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**1. Lecture 2: Some Basic Distributions.
**

We start be extending the notion of kurtosis and skewness for random variables.

Let a random variable X, with variance σ

2

and mean µ. The skewness is deﬁned

as

E

_

_

X −µ

σ

_

3

_

and the kurtosis as

E

_

_

X −µ

σ

_

4

_

.

The following Lemma will be useful. It tells us how to derive the pdf of functions

of random variables, whose pdf is known.

Lemma 1. Let X a continuous random variable with pdf f

X

(x) and g a diﬀerentiable

and strictly monotonic function. Then Y = g(X) has the pdf

f

Y

(y) = f

X

(g

−1

(y))

¸

¸

¸

d

dy

g

−1

(y)

¸

¸

¸,

for y such that y = g(x), for some x. Otherwise f

Y

(y) = 0.

Proof. The proof is an easy application of the change of variables and is left as an

exercise.

The following is also a well known fact

Proposition 1. Let X

1

, X

2

, . . . , X

n

independent random variables. Then Var(X

1

+

· · · + X

n

) = Var(X

1

) +· · · + Var(X

n

)

Some important notions are the characteristic function and the moment generat-

ing function of a random variable X. The characteristic function is deﬁned as

φ(t) = E

_

e

itX

¸

, t ∈ R

and the moment generating function, or Laplace transform is deﬁned as

M(t) = E

_

e

tX

¸

, t ∈ R

The importance of these quantinties is that they uniquely deﬁne the corresponding

distribution.

1

2

1.1. Normal Distribution.

Normal distributions are probably the most fundamental ones. The reason for this

lies in the Central Limit Theorem , which states that if X

1

, X

2

, . . . are independent

random variables with mean zero and variance one, then

X

1

+· · · + X

n

√

n

converges in distribution to a standard normal distribution.

The standard normal distribution, often denoted by N(0, 1), is the distribution

with probability density function (pdf)

f(x) =

1

√

2π

e

−

x

2

2

.

The normal distribution with mean µ and variance σ

2

, often denoted by N(µ, σ

2

),

has pdf

f(x) =

1

√

2πσ

2

e

−

(x−µ)

2

2σ

2

.

Let

F(x) =

1

√

2π

_

x

−∞

e

−

y

2

2

dy

be the cumulative function of a N(0, 1) distribution. The q-quantile of the N(0, 1)

distribution is F

−1

(q). The (1 −α)−quantile of the N(0, 1) distribution is denoted

by z

α

. We will see later on that z

α

is widely used for conﬁdence intervals.

The characteristic function of a random variable X with N(µ, σ

2

) distribution is

E

_

e

itX

¸

=

_

∞

−∞

e

itx

1

√

2πσ

2

e

−

(x−µ)

2

2σ

2

dx

= e

−

σ

2

t

2

2

.

1.2. Lognormal Distribution.

Consider a N(µ, σ

2

) random variable Z, then the random variable X = exp(Z)

is said to have a lognormal distribution. In other words X is lognormal if its

logarithm log X has a normal distribution. It is easy to see that the pdf of a

lognormal distribution associated to a N(µ, σ

2

) distribution is

f(x) =

1

x

√

2πσ

2

e

−

(log x−µ)

2

2σ

2

.

The median of the above distribution is exp(µ), while its mean is exp(µ+σ

2

/2). The

mean is larger than the median which indicates that the lognormal distribution is

right skewed. In fact the larger the variance σ

2

of the associated normal distribution,

the more skewed the lognormal distribution is.

3

Lognormal distributions are particularly important in mahtematical ﬁnance, as

it appears in the modelling of returns, where geometric Brownian Motion appears.

We will try to sketch this relation below. For more detailed discussion you can look

at Ruppert: ”Statistics and Finance: An Introduction”, pg. 75-83.

The Net return of an asset measures the changes in prices of assets expressed

as fractions of the initial price. For example if P

t

is the proce of the asset at time t

then the net return at time t is deﬁned as

R

t

=

P

t

P

t−1

−1 =

P

t

−P

t−1

P

t

.

The revenue from holding an asset is

revenue=initial investment× net return.

The simple gross return is

P

t

P

t−1

= R

t

+ 1.

