Quantitative methods for finance

Lecture 2

Serafeim Tsoukas

Probability
Probability underlies statistical inference the
drawing of conclusions from a sample of data.

If samples are drawn at random, their

characteristics (such as the sample mean) depend
upon chance.
Hence to understand how to interpret sample
evidence, we need to understand chance, or
probability.

The definition of probability

The probability of an event A may defined in
different ways:

The frequentist view: the proportion of trials in

which the event occurs, calculated as if the
number of trials approaches infinity.
The subjective view: someones degree of belief
about the likelihood of an event occurring.

Some vocabulary
An experiment: an activity such as tossing a coin,
which has a range of possible outcomes.
A trial: a single performance of the experiment.

The sample space: all possible outcomes of the

experiment. For a single toss of a coin, the
sample space is {heads, tails}.

Probabilities
With each outcome in the sample space we can
associate a probability (calculated according to
either the frequentist or subjective view).
Pr(heads) = 1/2
Pr(tails) = 1/2.
This is an example of a probability distribution
(more detail in Chapter 3).

Rules for probabilities

0 Pr(A) 1

p 1 , summed over all outcomes

Pr(not-A) = 1 Pr(A)
The complement
of the event A

Examples: picking a card from a pack

The probability of picking any one card
from a pack (e.g. king of spades) is 1/52.
This is the same for each card.
Summing over all cards: 1/52 + 1/52 + = 1.
Pr(not-king of spades) = 51/52 = 1 Pr(king of
spades).

Compound events
Often we need to calculate more complicated
probabilities:

What is the probability of drawing any spade?

What is the probability of throwing a double six
with two dice?
What is the probability of collecting a sample of
people whose average IQ is greater than 100?

These are compound events.

Rules for calculating compound probabilities

1. The addition rule: the or rule
Pr(A or B) = Pr(A) + Pr(B)
The probability of rolling a five or six on a single
roll of a die is
Pr(5 or 6) = Pr(5) + Pr(6) = 1/6 + 1/6 = 1/3.

A slight complication
If A and B can simultaneously occur, the previous
formula gives the wrong answer

Pr(king or heart) = 4/52 + 13/52 = 17/52

This double counts the king of hearts

16 dots highlighted.
A

10

Spades

Hearts

Diamonds

Clubs

A slight complication (Continued)

We therefore subtract the king of hearts:

Pr(king or heart) = 4/52 + 13/52 1/52 = 16/52.

The formula is therefore

Pr(A or B) = Pr(A) + Pr(B) Pr(A and B).

When A and B cannot occur simultaneously, Pr(A

and B) = 0.

The multiplication rule

When you want to calculate Pr(A and B):

Pr(A and B) = Pr(A) Pr(B).

The probability of obtaining a double-six when

rolling two dice is

Pr(Six and Six) = Pr(Six) Pr(Six)

= 1/6 1/6 = 1/36.

This

is very unlikely!

Another slight complication:

independence
Pr(drawing two aces from a pack of cards, without
replacement).
If the first card drawn is an ace (P = 4/52), that
leaves 51 cards, of which 3 are aces.

The probability of drawing the second ace is 3/51,

different from the probability of drawing the first ace.
They are not independent events. The probability
changes.
Pr(two aces) = 4/52 3/51 = 1/221.

Conditional probability
3/51 is the probability of drawing an ace given
that an ace was drawn as the first card.
This is the conditional probability and is written
Pr(Second ace | ace on first draw).
To simplify notation write as Pr(A2|A1).
This is the probability of event A2 occurring, given
A1 has occurred.

Conditional probability (Continued)

Consider Pr(A2 | not-A1)
A not-ace is drawn first, leaving 51 cards of
which 4 are aces
Hence Pr(A2 | not-A1) = 4/51
So Pr(A2 | not-A1) Pr(A2 | A1)

They are not independent events.

The multiplication rule again

The general rule is

Pr(A and B) = Pr(A) Pr(B|A).

For independent events

Pr(B|A) = Pr(B|not-A) = Pr(B)

and so

Pr(A and B) = Pr(A) Pr(B).

Combining the rules

Pr(1 head in two tosses)
= Pr( [H and T] or [T and H] )
= Pr( [H and T] ) + Pr( [T and H] )
= [1/2 1/2] + [1/2 1/2]
= 1/4 + 1/4 = 1/2.

The tree diagram

H
H

{H,H} P = 1/4

{H,T} P = 1/4
P=

{T,H} P = 1/4
{T,T} P = 1/4

But it gets complicated quickly

Pr(3 heads in 5 tosses)?
Pr(30 heads in 50 tosses)?

How many routes? Drawing takes too much time,

we need a formula.

