 x 0.25)
= 1.0

Chapter 5

5-

Discrete Random Variable
Summary Measures
(continued)
Variance of a discrete random variable
N
2
2
σ
=
[X
E(X)] P(X )
i
i
i
= 1

Standard Deviation of a discrete random variable

N
2
2
σ =
σ
=
[X
E(X)] P(X )
i
i
i
= 1

where:

E(X) = Expected value of the discrete random variable X X i = the i th outcome of X P(X i ) = Probability of the i th occurrence of X

Discrete Random Variable
Summary Measures
(continued)

σ =

Example: Toss 2 coins, X = # heads,
compute standard deviation (recall E(X) = 1)
2
σ =
∑ [X
E(X)] P(X )
i
i
2
2
2
(0
1) (0.25)
+
(1
1) (0.50)
+
(2
1) (0.25)
=
0.50
=
0.707

Possible number of heads = 0, 1, or 2

Chapter 5

5-

The Covariance

The covariance measures the strength of the linear relationship between two variables

The covariance:

N
=
[X
E(X)][(Y
E(Y)] P(X Y )
σ XY
i
i
i
i
i
= 1

where:

X = discrete variable X X i = the i th outcome of X Y = discrete variable Y Y i = the i th outcome of Y P(X i Y i ) = probability of occurrence of the i th outcome of X and the i th outcome of Y

 Numerical Problems Ref. # 5-9 Page No.230: The only information available to you regarding the probability distribution of a set of outcomes is the following list of frequencies: X 0 15 30 45 60 75 Frequency 25 125 75 175 75 25 Construct a probability distribution for the set of outcomes. a. Find the expected value of an outcome. b. Compute the variance and standard deviation for the distribution. Observati Probability Deviation Deviation on (X) Frequency P(x) X.P(X) (x-mean) Squared*P(X) 0 25 0.05 0.00 -36.75 67.53 15 125 0.25 3.75 -21.75 118.27 30 75 0.15 4.50 -6.75 6.83 45 175 0.35 15.75 8.25 23.82 60 75 0.15 9.00 23.25 81.08 75 25 0.05 3.75 38.25 73.15 500 1.00 36.75 370.69 Expected value Variance

Chapter 5

5-

Computing the Mean for
Investment Returns
Return per \$1,000 for two types of investments
 Investment P(X i Y i ) Economic condition Passive Fund X Aggressive Fund Y 0.2 Recession - \$ 25 - \$200 0.5 Stable Economy + 50 + 60 0.3 Expanding Economy + 100 + 350

E(X) = µ X = (-25)(0.2) +(50)(0.5) + (100)(0.3) = 50

E(Y) = µ Y = (-200)(0.2) +(60)(0.5) + (350)(0.3) = 95

Computing the Standard Deviation for Investment Returns

Investment
P(X i Y i )
Economic condition
Passive Fund X
Aggressive Fund Y
0.2
Recession
- \$ 25
-
\$200
0.5
Stable Economy
+ 50
+ 60
0.3
Expanding Economy
+ 100
+ 350

= 43.30

 σ = Y (-200 − 2 95) (0.2) + (60 − 2 95) (0.5) + (350 − 2 95) (0.3)

= 193.71

σ

X =

(-25

2

50) (0.2)

+

(50

2

50) (0.5)

+

(100

2

50) (0.3)

Chapter 5

5-

Computing the Covariance for Investment Returns

Investment
P(X i Y i )
Economic condition
Passive Fund X
Aggressive Fund Y
0.2
Recession
- \$ 25
- \$200
0.5
Stable Economy
+
50
+
60
0.3
Expanding Economy
+ 100
+ 350
=
(-25
50)(-200
95)(0.2)
+
(50
50)(60
95)(0.5)
σ XY
+
(100
50)(350
95)(0.3)
= 8250
Interpreting the Results for
Investment Returns

The aggressive fund has a higher expected return, but much more risk

µ Y = 95 > µ X = 50 but σ Y = 193.71 > σ X = 43.30

The Covariance of 8250 indicates that the two investments are positively related and will vary in the same direction