The gross return over a period of k units of time is

1 + R

t

(k) =

P

t

P

t−k

=

P

t

P

t−1

·

P

t−1

P

t−2

· · ·

P

t−k+1

P

t−k

= (1 + R

t

)(1 + R

t−1

) · · · (1 + R

t−k+1

)

Often it is easier to work with log returns (also known as continuously compounded

returns). This is

r

t

= log(1 + R

t

) = log

P

t

P

t−1

By analogy with above the log return over a period of k units of time is

r

t

(k) = r

t

+· · · + r

t−k+1

.

4

A very common assumption in ﬁnance is to assume that the log returns on diﬀerent

times are independent and identically distributed.

By the deﬁnition of the return the price of the asset at time t will be given by the

formula

P

t

= P

0

exp

_

r

t

+· · · + r

1

_

If the distribution of each r

i

is N(µ, σ

2

) then the distribution of the sum in the

above exponential will be N(tµ, tσ

2

). Therefore, the price of the asset at time t will

be a log-normal distribution.

Later on, you will see that is the time increments are taken to be inﬁnitesimal

the sum in the above exponential will approach a Brownian Motion with drift and

then the price of the asset will follow the exponential Brownian Motion.

1.3. Exponential, Laplace, Gamma. The exponential distribution with sclae

parameter θ > 0, often denoted by Exp(θ) has pdf

e

−x/θ

θ

, x > 0,

mean θ and standard deviation θ. The Laplace distribution with mean µ and scale

parameter θ has pdf

e

−|x−µ|

2θ

, x ∈ R.

The standard deviation of the Laplace distribution is

√

2θ.

The Gamma distribution with scale parameter θ and shape parameter α has pdf

θ

−α

Γ(α)

x

α−1

e

−x/θ

, x > 0,

with the normalisation

Γ(α) =

_

∞

0

x

α−1

e

−u

du, α > 0

which is the so called gamma function. Notice that when α = 1 one recovers the

exponential distribution with scale parameter θ.

5

Proposition 2. Consider two independent random variables X

1

, X

2

, gamma dis-

tributed with shape parameters α

1

, α

2

respectively and scale parameters equal to θ.

Then the distribution of X

1

+X

2

is gamma with shape parameter α

1

+α

2

and scale

parameter θ.

The proof uses the following lemma

Lemma 2. If X

1

, X

2

are independent random variables with continuous probability

density functions f

X

1

(x) and f

X

2

(x), then the pdf of X

1

+ X

2

is

f

X

1

+X

2

(x) =

_

f

X

1

(x −y)f

X

2

(y)dy.

Proof. Let formally f

X

1

+X

2

(x) = P(X

1

+ X

2

= x). We know that striclty speaking

the right hand side is zero in the case of a continuous random variable. We think,

though, of this as P(X

1

+ X

2

x). We then have

P(X

1

+ X

2

= x) =

_

P(X

1

+ X

2

= x, X

2

= y)dy

=

_

P(X

1

= x −y, X

2

= y)dy

=

_

P(X

1

= x −y)P(X

2

= y)dy

=

_

f

X

1

(x −y)f

X

2

(y)dy,

where in the last step we used the independence of X

1

, X

2

.

We are now ready for the proof of Proposition 2

6

Proof. For simplicity we will assume that θ = 1. The general case follows along the

same lines. Based on the previous Lemma we have

f

X

1

+X

2

(x) =

_

f

X

1

(x −y)f

X

2

(y)dy

=

_

x

0

(x −y)

α

1

−1

Γ(α

1

)

e

−(x−y)

y

α

2

−1

Γ(α

2

)

e

−y

dy

=

x

α

1

+α

2

−1

Γ(α

1

)Γ(α

2

)

e

−x

_

1

0

(1 −y)

α

1

−1

y

α

2

−1

dy

=

x

α

1

+α

2

−1

Γ(α

1

+ α

2

)

e

−x

The third equality follows from an easy change of variables, while the last from

the well known property of Gamma functions that

_

1

0

(1 −x)

α

1

−1

x

α

2

−1

dx =

Γ(α

1

)Γ(α

2

)

Γ(α

1

+ α

2

)

.

1.4. χ

2

Distribution.

If X is a N(0, 1) random variable, then the distribution of X

2

is called the χ

2

distribution with 1 degree of freedom. Often we denote the χ

2

distribution with

one degree of freedom by χ

2

1

.

