Académique Documents
Professionnel Documents
Culture Documents
Chocolate Data
Random Variables and Discrete
Probability Distributions
Random variable
A function that assigns numerical values to the
LO 5.1
Random Variables and Discrete
Probability Distributions
Random variables may be classified as:
Discrete
LO 5.1
Random Variables and Discrete
Probability Distributions
Consider an experiment in which two shirts are selected
from the production line and each is either defective (D)
or non-defective (N).
Here is the sample space:
(D,D)
The random variable X is (D,N)
the number of defective shirts. (N,D)
(N,N)
The possible number of
defective shirts is the set {0, 1, 2}.
Since these are the only a countable number of possible
outcomes, this is a discrete random variable.
LO 5.1
Random Variables and Discrete
Probability Distributions
Every random variable is associated with a probability
distribution that describes the variable completely.
A probability mass function is used to describe discrete
random variables.
A probability density function is used to describe
continuous random variables.
A cumulative distribution function may be used to
describe either discrete or continuous random variables.
LO 5.2
Random Variables and Discrete
Probability Distributions
The probability mass function for a discrete random
variable X is a list of the values of X with the associated
probabilities, that is, the list of all possible pairs
x,P X x
The cumulative distribution function for X is defined as
P X x
LO 5.2
Random Variables and Discrete
Probability Distributions
Two key properties of discrete probability distributions:
The probability of each value x is a value between
0 and 1, or equivalently
0 P X x 1
The sum of the probabilities equals 1. In other words,
= =1
where the sum extends over all values x of X.
LO 5.2
EXAMPLE
LO 5.2
Expected Value, Variance, and Standard
Deviation
Summary measures for a random variable
include the
Mean (Expected Value)
Variance
Standard Deviation
LO 5.3
Expected Value, Variance, and Standard
Deviation
Expected Value Population Mean
E(X)
E(X) is the long-run average value of the random variable over
infinitely many independent repetitions of an experiment.
For a discrete random variable X with values x1, x2, x3, . . .
that occur with probabilities P(X = xi), the expected value
of X is the probability weighted average of the values:
E X xi P X x i
LO 5.3
Expected Value, Variance, and Standard
Deviation
Variance and Standard Deviation
For a discrete random variable X with values x1, x2, x3, . . . that
occur with probabilities P(X = xi), the variance is defined as:
Var X xi P X xi
2 2
xi2P X xi 2
The standard deviation is the square root of the variance.
SD X 2
LO 5.3
Expected Value, Variance, and Standard
Deviation
Example: Brad Williams, owner of a car dealership in
Chicago, decides to construct an incentive
compensation program based on performance.
LO 5.3
Expected Value, Variance, and Standard
Deviation
Solution: Let the random variable X denote the bonus
amount (in $1,000s) for an employee.
x P(x)
0 0.05
1 0.05
The probability distribution of 2 0.06
booking of rooms of a hotel in 3 0.10
Waynad during December is: 4 0.13
5 0.20
6 0.15
7 0.26
Total 1.00
pmf (example)
x P(x) x P(x)
0 0.05 0.00
First find the expected value 1 0.05 0.05
7 2 0.06 0.12
E ( X ) xi P ( xi ) 3 0.10 0.30
i 1 4 0.13 0.52
5 0.20 1.00
= 4.71 rooms 6 0.15 0.90
7 0.26 1.82
Total 1.00 = 4.71
pmf (example)
7
V ( X ) 2 [ xi ]2 P ( xi )
The E(X) is then
used to find i 1
the variance: x P(x) x P(x) [x]2 [x]2 P(x)
0.25
The mode is 7 0.20
Probability
rooms rented but 0.15
0.00
0 1 2 3 4 5 6 7
Num ber of Room s Rented
E(X + c) = E(X) + c
E(cX) = cE(X)
We can pull a constant out of the expected value expression (either as part of
a sum with a random variable X or as a coefficient of random variable X).
Example
Monthly sales have a mean of $25,000 and a standard deviation of
$4,000. Profits are calculated by multiplying sales by 30% and
subtracting fixed costs of $6,000.