Chapter 5

5-

The Sum of
Two Random Variables

Expected Value of the sum of two random variables:

E(X + Y) = E(X) + E(Y)

Variance of the sum of two random variables:

Var(X + Y) = σ

2

X

+ Y

= σ + σ + 2σ

X

Y

2

2

XY

Standard deviation of the sum of two random variables:

σ

X

+

Y

=

2
σ
X
+
Y
Portfolio Expected Return
and Portfolio Risk

Portfolio expected return (weighted average return):

E(P) = w E(X) + (1w)E(Y)

Portfolio risk (weighted variability)

Where

w = portion of portfolio value in asset X (1 - w) = portion of portfolio value in asset Y

σ

P =

2

w σ

2

X

2

+ (1w) σ

2

Y

+ 2w(1- w)σ

XY

Chapter 5

5-

Portfolio Example
Investment X:
µ X = 50
µ Y = 95
σ X = 43.30
Investment Y:
σ Y = 193.21
σ XY = 8250

Suppose 40% of the portfolio is in Investment X and 60% is in Investment Y:

E(P) = 0.4(50) + (0.6)(95) = 77

σ

2
(0.4) (43.30)
P =
= 133.30

2

+

2

(0.6) (193.71)

2

+

2(0.4)(0.6)(8250)

The portfolio return and portfolio variability are between the values for investments X and Y considered individually

 Day 4 Session- II

PROBABILITY DISTRIBUTIONS

Chapter 5

5-

Probability Distributions
Probability
Distributions
Discrete
Continuous
Probability
Probability
Distributions
Distributions
Binomial
Normal
Poisson
Uniform
Hypergeometric
Exponential
The Binomial Distribution
Probability
Distributions
Discrete
Probability
Distributions
Binomial
Poisson
Hypergeometric

Chapter 5

5-

Binomial Probability Distribution
A fixed number of observations, n

e.g., 15 tosses of a coin; ten light bulbs taken from a warehouse

Two mutually exclusive and collectively exhaustive categories

e.g., head or tail in each toss of a coin; defective or not defective light bulb Generally called “success” and “failure” Probability of success is p, probability of failure is 1 – p

Constant probability for each observation

e.g., Probability of getting a tail is the same each time we toss the coin

Observations are independent

The outcome of one observation does not affect the outcome of the other

Applications of Binomial Distribution

A manufacturing plant labels items as either defective or acceptable

A firm bidding for contracts will either get a contract or not

A marketing research firm receives survey responses of “yes I will buy” or “no I will not”

New job applicants either accept the offer or reject it

Chapter 5

5-

Rule of Combinations

The number of combinations of selecting X objects out of n objects is

n!

X!(n

X)!

where:

n! =(n)(n - 1)(n - 2)

X! = (X)(X - 1)(X - 2)

0! = 1 (by definition)

(2)(1)

(2)(1)

n

C x

=

Binomial Distribution Formula
Define a random variable
X ~ BIN (n,p)

X ! (

n !

n

X

)!

P(X) = probability of X successes in n trials, with probability of success p on each trial

 X = number of ‘successes’ in sample, (X = 0, 1, 2, , n) n = sample size (number of trials or observations) p = probability of “success”

Example: Flip a coin four times, let x = # heads:

n = 4

p = 0.5

1 - p = (1 - 0.5) = 0.5

X = 0, 1, 2, 3, 4

P(X)

====

p

X (1-p)

n −−−− X

Chapter 5

5-

Example:
Calculating a Binomial Probability

What is the probability of one success in five observations if the probability of success is .1?

X = 1, n = 5, and p = 0.1

 P(X = 1) = = = =

n!

X!(n

X)!

5!

1!(5

(5)(0.1)(0.9)

0.32805

1)!