It follows easily using Lemma 1, that the χ

2

1

distribution is actually a Gamma

distribution with shape and scale parameters 1/2 and 2, respectively. (Check this !)

If now U

1

, U

2

, . . . , U

n

are independent χ

2

1

distributions, then then distribution of

the sum U

2

1

+ · · · + U

2

n

is called the χ

2

distribution with n degrees of freedom

and is denoted by χ

2

n

.

Since the χ

2

1

is a Gamma(1/2,2) distribution, we know from Proposition 2 that

the χ

2

n

distribution is acutally the Gamma distribution with shape parameter n/2

and scale parameter 2.

The χ

2

distribution is important since it is used to estimate the variance of a

random variable, based on the sample variance as this will be measured in a sampling

process. To see the relevance compare with the deﬁnition of the sample variance as

this is given in Deﬁnition 4 of Lecture 1.

1.5. t-Distribution.

The t-distribution is important when we want to derive conﬁdence intervals (we

will study this later on) for certain parameters of interest, when the (population)

variance of the underlying distribution is not known.At this stage we would need to

7

have a sampling estimate for the (population) variance, thus the t−distribution is

related to the χ

2

distribution.

Let’s proceede with the deﬁnition of the t−distribution. If Z ∼ N(0, 1), and

U ∼ χ

2

n

then the distribution of Z/

_

U/n is called the t-distribution with n

degrees of freedom, often denoted by t

n

.

The pdf of the t−distribution with n degrees of freedom is given by

Γ((n + 1)/2)

_

nπΓ(n/2)

_

1 +

t

2

n

_

−(n+1)/2

To prove this we will need the following lemma

Lemma 3. Let X, Y two continuous random variables with joint pdf f

X,Y

(x, y).

Then the pdf of the quotient Z = Y/X is given by

f

Z

(z) =

_

|x|f

X,Y

(x, xz)dx

Proof.

P

_

Y

X

< z

_

=

_

∞

0

_

zx

−∞

f

XY

(x, y) +

_

0

−∞

_

∞

zx

f

XY

(x, y)

Diﬀerentiating both sides with repsect to z we get

f

Y/X

(z) =

_

∞

0

xf

XY

(x, xz)dx −

_

0

−∞

xf

XY

(x, zx)dx

and the result follows.

The rest is left as an exercise.

As the degrees of freedom n tend to inﬁnity the t

n

distribution approximates the

standard normal distribution. To see this one needs to use the fact that

(1 +

x

2

n + 1

)

(n+1)/2

∼ e

n+1

2n

x

2

∼ e

x

2

/2

and the asymptotics of the Gamma function

Γ(n) ∼

√

2πnn

n

e

−n

.

Recall that when n is an integer Γ(n+1) = n!, so the above is just Stirling’s formula,

but it also holds in the general case that n is not integer.

8

1.6. F-Distribution.

If U, V independent and U ∼ χ

2

n

1

, V ∼ χ

2

n

2

then the distribution of

W =

U/n

1

V/n

2

is called the F-distribution with n

1

, n

2

degrees of freedom. F-distributions are

used in regression analysis. The pdf of the F-distribution is given by

Γ((n

1

+ n

2

)/2)

Γ(n

1

/2)Γ(n

2

/2)

_

n

1

n

2

_

n

1

/2

x

n

1

/2−1

_

1 +

n

1

n

2

x

_

−(n

1

+n

2

)/2

The proof is similar to the derivation of the pdf of the t−distribution and is therefore

left as an exercise.

9

1.7. Heavy-Tailed Distributions.

Distributions with high tail probabilities compared to a normal distribution, with

same mean and variance are called heavy-tailed. In other words a distribution F

with mean zero and variance one is heavy (right) tailed if

1 −F(x)

_

∞

x

e

−x

2

/2

/

√

2π

>> 1, x →+∞

Similar statement holds for the left tail. A heavy-tailed distribution can also be

detected from high kurtosis (why ?)

A heavy-tailed distribution is more prone to extreme values, often called outliers.

In ﬁnance applications one is especially concerned with heavy-tailed returns, since

the possibility of an extreme negative value can deplete the capital reserves of a

ﬁrm.

For example t-distribution is heavy tailed, since its density is proportional to

1

1 + (x

2

/n)

(n+1)/2

∼ |x|

−(n+1)

>> e

−x

2

/2

for large x.

A particular class of heavy-teiled distribution are the Pareto distributions or

simply power law distributions.

