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Probability problems, Theory

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nCr

n!/(r!)*(n-r)!

Nr

Pristine

(Confidential)

Question-Counting Principle

In how many ways 3 stocks can be chosen out of 10 stocks in a portfolio?(Combination)

Choosing 3 out of 10 stocks is basically the number of combinations of 3 objects out of 10

10!

Therefore, the number of ways are 10C3= 3!*(10 3)!=120

In how many ways 3 stocks can be sold, if the sold stock is bought back in the portfolio before the

next stock is sold?

Second can be sold in again 10 ways

Third stock can again be sold in 10 ways

Therefore total number of ways become =103 =1000

Pristine

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Question

You wish to choose a portfolio of 3 bonds and 4 stocks from a list of 5 bonds and 8 stocks.

How many different 7 asset portfolio can you make from this list.

80

700

1,716

100,800

Pristine

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Solution

B

Solution:

5

C3*8C4

Pristine

5!

8!

5* 4 8* 7 * 6 *5

*

*

10*70 700

3!(5 3)! 4!(8 4)! 2*1 4*3* 2*1

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Question

There are 10 sprinters in the Olympic finals. How many ways can the gold, silver, and bronze

medals be awarded?

120

720

1,440

604,800

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Solution

B

10P3 = 720

Please note that this is a case of Permutation and not Combination.

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Probability - Definitions

A probability experiment involves performing a number of trials to enable us to measure the

chance of an event occurring in the future. A trial is a process by which an outcome is noted.

Examples of Definitions:

Event of interest: A six faces upwards

Trial: Roll the die once

Number of trials: 200

Outcomes: 1, 2, 3, 4, 5 or 6

Probability of an event to occur is defined as number of cases favorable for the event, over the

number of total outcomes possible in unbiased experiment

For example, if the event is "occurrence of an even number when a die is rolled

The probability is given by 3/6=1/2, since 3 faces out of the 6 have even numbers

and each face has the same probability of appearing.

Pristine

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Joint Probability

A statistical measure where the likelihood of two events occurring together and at the same point in

time are calculated. Joint probability is the probability of event Y occurring at the same time event X

occurs.

Notation for joint probability takes the form:

P(X Y) or P(X,Y)

Which reads the joint probability of X and Y.

The following table shows the joint probability of different events. Lets say an economist is predicting

the market scenario and the price of IBM stock from the next year.

Next year market can be Good, Bad or Neutral

IBM stock may go up or go down

Joint Probability Table:

Market

IBM

UP

DOWN

Total

Good

Bad

Neutral

Total

10%

0%

10%

30%

15%

45%

5%

40%

45%

45%

55%

100%

The probability of IBM stock being Up and Market being Good is 10%

Similarly, the probability of IBM stock being down and Market being neutral is 40%

Pristine

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Conditional Probability

Probability of an event or outcome based on the occurrence of a previous event or outcome.

Conditional probability is calculated by multiplying the probability of the preceding event by the updated

probability of the succeeding event

The probability of event A given that the event B has occurred is P(A/B), which is equal to the ratio of

joint probability of A and B, and unconditional probability of B.

P( A B)

P( A / B)

P(B)

The unconditional probability of market being Neutral is 45%. Then using the table below we can

find 3 conditional probabilities.

P(Up/Neutral) = 0.05 / 0.45

P(Up/Good) = 0.1/0.1

P(Down/Bad) = 0.15/0.45

Joint Probability Table:

Market

IBM

UP

DOWN

Total

Pristine

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Good

Bad

Neutral

Total

10%

0%

10%

30%

15%

45%

5%

40%

45%

45%

55%

100%

being UP/Down

MARKET

Unconditional

Probability

of Market

IBM

10%

45%

Good

UP

10%

45%

Bad

DOWN

0%

UP

30%

Neutral

UP

DOWN

15%

5%

DOWN

40%

Calculate:

Unconditional Probability of market to be good next year?

Conditional Probability of IBM stock rising when the market is neutral?

Conditional Probability of market being good when IBM stock is down?

