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Mean Variance portfolio theory explained

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You are on page 1of 30

**Expectation, variance, covariance, correlation
**

Expectation

• Discrete RV - weighted average

• Continuous RV - use integral to take the weighted average

Variance

• Variance is the average of (X −µ)

2

• Standard deviation

Covariance and correlation

• Covariance is the average of (X −µ

X

)(Y −µ

Y

)

• Correlation is a scaled version of covariance

Lots of examples

PHP 2510 – Oct 8, 2008 1

Expected value

Synonyms for expected value: ‘average’, ‘mean’

The expectation or expected value of a random variable X is a

weighted average of its possible outcomes.

For a discrete random variable, each outcome is weighted by its

probability of occurrence, using the mass function:

E(X) =

i

x

i

· P(X = x

i

) =

i

x

i

p(x

i

)

For a continuous random variable, each outcome is weighted by the

relative frequency of its occurrence, using the density function:

E(X) =

_

x f(x) dx

PHP 2510 – Oct 8, 2008 2

Examples: Discrete random variables

Example 1. Let X denote the number of boys in a family with

three children. Assume the probability of having a boy is .5.

Step 1: Compute the mass function

k p(k)

0 .125

1 .375

2 .375

3 .125

Step 2: Compute weighted average

E(X) =

3

k=0

k p(k)

= (0)(.125) + (1)(.375) + (2)(.375) + (3)(.125)

= 1.5

PHP 2510 – Oct 8, 2008 3

Example 2: Roulette. In roulette, a ball is tossed on a spinning

wheel, and it lands on one of 38 numbers (each of 1 to 36, plus 0

and 00). If you bet $1 on a particular number, the payoﬀ for

winning is $36.

Suppose you bet $1 on the number 12. Deﬁne the random variable

X to be your winnings on one play of the roulette wheel. Then

X =

_

_

_

36 if the number is 12

−1 if the number is not 12

Find E(X), or your expected winnings.

PHP 2510 – Oct 8, 2008 4

Step 1: Compute mass function

k p(k)

36

1

38

–1

37

38

Step 2: Compute E(X) as weighted average of outcomes

E(X) =

k=−1,36

k p(k)

= (−1)

_

37

38

_

+ (36)

_

1

38

_

= −0.026

Question: What the expected return in 100 plays of roulette?

PHP 2510 – Oct 8, 2008 5

Expected value for common discrete RV’s

Binomial. If X has the binomial distribution with parameters n

and π, then E(X) = nπ.

Example: Toss a coin 50 times, and let X denote the number of

heads. Then

E(X) = nπ = 50 ×.5 = 25

Example: The proportion of individuals with coronary artery

disease is .3. In a sample of 45 individuals, what is the

expected number of cases of CAD?

E(X) = nπ = 45 ×.3 = 13.5

Suppose one person is selected from the population. Deﬁne a

random variable Y such that Y = 1 if the person has CAD and

Y = 0 if not. Then

E(Y ) = nπ = 1 ×.3 = .3

PHP 2510 – Oct 8, 2008 6

Poisson. If X has the Poisson distribution with rate parameter λ,

then E(X) = λ. This is because

E(X) =

∞

k=0

k

_

e

−λ

λ

k

k!

_

= λ

The mean of a Poisson RV is the number of events you expect to

observe.

PHP 2510 – Oct 8, 2008 7

Geometric. If X has the Geometric distribution with success

probability π, then E(X) = 1/π. This is because

E(X) =

∞

k=1

k

_

(1 −π)

k−1

π

_

=

1

π

The mean of a geometric RV is the number of trials you expect to

require before observing the ﬁrst success. Hence if the success

probability π is low, E(X) will be high; and vice-versa.

Example. If you roll two dice, the probability of rolling a 3 is 2/36

or about 0.56. Let X denote the number of rolls until a 3 comes

up. What is E(X)? (Ans: 18)

PHP 2510 – Oct 8, 2008 8

Expected value for continuous RV

Let X be a continuous random variable deﬁned on an interval A.

Then the expected value is a weighted average of outcomes,

weighted by the relative frequency of each outcome. The weighted

average is computed using an integral,

E(X) =

_

A

x f(x) dx

PHP 2510 – Oct 8, 2008 9

Example. Suppose X is a uniform random variable on the interval

[1, 4]. Find E(X).

Step 1: Recall that f(x) =

1

4−1

=

1

3

, and that the interval A is

[1, 4]. So the appropriate integral is

_

4

1

x f(x) dx =

_

4

1

x

1

3

dx

Step 2: Evaluate the integral

_

4

1

x

1

3

dx =

1

3

x

2

2

¸

¸

¸

¸

4

1

= 2.5

PHP 2510 – Oct 8, 2008 10

Expected values for common continuous RV’s

Normal. If X has a normal distribution with parameters µ and σ,

then E(X) = µ.