These are distributions with pdf

L(x)

|x|

α

.

L(x) is a slowly varying function, that is a function with the property that, for any

constant c,

L(cx)

L(x)

→1, x →∞.

An example of a slowly varying function is log x, or exp

_

(log x)

β

_

, for β < 1. In the

Pareto distribution α > 1, or α = 1 if L(x) decays suﬃciently fast.

1.8. Multivariate Normal Distributions.

The random vector (X

1

, X

2

, . . . , X

n

) ∈ R

n

is said to have a multivariate normal

distribution if for every constant vector (c

1

, c

2

, . . . , c

n

) ∈ R

n

, the distribution of

c

1

X

1

+· · · + c

n

X

n

is normal.

Multivariate normal distributions facilitate modelling on portfolios. A portfolio

is a weighted average of the assets with weights that sum up to one. The weights

specify what fraction of the total investment is allocated to assets.

As in one dimensional normal distributions, the multivariate distribution is de-

termined by the mean

(µ

1

, . . . , µ

n

),

10

with µ

i

= E[X

i

] and the covariance matrix. That is the matric G = (G

i,j

) with

entries

G

ij

= E[X

i

X

j

] −µ

i

, µ

j

.

For simplicity let’s assume that µ

i

= 0, for i = 1, 2 . . . , n. Then the multivariate

normal density function is given by

1

(2π)

n/2

(detG)

1/2

exp

_

−

1

2

< x, G

−1

x >

_

, x ∈ R

n

,

where G

−1

is the inverse of G, detG the determinant of G and < ·, · > denotes the

inner product in R

n

, that is, if x, , y ∈ R

n

, then < x, y >=

n

i=1

x

i

y

i

.

1.9. Exercises.

1 (Logonormal Distributions) Compute the moments of a logonormal distribution

X = e

Z

, with Z a normal N(µ, σ

2

) distribution. In particular compute its mean,

standard deviation, skewness and kurtosis.

2. (Exponentials and Poissons) Exponential distributions often arise in the study

of arrivals, qeueing etc. modeling the time between interarrivals. Consider T to

be the time for the ﬁrst arrival in a system and suppose it has an exponential

distribution with scale parameter 1. Compute P(T > t + s|T > s).

Suppose that the number of arrivals on a system is a Poisson process with pa-

rameter λ. That is

Prob(#{arrivals before time t} = k) = e

−λt

(λt)

k

k!

and arrivals in disjoint time intervals are independent.

What is the distribution of the interarrival times ?

3. Compute the moments of a gamma distribution with shape parameter α and

scale parameter 1.

4. Prove Lemma 1

5. Prove that the distribution of χ

2

1

is a Gamma(1/2,1/2).

6. Show that a heavy tailed distribution has high kurtosis.

7. Derive the pdf of the t−distribution.

8. Compute the kurtosis of (a) N(0, 1), (b) an exponential with scale parameter

one.

9. (Mixture models). Let X

1

∼ N(0, σ

2

1

) and X

2

∼ N(0, σ

2

2

) two independent

normal distribution. Let also Y be another independent random variable with a

Bernoulli distribution, that is P(Y = 1) = p and P(Y = 0) = 1 − p, for some

0 < p < 1.

A. What is the mean and the variance of Z = Y X

1

+ (1 −Y )X

2

?

B. Are the tails of its distribution heavier or lighter when compared to a normal

distribution with the same mean and variance? If so, for what values of p ? Give

also an intuitive explanation of your mathematical derivation

11

Use some statistical software to draw the distribution of the mixture model, for

some values of the parameter p and compare it (especially the tails) with the one of

the corresponding normal.