Find the mean monthly profit.
V(X + c) = V(X)
The variance of a random variable and a constant is just the variance of the
random variable (per 1 above).
V(cX) = c2V(X)
The variance of a random variable and a constant coefficient is the coefficient
squared times the variance of the random variable.
Example
Monthly sales have a mean of $25,000 and a standard deviation of $4,000.
Profits are calculated by multiplying sales by 30% and subtracting fixed costs
of $6,000.
Find the standard deviation of monthly profits.
y y
x x
y y
x x
Strong relationships Weak relationships
y y
x x
y y
x x
No relationship
x
Correlation Coefficient
cov( x, y )
rxy
sx s y
1
cov( x, y ) ( xi x )( yi y )
n
1 1
sx
n
( xi x ) 2
s y
n
( y i y ) 2
Features of correlation coefficient
Unit free
Range between -1.00 and 1.00
-1r<0 implies that as X (), Y ( )
0< r1 implies that as X (), Y ()
The closer to -1.00, the stronger the negative linear relationship
The closer to 1.00, the stronger the positive linear relationship
The closer to 0.00, the weaker the linear relationship
r=0 implies that X and Y are not linearly associated
Examples of Approximate r Values
y y y
x x x
r = -1.00 r = -.60 r = 0.00
y y
x x
r = 0.20 r = 1.00
Portfolio Returns
Investment opportunities often use
Expected return as a measure of reward.
Variance or standard deviation of return as a measure of risk.
A portfolio is defined as a collection of assets such as stocks
and bonds.
Let X and Y represent two random variables of interest, denoting the
returns of two assets.
If an investor has invested in both assets, we want to evaluate the
return generated by the portfolio, which is a linear combination of X
and Y.
Portfolio Returns
Properties of random variables useful in evaluating
portfolio returns.
Given two random variables X and Y,
The expected value of X and Y is
E X Y E X E Y
The variance of X and Y is
Var X Y Var X Var Y 2Cov X ,Y
where Cov(X,Y) is the covariance between X and Y.
For constants a, b, the formulas extend to
E aX bY aE X bE Y
Var aX bY a2Var X b2Var Y 2abCov X ,Y
LO 5.5
Portfolio Returns
Expected return, variance, and standard
deviation of portfolio returns.
Given a portfolio with two assets, Asset A and Asset
B, the expected return of the portfolio E(Rp) is
computed as:
E Rp w AE RA wBE RB
Var Rp w A2 A2 wB 2 B 2 2w AwB AB A B
2 and 2 are the variances of the returns for Asset A and Asset
B
is the covariance between the returns for Asset A and Asset
B
is the correlation coefficient between the returns for Asset A
and Asset B.
LO 5.5
Portfolio Diversification and Asset Allocation
OR
Rp = w1R1 + w2R2 = (.4)(.25) + (.6)(-.10) = .04
Portfolio Diversification and Asset Allocation
An investor has decided to form a portfolio by putting 25% of his money into
McDonalds stock and 75% into Cisco Systems stock. The investor assumes
that the expected returns will be 8% and 15%, respectively, and that the
standard deviations will be 12% and 22%, respectively.
a Find the expected return on the portfolio.
b Compute the standard deviation of the returns on the portfolio assuming
that
(i) the two stocks returns are perfectly positively correlated
(ii) the coefficient of correlation is .5
(iii) the two stocks returns are uncorrelated
Solution
When = 1
V(Rp) = .0281 + .0099(1) = .0380
When = .5
V(Rp) = .0281 + .0099(.5) = .0331
When = 0
V(Rp) = .0281 + .0099(0) = .0281
Portfolios with More Than Two Stocks
We can extend the formulas that describe the mean and variance of the returns of a
portfolio of two stocks to a portfolio of any number of stocks.
k k k
V(Rp ) =
i 1
w w COV(R , R )
w i2 i2 2
i 1 ji 1
i j i j
Where Ri is the return of the ith stock, wi is the proportion of the portfolio invested in stock i, and k is the number of
stocks in the portfolio.
Portfolios with More Than Two Stocks