4

p

X (1

p)

n

X

1

(0.1) (1

0.1)

5

1

Binomial Distribution
Characteristics

Mean

µ = E(x) = np

Variance and Standard Deviation

σ 2 =
np(1- p)
σ =
np(1- p)

Where

n = sample size p = probability of success (1 – p) = probability of failure

Chapter 5

5-

Binomial Distribution

The shape of the binomial distribution depends on the values of p and n

Mean

 Here, n = 5 and p = 0.1 Here, n = 5 and p = 0.5
P(X)
n
= 5
p = 0.1
.6
.4
.2
0
X
0
1
2
3
4
5
P(X)
n
= 5
p = 0.5
.6
.4
.2
0
X
0
1
2
3
4
5
Binomial Characteristics
Examples

µ

σ

=

= np = (5)(0.1) = 0.5

(5)(0.1)(1

0.1)

0.6708

=

=

.6

P(X)

n = 5

p = 0.1

.4
.2
0
X

0 1

2

3

4

5

µ

= np = (5)(0.5) = 2.5

.6

P(X)

n

= 5

p = 0.5

σ

=

1.118

(5)(0.5)(1

0.5)

0

1

2

3

4

5

Chapter 5

5-

Using Binomial Tables
n = 10
x
p=.20
p=.25
p=.30
p=.35
p=.40
p=.45
p=.50
0
0.1074
0.0563
0.0282
0.0135
0.0060
0.0025
0.0010
10
1
0.2684
0.1877
0.1211
0.0725
0.0403
0.0207
0.0098
9
2
0.3020
0.2816
0.2335
0.1757
0.1209
0.0763
0.0439
8
3
0.2013
0.2503
0.2668
0.2522
0.2150
0.1665
0.1172
7
4
0.0881
0.1460
0.2001
0.2377
0.2508
0.2384
0.2051
6
5
0.0264
0.0584
0.1029
0.1536
0.2007
0.2340
0.2461
5
6
0.0055
0.0162
0.0368
0.0689
0.1115
0.1596
0.2051
4
7
0.0008
0.0031
0.0090
0.0212
0.0425
0.0746
0.1172
3
8
0.0001
0.0004
0.0014
0.0043
0.0106
0.0229
0.0439
2
9
0.0000
0.0000
0.0001
0.0005
0.0016
0.0042
0.0098
1
10
0.0000
0.0000
0.0000
0.0000
0.0001
0.0003
0.0010
0
p=.80
p=.75
p=.70
p=.65
p=.60
p=.55
p=.50
x

Examples:

 n = 10, p = 0.35, x = 3: P(x = 3|n =10, p = 0.35) = 0.2522 n = 10, p = 0.75, x = 2: P(x = 2|n =10, p = 0.75) = 0.0004
When n is constant, notice the changes due to changes in p,
probability of success.

1. when p is small (0.1), the binomial distribution is skewed to the

right.

2. As p increases (to 0.3), the skewness is less noticeable.

3. When p = 0.5, the binomial dist. Is symmetrical.

4. When p is larger than 0.5, the distribution is skewed to the left.

5. When p =0.7, the probabilities are the same as for p=0.3 except

that the values are reversed.

Let us examine when p stays constant but n is increased. 1. As n increases, the vertical lines not only become more numerous but also tend to bunch up together to form a bell shape.

Note:

Look at the Excel worksheet

Chapter 5

5-

Numerical Problems
Ref. # 5-18 Page No.247: For a Binomial distribution with
n = 7 and p = 0.2, find
 a. P(X=5) b. P(X>2) c. P(X<8) d. P(X≥4) Ans. • .0043 • .1480 • 1 • .0333
Numerical Problems
Ref. # 5-22 Page No.248: Harley Davidson, director of quality control
for the Kyoto Motor company is conducting his monthly spot check of
automatic transmissions. In that procedure, 10 transmissions are
removed from the pool of components and are checked for
manufacturing defects. Historically, only 2% of the transmissions have
such flaws. (Assume that flaws occur independently in different
transmissions)

a. What is the probability that Harley’s sample contains more than two transmissions with manufacturing flaws?

b. What is the probability that none of the selected transmissions has manufacturing flaws.