The Binomial distribution

If we define P as the probability of heads, and
hence (1 P) is the probability of tails, we can
write:

Pr(1 head) = P1 (1 P)1 2C1

or, in general

Pr(r heads) = Pr (1 P)(nr) nCr.

This is the formula for the Binomial distribution.

Example
P(3 heads in 5 tosses):

n = 5, r = 3, P =

Pr(3 heads) = Pr (1 P)(n r) nCr

= 3 (1 )2 5C3
= 1/8 1/4 5!/(3! 2!)
= 10/32.

Bayes Theorem
A ball is drawn at random from one of the boxes
below. It is red.

Box A

Box B

Intuitively, it seems more likely to have come

from Box A. But what is the precise probability?
Bayes theorem answers this question.

Solution
We require Pr(A|R). This can be written:
Pr( A and R)
Pr( A | R)
Pr(R)

Expanding top and bottom we have:

Pr(R | A) Pr( A)
Pr( A | R)
Pr(R | A) Pr( A) Pr(R | B) Pr(B)

We now have the answer in terms of probabilities

we can evaluate.

Solution (Continued)
Hence we obtain:
6 / 10 0.5
2
Pr( A | R)

6 / 10 0.5 3 / 10 0.5 3

There is a 2/3 probability that the ball was taken

from Box A.
A similar calculation yields Pr(B|R) = 1/3.
These are the posterior probabilities. The prior
probabilities were , .

Prior and posterior probabilities

Prior probabilities: Pr(A), Pr(B)
Likelihoods: Pr(R|A), Pr(R|B)
Posterior probabilities: Pr(A|R), Pr(B|R)
likelihood prior probability
posterior probability =
likelihood prior probability

Table of likelihoods and probabilities

Prior probabilities

Likelihoods

0.5

0.6

0.30

0.30/0.45 2/3

0.5

0.3

0.15

0.15/0.45 1/3

Total

Prior likelihood Posterior probabilities

0.45

The posterior probabilities are calculated as 2/3

and 1/3, as before.

Summary
Probability underlies statistical inference.
There are rules (e.g. the multiplication rule) for
calculating probabilities.
Independence simplifies the rules.
These rules lead on to probability distributions
such as the Binomial.

Bayes theorem tells us how to update

probabilities in the light of evidence.

Hypothesis testing
Hypothesis testing is about making decisions.
Is a hypothesis true or false?
e.g. are women paid less, on average, than men?

Principles of hypothesis testing

The null hypothesis is initially presumed to be true.

Evidence is gathered, to see if it is consistent with the

hypothesis.
If it is, the null hypothesis continues to be considered
true (later evidence might change this).
If not, the null is rejected in favour of the alternative
hypothesis.

Two possible types of error

Decision making is never perfect and mistakes
can be made

Type I error: rejecting the null when true

Type II error: accepting the null when false.

Type I and Type II errors

True situation
Decision

H0 true

H0 false

Accept H0

Correct
decision

Type II error

Type I error

Correct
decision

Reject H0

Avoiding incorrect decisions

We wish to avoid both Type I and II errors.
We can alter the decision rule to do this.
Unfortunately, reducing the chance of making a
Type I error generally means increasing the
chance of a Type II error.

Hence a trade-off.

Diagram of the decision rule

f x

H1

H0

Type II error

Type I
error

x
Rejection region

xD

Non-rejection region

How to make a decision

Where do we place the decision line?
Set the Type I error probability to a particular
value. By convention, this is 5%.
This is known as the significance level of the test.
It is complementary to the confidence level of
estimation.
5% significance level 95% confidence level.

Example: How long do LEDs last?

A manufacturer of LEDs claims its product lasts
at least 5,000 hours, on average.
A sample of 50 LEDs is tested. The average time
before failure is 4,900 hours, with standard
deviation 500 hours.

Should the manufacturers claim be accepted or

rejected?

The hypotheses to be tested

H0: m = 5,000
H1: m < 5,000
This is a one-tailed test, since the rejection region
occupies only one side of the distribution.

Should the null hypothesis be rejected?

Is 4,900 far enough below 5,000?
Is it more than 1.64 standard errors below 5,000?
(1.64 standard errors below the mean cuts off the
bottom 5% of the Normal distribution).
z

xm
2

s n

4,900 5,000
2

500 80

1.79

Should the null hypothesis be rejected? (Continued)

4,900 is 1.79 standard errors below 5,000, so falls into the
rejection region (bottom 5% of the distribution)
Hence, we can reject H0 at the 5% significance level or,
equivalently, with 95% confidence.
If the true mean were 5,000, there is less than a 5%
chance of obtaining sample evidence such as
from a sample of n = 80.

x 4,900

Formal layout of a problem

1. H0: m = 5,000
H1: m < 5,000
2. Choose significance level: 5%

3. Look up critical value: z* = 1.64

4. Calculate the test statistic: z = 1.79

5. Decision: reject H0 since 1.79 < 1.64 and falls

into the rejection region.