. then the random variable X = exp(Z) is said to have a lognormal distribution. The characteristic function of a random variable X with N (µ. is the distribution with probability density function (pdf) x2 1 f (x) = √ e− 2 . The reason for this lies in the Central Limit Theorem . which states that if X1 . In other words X is lognormal if its logarithm log X has a normal distribution. then X 1 + · · · + Xn √ n converges in distribution to a standard normal distribution. Consider a N (µ. . x 2πσ 2 The median of the above distribution is exp(µ). are independent random variables with mean zero and variance one. Lognormal Distribution. 1. often denoted by N (µ. σ 2 ) random variable Z. σ 2 ). Normal distributions are probably the most fundamental ones. σ 2 ) distribution is E eitX = (x−µ)2 1 e− 2σ2 dx eitx √ 2πσ 2 −∞ σ 2 t2 2 ∞ = e− . The standard normal distribution. often denoted by N (0. The q-quantile of the N (0. σ 2 ) distribution is (log x−µ)2 1 f (x) = √ e− 2σ2 . 1) distribution. 1). We will see later on that zα is widely used for conﬁdence intervals. X2 . has pdf (x−µ)2 1 f (x) = √ e− 2σ2 . Normal Distribution. 2π The normal distribution with mean µ and variance σ 2 . The mean is larger than the median which indicates that the lognormal distribution is right skewed. In fact the larger the variance σ 2 of the associated normal distribution. . The (1 − α)−quantile of the N (0.2.1. the more skewed the lognormal distribution is. It is easy to see that the pdf of a lognormal distribution associated to a N (µ. 1) distribution is F −1 (q). while its mean is exp(µ+σ 2 /2). 2πσ 2 Let x y2 1 √ e− 2 dy F (x) = 2π −∞ be the cumulative function of a N (0.2 1. . 1) distribution is denoted by zα .

. The simple gross return is Pt = Rt + 1. For more detailed discussion you can look at Ruppert: ”Statistics and Finance: An Introduction”. Pt−1 The gross return over a period of k units of time is Pt Pt Pt−1 Pt−k+1 1 + Rt (k) = = · ··· Pt−k Pt−1 Pt−2 Pt−k = (1 + Rt )(1 + Rt−1 ) · · · (1 + Rt−k+1 ) Often it is easier to work with log returns (also known as continuously compounded returns). 75-83. We will try to sketch this relation below. where geometric Brownian Motion appears. as it appears in the modelling of returns. For example if Pt is the proce of the asset at time t then the net return at time t is deﬁned as Pt Pt − Pt−1 Rt = −1= . Pt−1 Pt The revenue from holding an asset is revenue=initial investment× net return. The Net return of an asset measures the changes in prices of assets expressed as fractions of the initial price. This is Pt rt = log(1 + Rt ) = log Pt−1 By analogy with above the log return over a period of k units of time is rt (k) = rt + · · · + rt−k+1 . pg.3 Lognormal distributions are particularly important in mahtematical ﬁnance.

Γ(α) with the normalisation ∞ x > 0. Therefore. Laplace. By the deﬁnition of the return the price of the asset at time t will be given by the formula Pt = P0 exp rt + · · · + r1 If the distribution of each ri is N (µ. Exponential. θ x > 0. you will see that is the time increments are taken to be inﬁnitesimal the sum in the above exponential will approach a Brownian Motion with drift and then the price of the asset will follow the exponential Brownian Motion. tσ 2 ). 1. Γ(α) = 0 xα−1 e−u du.3. α>0 which is the so called gamma function. the price of the asset at time t will be a log-normal distribution. Gamma. mean θ and standard deviation θ. Notice that when α = 1 one recovers the exponential distribution with scale parameter θ. √ The standard deviation of the Laplace distribution is 2θ.4 A very common assumption in ﬁnance is to assume that the log returns on diﬀerent times are independent and identically distributed. The exponential distribution with sclae parameter θ > 0. σ 2 ) then the distribution of the sum in the above exponential will be N (tµ. Later on. The Laplace distribution with mean µ and scale parameter θ has pdf e−|x−µ| . . 2θ x ∈ R. The Gamma distribution with scale parameter θ and shape parameter α has pdf θ−α α−1 −x/θ x e . often denoted by Exp(θ) has pdf e−x/θ .

We think. Consider two independent random variables X1 . We know that striclty speaking the right hand side is zero in the case of a continuous random variable. We are now ready for the proof of Proposition 2 . X2 are independent random variables with continuous probability density functions fX1 (x) and fX2 (x). X2 = y)dy P (X1 = x − y. gamma distributed with shape parameters α1 . where in the last step we used the independence of X1 . α2 respectively and scale parameters equal to θ. then the pdf of X1 + X2 is fX1 +X2 (x) = fX1 (x − y)fX2 (y)dy. The proof uses the following lemma Lemma 2.5 Proposition 2. Let formally fX1 +X2 (x) = P (X1 + X2 = x). X2 = y)dy P (X1 = x − y)P (X2 = y)dy fX1 (x − y)fX2 (y)dy. Proof. though. If X1 . X2 . We then have P (X1 + X2 = x) = = = = P (X1 + X2 = x. of this as P (X1 + X2 x). Then the distribution of X1 + X2 is gamma with shape parameter α1 + α2 and scale parameter θ. X2 .