Exponential. If X has the exponential distribution with

parameter θ, then E(X) = θ. In this case, θ is the expected waiting

time until an event occurs, and 1/θ is called the event rate.

PHP 2510 – Oct 8, 2008 11

Some properties of expected values.

1. Linear combinations. If a and b are constants, then

E(aX +b) = aE(X) +b

2. Sums of random variables. The expected value of a sum of

random variables is the sum of expected values.

E(X

1

+X

2

+ · · · +X

n

) = E(X

1

) +E(X

2

) + · · · +E(X

n

)

PHP 2510 – Oct 8, 2008 12

Example. Suppose X is a Poisson random variable denoting the

number of lottery winners per week. Its expected value is

E(X) = 2. What is the expected number of winners over 4 weeks?

E(4X) = 4 ×E(X) = 4 × 2 = 8

Example. Let X denote the daily low temperature for each day in

September, and let E(X) denote its average. Suppose E(X) = 65,

measured in degrees Fahrenheit. What is the mean temperature in

degrees Celsius?

To convert X from F to C, deﬁne a new random variable

Y =

5

9

X −

160

9

Then using the rule about linear combinations,

E(Y ) =

5

9

E(X) −

160

9

≈ 18.3

PHP 2510 – Oct 8, 2008 13

Computing means from a sample of data

Loosely speaking, for a sample of observed data x

1

, x

2

, . . . , x

n

, each

of the individual x

i

can be thought of as having associated

probability mass p(x

i

) = 1/n.

So the sample mean is

x =

n

i=1

x

i

p(x

i

)

=

n

i=1

x

i

(1/n)

=

1

n

n

i=1

x

i

Simply put, take the sum of the observations and divide by n.

Sample means are not expected values! They are random variables.

We will discuss sample means later on ....

PHP 2510 – Oct 8, 2008 14

Variance of a random variables

Variance measures dispersion of a random variable’s distribution.

It is just an average. It is the average squared deviation of a

random variable from its mean.

To make notation simple, let µ = E(X). Then

var(X) = E{(X −µ)

2

}

In other words, it is the average value of (X −µ)

2

.

For a discrete random variable,

var(X) =

i

(x

i

−µ)

2

p(x

i

)

For a continuous random variable,

var(X) =

_

(x −µ)

2

f(x) dx

PHP 2510 – Oct 8, 2008 15

Example 1 (consumers of alcohol). In a certain population,

the proportion of those consuming alcohol is .65. Select a person at

random, with X = 1 if consumer of alcohol and X = 0 if not.

In this example, E(X) = µ = 0.65.

var(X) = E{(X − 0.65)

2

}

=

i

(x

i

− 0.65)

2

p(x

i

)

= (1 − 0.65)

2

(0.65) + (0 − 0.65)

2

(0.35) = .228

Example 2. Suppose instead the probability was 0.1. What then

is var(X)? Ans = 0.09.

Pattern: For a Binomial random variable X with n = 1 and

success probability π,

var(X) = π(1 −π)

PHP 2510 – Oct 8, 2008 16

Properties of variance

• If a and b are constants, then

var(aX +b) = a

2

var(X)

(Why is b not included?)

• If X

1

, X

2

, . . . , X

n

are independent random variables, then

var(X

1

+X

2

+ · · · +X

n

) = var(X

1

) + var(X

2

) + · · · + var(X

n

)

PHP 2510 – Oct 8, 2008 17

Computing variances from a sample of data

Like with the sample mean, for a sample of observed data

x

1

, x

2

, . . . , x

n

, each of the individual x

i

can be thought of as having

associated probability mass p(x

i

) = 1/n.

To calculate the sample variance, we take an average of (x

i

−x)

2

.

The sample variance is

S

2

=

n

i=1

(x

i

−x)

2

p(x

i

)

=

n

i=1

(x

i

−x)

2

(1/n)

=

1

n

n

i=1

(x

i

−x)

2

It is more common to use

1

n−1

instead of

1

n

. We will discuss reasons

for this later.

For now, you should think of variance as an average.

PHP 2510 – Oct 8, 2008 18

Standard deviation

The standard deviation measures the average distance of a random

variable X from its mean. By deﬁnition, SD(X) =

_

var(X).

The logic goes like this:

1. because var(X) measures average squared deviation between X

and its mean; and

2. because SD(X) =

_

var(X); then

3. SD(X) is approximately equal to the average absolute deviation

between X and its mean

PHP 2510 – Oct 8, 2008 19

Example.

In September in Providence, noon time temperature has mean 65

and variance 100.

• What is the SD of the temperatures?

• Select a day at random. What does SD tell us about the

temperature on that day, relative to the average temperature?

• Suppose noon time temps are normally distributed. Should a

noon time temperature of 85 be considered unusual? Why or

why not?