Ans.

a. .0009

b. .8171

Chapter 5

5-

Numerical Problems
Ref. # 5-25 Page No.248: A recent study of how Indians spend their
leisure time surveyed workers employed more than 5 years. They
determined the probability an employee has 2 weeks of vacation
time to be 0.45, 1 week of vacation time to be 0.10, and 3 or more
weeks to be 0.20. Suppose 20 workers are selected at random.
what is the probability that;

a. 8 have 2 weeks of vacation time?

b. Only one worker has 1 week of vacation time?

c. At most 2 of the workers have 3 or more weeks of vacation time?

d. At least 2 workers have 1 week of vacation time? Ans.

a. 0.1623

b. 0.2702

c. 0.2061

d. 0.6083

Numerical Problems
Ref. # 5-26 Page No.248: Harry Ohme is in charge of the electronics
section of a large department store. He has noticed that the
probability that a customer who is just browsing will buy something is
0.3. Suppose that 15 customers browse in the electronics section
each hour. What is the probability that;

a. At least one browsing customer will buy something during a specified hour?

b. At least four browsing customers will buy something during a specified hour?

c. No browsing customers will buy anything during a specified hour?

d. No more than four browsing customers will buy something during a specified hour? Ans.

a. 0.9953

b. 0.7031

c. 0.0047

d. 0.5155

Chapter 5

5-

The Poisson Distribution
Probability
Distributions
Discrete
Probability
Distributions
Binomial
Poisson
Hypergeometric
The Poisson Distribution

Apply the Poisson Distribution when:

 You wish to count the number of times an event occurs in a given area of opportunity Distribution of telephone calls going through a switchboard system. The demand (needs) of patients for service at a health institution.

The arrivals of trucks and cars at a tollbooth.

The above examples all have common element that they can be described by a discrete random variable that takes on integer values 0,1,2,3,4…

The number of events that occur in one area of opportunity is independent of the number of events that occur in the other areas of opportunity

The average number of events per unit is λλλλ (lambda)

Chapter 5

5-

Poisson Distribution Formula

P(X) =

e −λ

x

λ

X!

where:

X = number of events in an area of opportunity λ = expected number of events e = base of the natural logarithm system (2.71828

)

Poisson Distribution
Characteristics

Mean

µ = λ

Variance and Standard Deviation

where

σ
2 =
λ
σ = λ

λ = expected number of events

Chapter 5

5-

Using Poisson Tables
 λλλλ X 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 0 0.9048 0.8187 0.7408 0.6703 0.6065 0.5488 0.4966 0.4493 0.4066 1 0.0905 0.1637 0.2222 0.2681 0.3033 0.3293 0.3476 0.3595 0.3659 2 0.0045 0.0164 0.0333 0.0536 0.0758 0.0988 0.1217 0.1438 0.1647 3 0.0002 0.0011 0.0033 0.0072 0.0126 0.0198 0.0284 0.0383 0.0494 4 0.0000 0.0001 0.0003 0.0007 0.0016 0.0030 0.0050 0.0077 0.0111 5 0.0000 0.0000 0.0000 0.0001 0.0002 0.0004 0.0007 0.0012 0.0020 6 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0001 0.0002 0.0003 7 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

Example: Find P(X = 2) if λ = 0.50

P(X

= 2)

=

 e − λ X λ = e − 0.50 (0.50) 2 X! 2!

= 0.0758

Graph of Poisson Probabilities
0.70
Graphically:
0.60
λλλλ = 0.50
0.50
λλλλ =
0.40
X
0.50
0.30
0
0.6065
0.20
1
0.3033
2
0.0758
0.10
3
0.0126
0.00
0
1
2
3
4
5
6
7
4
0.0016
x
5
0.0002
6
0.0000
P(X = 2) = 0.0758
7
0.0000
P(x)

Chapter 5

5-

P(x)

Poisson Distribution Shape

The shape of the Poisson Distribution depends on the parameter λ :

λ = 0.50

0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
0
1
2
3
4
5
6
7

x

λ = 3.00

0.25
0.20
0.15
0.10
0.05
0.00
1
2
3
4
5
6
7
8
9
10
11
12
P(x)

x

Numerical Problems
Ref. # 5-28 Page No.255: If the prices of new cars
increase an average of four times every 3 years, find the
probability of
 a. No price hikes in a randomly selected period of 3 years. P(X=0) b. Two price hikes P(X=2) c. Four price hikes P(X=4) d. Five or more P(X≥5) Ans. • .0183 • .1465 • .1954 • .3711