χ2 Distribution. respectively. The t-distribution is important when we want to derive conﬁdence intervals (we will study this later on) for certain parameters of interest. then the distribution of X 2 is called the χ2 distribution with 1 degree of freedom. If X is a N (0. then then distribution of 1 2 2 the sum U1 + · · · + Un is called the χ2 distribution with n degrees of freedom and is denoted by χ2 . U2 . based on the sample variance as this will be measured in a sampling process. . when the (population) variance of the underlying distribution is not known. Γ(α1 + α2 ) 1. t-Distribution.4. 1) random variable. To see the relevance compare with the deﬁnition of the sample variance as this is given in Deﬁnition 4 of Lecture 1. Often we denote the χ2 distribution with one degree of freedom by χ2 . For simplicity we will assume that θ = 1. 1.At this stage we would need to . The general case follows along the same lines. that the χ2 distribution is actually a Gamma 1 distribution with shape and scale parameters 1/2 and 2. n Since the χ2 is a Gamma(1/2.6 Proof. (Check this !) If now U1 . we know from Proposition 2 that 1 the χ2 distribution is acutally the Gamma distribution with shape parameter n/2 n and scale parameter 2. Based on the previous Lemma we have fX1 +X2 (x) = = 0 fX1 (x − y)fX2 (y)dy x (x − y)α1 −1 −(x−y) y α2 −1 −y e e dy Γ(α1 ) Γ(α2 ) 1 xα1 +α2 −1 −x e Γ(α1 )Γ(α2 ) xα1 +α2 −1 −x = e Γ(α1 + α2 ) = (1 − y)α1 −1 y α2 −1 dy 0 The third equality follows from an easy change of variables. 1 It follows easily using Lemma 1. . . The χ2 distribution is important since it is used to estimate the variance of a random variable. . Un are independent χ2 distributions. while the last from the well known property of Gamma functions that 1 (1 − x)α1 −1 xα2 −1 dx = 0 Γ(α1 )Γ(α2 ) .2) distribution.5.

so the above is just Stirling’s formula. thus the t−distribution is related to the χ2 distribution. often denoted by tn . The pdf of the t−distribution with n degrees of freedom is given by Γ((n + 1)/2) nπΓ(n/2) t2 1+ n −(n+1)/2 To prove this we will need the following lemma Lemma 3. The rest is left as an exercise.7 have a sampling estimate for the (population) variance. If Z ∼ N (0. xz)dx = 0 −∞ fXY (x. . 1). y). As the degrees of freedom n tend to inﬁnity the tn distribution approximates the standard normal distribution. Let’s proceede with the deﬁnition of the t−distribution. P Y <z X ∞ zx 0 ∞ |x|fX. but it also holds in the general case that n is not integer. Then the pdf of the quotient Z = Y /X is given by fZ (z) = Proof. Y two continuous random variables with joint pdf fX. and U ∼ χ2 then the distribution of Z/ U/n is called the t-distribution with n n degrees of freedom. zx)dx and the result follows. Recall that when n is an integer Γ(n+1) = n!.Y (x. y) + −∞ zx fXY (x. Let X. y) Diﬀerentiating both sides with repsect to z we get ∞ 0 fY /X (z) = 0 xfXY (x. xz)dx − −∞ xfXY (x. To see this one needs to use the fact that n+1 2 x2 (n+1)/2 2 ) ∼ e 2n x ∼ ex /2 (1 + n+1 and the asymptotics of the Gamma function √ Γ(n) ∼ 2πnnn e−n .Y (x.

V independent and U ∼ χ2 1 . F-distributions are used in regression analysis. n2 degrees of freedom. If U.8 1. The pdf of the F -distribution is given by Γ((n1 + n2 )/2) Γ(n1 /2)Γ(n2 /2) n1 n2 n1 /2 x n1 /2−1 n1 1+ x n2 −(n1 +n2 )/2 The proof is similar to the derivation of the pdf of the t−distribution and is therefore left as an exercise.6. V ∼ χ2 2 then the distribution of n n W = U/n1 V /n2 is called the F-distribution with n1 . . F-Distribution.