PHP 2510 – Oct 8, 2008 20

Mean and variance for some common RV’s

Random variable Mass or Density Function E(X) var(X)

Binomial(n, π)

_

n

x

_

π

x

(1 −π)

n−x

nπ nπ(1 −π)

Poisson(λ) e

−λ

λ

x

/x! λ λ

Geometric(π) (1 −π)

x−1

π 1/π 1/π

2

Normal(µ, σ

2

) µ σ

2

Exponential(θ) (1/θ)e

−θ/x

1/θ 1/θ

2

PHP 2510 – Oct 8, 2008 21

Correlation and Covariance

Correlation and covariance are one way to measure association

between two random variables that are observed at the same time

on the same unit.

Example: Height and weight measured on the same person

Example: years of education and income

Example: two successive measures of weight, taken on the same

person but one year apart.

PHP 2510 – Oct 8, 2008 22

Covariance

Covariance measures the degree to which two variables diﬀer from

their mean. It is an average:

cov(X, Y ) = E {(X −µ

X

)(Y −µ

Y

)}

cov(X, Y ) > 0 means that X and Y tend to vary in the same

direction relative to their means (both higher or both lower).

They have a positive association.

• Example: height and weight

cov(X, Y ) < 0 means that X and Y tend to vary in opposite

directions relative to their means (when one is higher, the other

is lower). They have a negative association.

• Example: weight and minutes of exercise per day

cov(X, Y ) = 0 generally means that X and Y are not associated.

PHP 2510 – Oct 8, 2008 23

Example: mean arterial pressure and body mass index

during pregnancy

SUMMARY STATISTICS

Variable | Obs Mean Std. Dev.

----------+---------------------------------

map24 | 326 76.55951 7.351673

bmi | 326 25.10736 6.217994

Give an interpretation for SD here.

PHP 2510 – Oct 8, 2008 24

m

a

p

2

4

bmi

20 40 60

40

60

80

100

PHP 2510 – Oct 8, 2008 25

Computing covariance

For individual i, let m

i

denote MAP and let b

i

denote BMI.

In this table, prod represents

(m

i

−m) × (b

i

−b)

Recall m = 76.6 and b = 25.1.

To compute covariance, we take the average (sample mean) of the

products (following pages)

DATA EXCERPT

map24 (m_i) bmi (b_i) prod

-------------------------------------

1. 72.7 15.9 35.53593

2. 69.3 16.3 63.9371

3. 81 16.3 -39.10899

4. 63.7 16.3 113.2583

5. 74 16.6 21.77467

6. 73.3 16.6 27.7298

PHP 2510 – Oct 8, 2008 26

7. 69.3 16.9 59.58139

8. 74.7 16.9 15.26169

9. 82.7 17 -49.78313

10. 73 17.2 28.14632

11. 66.3 17.2 81.12561

12. 74 17.8 18.70326

13. 73 17.8 26.01062

14. 84.3 17.9 -55.78852

15. 68.3 17.9 59.52924

16. 70.3 18 44.48857

SUMMARY STATISTICS

Variable | Obs Mean

---------+-----------------------

prod | 326 13.2753

PHP 2510 – Oct 8, 2008 27

Computing covariance from a sample

Like mean and variance, covariance is an average.

In a sample of pairs (x

1

, y

1

), (x

2

, y

2

), . . . , (x

n

, y

n

), we can assume

each pair is observed with probability p(x

i

, y

i

) = 1/n.

Then the sample covariance is a weighted average of

(x

i

−x) (y

i

−y):

¯ cov(X, Y ) =

n

i=1

(x

i

−x) (y

i

−y) p(x

i

, y

i

)

=

1

n

n

i=1

(x

i

−x) (y

i

−y)

PHP 2510 – Oct 8, 2008 28

Correlation is a standardized covariance

corr(X, Y ) =

cov(X, Y )

SD(X) × SD(Y )

Always between –1 and 1

Measures degree of linear relationship

(If relationship not linear, correlation not an appropriate

measure of association)

Pearson’s sample correlation plugs in sample estimates for the

quantities in the formula above

¯ corr(X, Y ) =

(1/n)

n

i=1

(x

i

−x)(y

i

−y)

S

x

×S

y

PHP 2510 – Oct 8, 2008 29

SUMMARY STATISTICS

Variable | Obs Mean Std. Dev. Min Max

---------+-----------------------------------------------------

prod | 326 13.2753 53.69735 -131.3067 391.1627

map24 | 326 76.55951 7.351673 55 101.3

bmi | 326 25.10736 6.217994 15.9 57.2

CORRELATION COEFFICIENT

(obs=326)

| bmi

---------+------------------

map24 | 0.2913

Using the numbers on the table above, how would you obtain the

correlation coeﬃcient?

PHP 2510 – Oct 8, 2008 30

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