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Seminar 1 / April 9, 2015

Valuation of International Financial Assets

Probability and Statistics

1. You are invested in two hedge funds. The probability that hedge fund Alpha gen- erates positive returns in any given year is 60%. The probability that hedge fund Omega generates positive returns in any given year is 70%. Assume the returns are independent. What is the probability that both funds generate positive returns in a given year? What is the probability that both funds lose money?

2. Corporation ABC issues $100 million of bonds. The bonds are rated BBB. The probability that the rating on the bonds is upgraded within the year us 8%. The probability of a downgrade is 4%. What is the probability that the rating remains unchanged?

3. Given the following density function:

f(x) = c(100 x 2 )

0

Calculate the value of c.

for

otherwise

10 x 10

4. Given the probability density function, F (x), for 0 x 10:

F(x) =

x

100 (20 x)

Check that this is a valid CDF; that is, show that F (0) = 0 and F (10) = 1. Calculate the probability density function, f (x).

5. Given the probability density function, f (x):

f(x) = c

x

where 1 x e. Calculate the cumulative distribution function, F (x), and solve for the constant c.

6. You own two bonds. Both bonds have a 30% probability of defaulting. Their default probabilities are statistically independent. What is the probability that both bonds default? What is the probability that only one bond defaults? What is the probability that neither bond defaults?

7. Your firm forecasts that there is a 50% probability that the market will be up signif- icantly next year, a 20% probability that the market will be down significantly next year, and a 30% probability that the market will be flat, neither up or down signif- icantly. You are asked to evaluate the prospects of a new portfolio manager. The manager has a long bias and is likely to perform better in an up market. Based on past data, you believe that the probability that the manager will be up if the market

Seminar 1 / April 9, 2015

Valuation of International Financial Assets

8.

9.

10.

is up significantly is 80%, and that the probability that the manager will be up if the market is down is only 10%. If the market is flat, the manager is just as likely to be up as to be down. What is the unconditional probability that the manager is up next year?

At the start of the year, a bond portfolio consists of two bonds, each worth $100. At the end of the year, if a bond defaults, it will be worth $20. If it does not default, the bond will be worth $100. The probability that both bonds default is 20%. The probability that neither bond defaults is 45%. What are the mean, median, and mode of the year-end portfolio?

Given the following probability density function:

f(x) =

x

50

s.t.

0 x 10

what are the mean, median, and mode of x?

Given the following equation:

y = (x + 5) 3 + x 2 + 10x

what is the expected value of y? Assume the following:

11.

12.

13.

14.

E[x] = 4 E[x 2 ] =

E[x 3 ] = 12

9

Assume that a random variable Y has a mean of zero and a standard deviation of one. Given two constants, µ and σ, calculate the expected value of X 1 and X 2 , where X 1 and X 2 are defined as:

X 1 = σY + µ

X 2 = σ(Y + µ)

X is a random variable. X has an equal probability of being -1, 0, or +1. What is the correlation between X and Y if Y = X 2 .

Prove the following result:

E[(X µ) 3 ] = E[X 3 ] 3µσ 2 µ 3

Given two random variables, X A and X B , with corresponding means µ A and µ B and standard deviations σ A and σ B , prove that the variance of X A plus X B is:

V ar[X A + X B ] = σ A + σ B + 2ρ AB σ A σ B

2

2

where ρ AB is the correlation between X A and X B .

Seminar 1 / April 9, 2015

Valuation of International Financial Assets

15. Assume we have four bonds, each with a 10% probability of defaulting over the next year. The event of default for any given bond is independent of the other bonds defaulting. What is the probability that zero, one, two, three, or all of the bonds default? What is the mean number of defaults? The standard deviation?

16. For a uniform distribution with a lower bound x 1 and an upper bound x 2 , prove that the formulas for calculating the mean and variance are:

µ =

σ 2 =

1

2

(x 2 + x 1 )

1

12

(x 2 x 1 ) 2

17. Prove that the normal distribution is a proper probability distribution. That is, show that:

Use:

−∞

1

2πσ 2 e

(xµ) 2

2σ 2

dx = 1

−∞

e x 2 dx = π

18. Prove that the mean of the normal distribution is µ. That is, show that:

−∞

x

1

2πσ 2 e

(xµ) 2

2σ 2

dx = µ

19. Prove that the variance of a normal distribution is σ 2 . You may find the following result useful:

−∞ x 2 e x 2 dx = 1 2 π

following result useful: −∞ x 2 e − x 2 dx = 1 2 √ π