. These are distributions with pdf L(x) . or exp (log x)β . the distribution of c1 X1 + · · · + cn Xn is normal. x → +∞ Similar statement holds for the left tail. Xn ) ∈ Rn is said to have a multivariate normal distribution if for every constant vector (c1 . that is a function with the property that. since the possibility of an extreme negative value can deplete the capital reserves of a ﬁrm. .8. Heavy-Tailed Distributions. the multivariate distribution is determined by the mean (µ1 . . . . for any constant c. As in one dimensional normal distributions. x → ∞. 1. .7. . Multivariate normal distributions facilitate modelling on portfolios. cn ) ∈ Rn . often called outliers. L(cx) → 1. . In ﬁnance applications one is especially concerned with heavy-tailed returns. . For example t-distribution is heavy tailed. µn ). A heavy-tailed distribution can also be detected from high kurtosis (why ?) A heavy-tailed distribution is more prone to extreme values. L(x) An example of a slowly varying function is log x. Distributions with high tail probabilities compared to a normal distribution. since its density is proportional to 1 2 ∼ |x|−(n+1) >> e−x /2 2 /n)(n+1)/2 1 + (x for large x. . A portfolio is a weighted average of the assets with weights that sum up to one. . or α = 1 if L(x) decays suﬃciently fast. Multivariate Normal Distributions. The weights specify what fraction of the total investment is allocated to assets.9 1. The random vector (X1 . X2 . In other words a distribution F with mean zero and variance one is heavy (right) tailed if ∞ −x2 /2 √ e / 2π x 1 − F (x) >> 1. for β < 1. . . |x|α L(x) is a slowly varying function. A particular class of heavy-teiled distribution are the Pareto distributions or simply power law distributions. with same mean and variance are called heavy-tailed. In the Pareto distribution α > 1. c2 .

σ1 ) and X2 ∼ N (0. 1). modeling the time between interarrivals. . that is P (Y = 1) = p and P (Y = 0) = 1 − p. then < x. That is the matric G = (Gi. 2 . Let X1 ∼ N (0.j ) with entries Gij = E[Xi Xj ] − µi . Derive the pdf of the t−distribution. 1 6. . σ 2 ) distribution. Suppose that the number of arrivals on a system is a Poisson process with parameter λ. That is P rob(#{arrivals before time t} = k) = e−λt (λt)k k! and arrivals in disjoint time intervals are independent. µj . if x. (b) an exponential with scale parameter one. n. A. . 7.1/2). Are the tails of its distribution heavier or lighter when compared to a normal distribution with the same mean and variance? If so. 2 2 9. 4.10 with µi = E[Xi ] and the covariance matrix. i=1 1. What is the mean and the variance of Z = Y X1 + (1 − Y )X2 ? B. G−1 x > . for i = 1. qeueing etc. Let also Y be another independent random variable with a Bernoulli distribution.9. 2 x ∈ Rn . skewness and kurtosis. that is. detG the determinant of G and < ·. for some 0 < p < 1. 2. Prove that the distribution of χ2 is a Gamma(1/2. · > denotes the inner product in Rn . . where G−1 is the inverse of G. standard deviation. for what values of p ? Give also an intuitive explanation of your mathematical derivation . (Exponentials and Poissons) Exponential distributions often arise in the study of arrivals. y ∈ Rn . Compute the moments of a gamma distribution with shape parameter α and scale parameter 1. Compute P (T > t + s|T > s). y >= n xi yi . Exercises. 1 (Logonormal Distributions) Compute the moments of a logonormal distribution X = eZ . (Mixture models). Show that a heavy tailed distribution has high kurtosis. σ2 ) two independent normal distribution. For simplicity let’s assume that µi = 0. What is the distribution of the interarrival times ? 3. 8. Then the multivariate normal density function is given by 1 (2π)n/2 (detG)1/2 1 exp − < x. Compute the kurtosis of (a) N (0. Consider T to be the time for the ﬁrst arrival in a system and suppose it has an exponential distribution with scale parameter 1. with Z a normal N (µ. In particular compute its mean. Prove Lemma 1 5.

11 Use some statistical software to draw the distribution of the mixture model. for some values of the parameter p and compare it (especially the tails) with the one of the corresponding normal. .

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