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Published by Amber Habib

An introduction to probability and statistics, from basic probability to sampling distributions and confidence intervals.

An introduction to probability and statistics, from basic probability to sampling distributions and confidence intervals.

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ICICI Centre for Mathematical Sciences

Mathematical Finance 2004-5

A Probability Primer

Dr Amber Habib

We will sum up the most essential aspects of Probability, and the transitionto Statistical Inference. We avoid technical distractions. The gaps we leavecan be ﬁlled in by consulting one of the references provided at the end.The ﬁgures have been produced using

Mathematica

.

Contents

1 Sample Space, Random Variables 22 Probability 33 Probability Distributions 44 Binomial Distribution 75 Normal Distribution 96 Expectation 117 Variance 138 Lognormal Distribution 179 Bivariate Distributions 1810 Conditional Probability and Distributions 2111 Independence 2412 Chi Square Distribution 2513 Random Samples 2614 Sample Mean and Variance 2815 Large Sample Approximations 29

1

1 SAMPLE SPACE, RANDOM VARIABLES

2

16 Point Estimation 3217 Method of Moments 3318 Maximum Likelihood Estimators 3419 Sampling Distributions 3620 Conﬁdence Intervals 41

1 Sample Space, Random Variables

The

sample space

is the collection of objects whose statistical propertiesare to be studied. Each such object is called an

outcome

, and a collectionof outcomes is called an

event

.

•

Mathematically, the sample space is a set, an outcome is a member of thisset, and an event is a subset of it.For example, our sample space may be the collection of stocks listed onthe National Stock Exchange. We may ask statistical questions about thisspace, such as: What is the average change in the value of a listed stock(an outcome) over the past year? Alternately, our sample space might bethe history of a single stock: All its daily closing prices, say, over the last5 years. Our question might be: What is the average weekly change of thevalue over the last year? Or, how large is the variation in the prices over its5 year history? We could ask more subtle questions: How likely is it that thestock will have a sudden fall in value over the next month?

•

Typical notation is to use

S

for sample space, lower case letters such as

x

for individual outcomes, and capital letters such as

E

for events.In a particular context, we would be interested in some speciﬁc numericalproperty of the outcomes: such as the closing price on October 25, 2004,of all the stocks listed on the NSE. This property allots a number to eachoutcome, so it can be viewed as a function whose domain is the sample space

S

and range is in the real numbers

R

.

•

A function

X

:

S

→

R

is called a

random variable

.

2 PROBABILITY

3Our interest is in taking a particular random variable

X

and studying howits values are distributed. What is the average? How much variation is therein its values? Are very large values unlikely enough to be ignored?

2 Probability

We present two viewpoints on the meaning of probability. Both are relevantto Finance and, interestingly, they lead to the same mathematical deﬁnitionof probability!

Viewpoint 1:

The probability of an event should predict the relative fre-quency of its occurrence. That is, suppose we say the probability of a randomstock having increased in value over the last month is 0.6. Then, if we lookat 100 diﬀerent stocks, about 60 of them should have increased in value. Theprediction should be more accurate if we look at larger numbers of stocks.

Viewpoint 2:

The probability of an event reﬂects our (subjective) opinionabout how likely it is to occur, in comparison to other events. Thus, if weallot probability 0.4 to event

A

and 0.2 to event

B

, we are expressing theopinion that

A

is twice as likely as

B

.Viewpoint 1 is appropriate when we are analyzing the historical data topredict the future. Viewpoint 2 is useful in analyzing how an individual mayact when faced with certain information. Both viewpoints are captured bythe following mathematical formulation:

•

Let

A

be the collection of all subsets of the sample space

S

: we call it the

event algebra

.

•

A

probability function

is a function

P

:

A→

[0

,

1] such that:1.

P

(

S

) = 1.2.

P

∞

i

=1

E

i

=

∞

i

=1

P

(

E

i

), if the

E

i

are pairwise disjoint events (i.e.,

i

=

j

implies

E

i

∩

E

j

=

∅

).Let

P

:

A →

[0

,

1] be a probability function. Then it automatically has thefollowing properties:

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