One- versus two-tailed tests

Should you use a one-tailed (H1: m < 5,000) or twotailed (H1: m 5,000) test?
If you are only concerned about falling one side of the
hypothesised value (as here: we would not worry if
LEDs lasted longer than 5,000 hours) use the onetailed test. You would not want to reject H0 if the
sample mean were anywhere above 5,000.
If for another reason, you know one side is impossible
(e.g. demand curves cannot slope upwards), use a
one-tailed test.

One- versus two-tailed tests (Continued)

Otherwise, use a two-tailed test.
If unsure, choose a two-tailed test.

Never choose between a one- or two-tailed test on

the basis of the sample evidence (i.e. do not
choose a one-tailed test because you notice that
4,900 < 5,000).
The hypothesis should be chosen before looking
at the evidence!

Two-tailed test example

It is claimed that an average child spends 15
hours per week watching television. A survey of
100 children finds an average of 14.5 hours per
week, with standard deviation 8 hours. Is the
claim justified?
The claim would be wrong if children spend either
more or less than 15 hours watching TV. The
rejection region is split across the two tails of the
distribution. This is a two-tailed test.

A two-tailed test diagram

f x
H1

H0

2.5%

H1

2.5%

x
Reject H0

Reject H0

Solution to the problem

1. H0: m = 15
H1: m 15
2. Choose significance level: 5%

3. Look up critical value: z* = 1.96

4. Calculate the test statistic:

xm
2

s n

14.5 15
2

0.625

8 100

5. Decision: we do not reject H0 since 0.625 < 1.96 and

does not fall into the rejection region.

The choice of significance level

Why 5%?
Like its complement, the 95% confidence level, it
is a convention. A different value can be chosen,
but it does set a benchmark.
If the cost of making a Type I error is especially
high, then set a lower significance level, e.g. 1%.
The significance level is the probability of making
a Type I error.

The prob-value approach

An alternative way of making the decision
Returning to the LED problem, the test statistic z
= 1.79 cuts off 3.67% in the lower tail of the
distribution. 3.67% is the prob-value for this
example

Since 3.67% < 5% the test statistic must fall into

the rejection region for the test.

Two ways to rejection

Reject H0 if either

z < z*

(1.79 < 1.64)

or

the prob-value < the significance level

(3.67% < 5%).

Testing a proportion
Same principles: reject H0 if the test statistic falls
into the rejection region.
To test H0: = 0.5 versus H1: 0.5 (e.g. a coin
is fair or not) the test statistic is

1
n

p 0.5
0.51 0.5
n

Testing a proportion (Continued)

If the sample evidence were 60 heads from 100
tosses (p = 0.6) we would have

0.6 0.5
2
0.51 0.5
100

so we would (just) reject H0 since 2 > 1.96.

Testing the difference of two means

To test whether two samples are drawn from
populations with the same mean
H0: m1 = m2 or H0: m1 m2 = 0
H1: m1 m2 or H1: m1 m2 0
The test statistic is

x1 x2 m1 m 2
z
s12 s22

n1 n2

Testing the difference of two proportions

To test whether two sample proportions are equal
H0: 1 = 2 or H0: 1 2 = 0
H1: 1 2 or H1: 1 2 0
The test statistic is

p1 p2 1 2
1 1

n1

n2

n1 p1 n2 p2

n1 n2

Small samples (n < 25)

Two consequences:

the t distribution is used instead of the standard

normal for tests of the mean

xm
s2 n

~ t n 1

tests of proportions cannot be done by the standard

methods used in the book.

Testing a mean
A sample of 12 cars of a particular make average
35 mpg, with standard deviation 15. Test the
manufacturers claim of 40 mpg as the true
average.
H0: m = 40
H1: m < 40.

Testing a mean (Continued)

The test statistic is
t

35 40
2

1.15

15 12

The critical value of the t distribution (df = 11, 5%

significance level, one tail) is t* = 1.796.
Hence we cannot reject the manufacturers claim.

Testing the difference of two means

The test statistic is

x1 x1 m1 m 2
t
S2 S2

n1 n2

where S2 is the pooled variance

2
2

1
s

1
s
1
2
2
S2 1

n1 n2 2

Summary
The principles are the same for all tests: calculate
the test statistic and see if it falls into the rejection
region.
The formula for the test statistic depends upon
the problem (mean, proportion, etc).
The rejection region varies, depending upon
whether it is a one or two-tailed test.