Pristine

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10

Definitions

Mutually Exclusive: If one event occurs, then other cannot occur

Exhaustive: all exhaustive events taken together form the complete sample space

(Sum of probability = 1)

Independent Events: One event occurring has no effect on the other event

P( A) [0,1]

If the probability of happening of event A is P(A), then the probability of A not happening is (1P(A)).

For example, if the probability of a company going bankrupt within one year period is 20%, then the

probability of company surviving within next one year period is 80%.

P( A) 1 P( A)

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Question

For a bond with B rating, assume 1 year probability of default for each issuer is 6%, and that

default probability of each issuer are independent. What is the probability that both issuers avoid

default during the 1st year.

88%

88.4%

94%

96.4%

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Solution

B

This implies that first does not default AND second does not default

= (1 PD (first)) x (1 PD (second))

= (1 0.06) x (1 0.06) = 0.884 = 88.4%

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The probability of happening of event A or event B can be given as the sum of the three portions

defined by the figure below.

P(A)

P( AB)

P(B)

P(A B)

P(A) P(B)if A andB areMutuallyExclusive

P (B )

P(A)

P( AB) 0

Pristine

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Question

Jensen, a portfolio manager is managing two portfolios. One for High Net Worth Individuals (HNI)

and second for Low Net Worth Individuals (LNI).

HNI portfolio contains 5 bonds and 7 stocks and LNI contains 6 bonds and 11 stocks.

One instrument from HNI is transferred to LNI portfolio.

Now Jensen selects an instrument from LNI, what is the probability that instrument selected is

bond?

0.5382

0.7821

0.6435

None of these

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Solution

B

Here required probability = [P(stock transferred from HNI) AND P(Stock selected from LNI)] OR [P(bond

transferred from HNI) AND P(Stock selected from LNI)]

So, the required probability = (7/12) (12/18) + (5/12) (11/18) = 139/216 = 0.6435

Hence option B is correct.

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The unconditional probability of event B is equal to the sum of joint probabilities of event (A,B) and

the probability of event (A,B). Here A is the probability of not happening of A.

The joint probability of events A and B is the product of conditional probability of B, given A has

occurred and the unconditional probability of event A.

We know that P(AB) = P(B/A) * P(A)

Also P(BA)= P(A/B) * P(B)

Now equating both P(AB) and P(BA) we get:

P(B / A) * P( A)

P( A / B)

P(B)

P(B) can be further broken down using sum rule defined above:

P(B / A)P( A)

P( A / B)

P(B / A)P( A) P(B / Ac )P( Ac )

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Question

Out of a group of 100 patients being treated for chronic back trouble, 25% are chosen at random to

receive a new, experimental treatment as opposed to the more usual muscle relaxant-based

therapy which the remaining patients receive. Preliminary studies suggest that the probability of a

cure with the standard treatment is 0.3, while the probability of a cure from the new treatment is

0.6.

How many patients (on an average) out of the 100 patients selected at random would be cured?

30

40

37.5

42.5

Some time later, one of the patients returns to thank the staff for her complete recovery.

What is the probability that she was given the new treatment?

0.375

0.425

0.4

0.425

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Solution

C

25% are given new treatment =>75% are given old treatment.

P(Cure) = P(Cure/New) * P(New) + P(Cure/Old) * P(Old) = 0.375

So out of 100 patients 37.5 will get cured

C

Apply Bayes Theorem

P (New / Cure) = P (Cure / New) * P (New) / P (Cure) = 0.6 * 0.25 / 0.375 = 0.40

Pristine

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19

Question

Calculate the probability of a subsidiary and parent company both defaulting over the next year.

Assume that the subsidiary will default if the parent defaults, but the parent will not necessarily

default if the subsidiary defaults. Assume that the parent had a 1 year PD = .5% and the subsidiary

has 1 year PD of .9%.

0.45%

0.5%

0.545%

0.55%

Pristine

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Solution

B

P (S| P) = 1 = P(P & S)/P(P)

P(P & S) = P(P) = 0.5%

Pristine

(Confidential)

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