Chapter 5

5-

Numerical Problems

Ref. # 5-32 Page No.256: Guy Ford, production supervisor for the Winstead company’s Charlottesville plant, is worried about an elderly employee’s ability to keep up the minimum work pace. In addition to the normal daily breaks, this employee stops for short rest periods an average of 4.1 times per hour. The rest period is a fairly consistent 3 minutes each time. Ford has decided that if the probability of the employee resting for 12 minutes (not including normal breaks) or more per hour is greater than 0.5, he will move the employee to a different job. Should he do so? Ans.

Yes, the probability of resting at least 12 minutes is 0.5859

Numerical Problems

Ref. # 5-34 Page No.256: Southwestern Electronics has developed a new calculator that performs a series of functions not yet performed by any other calculator. The marketing department is planning to demonstrate this calculator to a group of potential customers, but it is worried about some initial problems, which have resulted in 4 percent of new calculators developing mathematical inconsistencies. The marketing VP is planning on randomly selecting a group of calculators for this demonstration and is worried about the chances of selecting a calculator that could start malfunctioning. He believes that whether or not a calculator malfunctions is Bernoulli process, and he is convinced that the probability of a malfunctions really about 0.04.

a. Assuming that the VP selects exactly 50 calculators to use in the demonstration, and using the Poisson distribution as an approximation of the binomial, what is the chance of getting at least three calculators that malfunction?

b. No calculators malfunctioning? Ans.

a. 0.3233

b. 0.1353

Chapter 5

5-

Numerical Problems
Ref. # 5-36 Page No.256: The U.S. Bureau of printing and engraving
is responsible for printing this country’s paper money. The BPE has
an impressively small frequency of printing errors; only 0.5 percent of
all bills are too flawed for circulation. What is the probability that out
of a batch of 1000 bills;

a. None are too flawed for circulation?

b. Ten are too flawed for circulation?

c. Fifteen are too flawed for circulation?

Ans.

a. 0.00674

b. 0.01813

c. 0.00016

Poisson Distribution as an Approximation of
the Binomial Distribution
−np
x
e
(
np
)
P
(
X
) =
X !

Poisson Distribution can be a reasonable approximation of the Binomial, but only under certain conditions. These conditions occur when n is large and p is small, that is when The number of trials is large (n 20)and The binomial probability of success is small (p < 0.05).

with above conditions the mean of Poisson can be substituted by mean of binomial i.e. np

Chapter 5

5-

The Hypergeometric Distribution
Probability
Distributions
Discrete
Probability
Distributions
Binomial
Poisson
Hypergeometric
The Hypergeometric Distribution

“n” trials in a sample taken from a finite population of size N

Sample taken without replacement

Outcomes of trials are dependent

Concerned with finding the probability of “X” successes in the sample where there are “A” successes in the population

Chapter 5

5-

Hypergeometric Distribution
Formula
 A   N A 
P(X) =
N 
C n
N
 
n
 
 Where N = population size A = number of successes in the population N – A = number of failures in the population n = sample size X = number of successes in the sample n – X = number of failures in the sample

[

A C

X

][

N

A

C

n

X

]

=

 
 
X
n
X
  
 
Properties of the
Hypergeometric Distribution

The mean of the hypergeometric distribution is

nA
µ = E(x) =
N

The standard deviation is

σ =

nA(N - A)
N-n
N
2 N -1

Where

N-n
N -1

is called the “Finite Population Correction Factor” from sampling without replacement from a finite population

Chapter 5

5-

Using the
Hypergeometric Distribution

Example: 3 different computers are checked from 10 in the department. 4 of the 10 computers have illegal software loaded. What is the probability that 2 of the 3 selected computers have illegal software loaded?

 N = 10 n = 3 A = 4 X = 2
 A   N − A
 4  6 
 
= 0.3
N 
  10 
120
 
n
3
 
  

The probability that 2 of the 3 selected computers have illegal software loaded is 0.30, or 30%.

P(X

=

2)

=

  

X

n

X

=

   

2

1

=

(6)(6)