02-11-2020

Financial Analytics
Sessions 1

Dilip Kumar 1

Definition of Probability
• Experiment: Any procedure which can be repeated infinitely and has well
defined set of outcomes. For example: up and down movements in prices
in n steps, toss a coin twice.
• Sample space: possible outcomes of an experiment
– S = {HH, HT, TH, TT}
– For up and down shift in price (one step binomial model): S= {u, d}
– For two step binomial model: S= {uu, ud, du, dd}
– For three step binomial model: S= {uuu, uud, udu, duu, udd, dud, ddu, ddd}
• Event: a subset of possible outcomes (e.g. A={HH}, B={HT, TH})
• Probability of an event :
– Axiom 1: Pr(A)  0
– Axiom 2: Pr(S) = 1
– Axiom 3: For every sequence of disjoint events Pr(i Ai )   i Pr( Ai )

Dilip Kumar

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Laws of Probability (Law 1 and 2)

Law1: The probability of an event A is a number between 0 and 1:

If an event has probability 1 it is certain to occur.

Law2: Suppose A and B are two mutually exclusive events, which means
that they cannot both occur at the same time. Then the probability of
either A occurring or B occurring is the sum of their probabilities. That is

The event that A does not occur is called the complement of A

Dilip Kumar 3

Joint Probability (Law 3)

Law3: The joint probability of two events A and B occurring is:

For events A and B, joint probability Pr(AB) stands for the probability that both
events happen.
P(A|B) = conditional probability of A occurring, given that B occurs.
• It is 0 if the events are mutually exclusive.
P(B) = the marginal probability of B (prior probability)

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Independence (Law 3)
Two events A and B are independent in case
Pr(AB) = Pr(A)Pr(B)
A set of events {Ai} is independent in case
Pr( i Ai )   i Pr( Ai )

Dilip Kumar 5

Law 4
Law4: Let A and B be any two events. Then the probability of
either A occurring or B occurring is the sum of their probabilities
less the probability that they both occur. That is:

Dilip Kumar 6

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Random variable, density and distribution

A random variable is a variable whose values are stochastic (uncertainty
about the values).
Deterministic variable: whose values are completely determined by the
information we currently hold.
A realization(also called an observation) on a random variable X may be
thought of as a number that is associated with a chance outcome. Since
every outcome is determined by a chance event, every outcome has a
measure of probability associated with it. The set of all outcomes and their
associated probabilities is called a probability measure.
Two ways to represent Probability measure:
Probability distribution function
Probability density function
Dilip Kumar 7

Expectation
A random variable X~Pr(X=x). Then, its expectation is
E[ X ]   x x Pr( X  x)
In an empirical sample, x1, x2,…, xN,

1 N
E[ X ] 
N
 i1 xi
Continuous case:

E[ X ]   xp ( x) dx


Expectation of sum of random variables

E[ X1  X 2 ]  E[ X1 ]  E[ X 2 ]

Dilip Kumar 8

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Variance
The variance of a random variable X is the expectation of
(X-E[x])2 :

Var ( X )  E (( X  E[ X ])2 )
 E ( X 2  E[ X ]2  2 XE[ X ])
 E ( X 2  E[ X ]2 )
 E[ X 2 ]  E[ X ]2

Dilip Kumar 9

Probability density function

Let X be a continuous random variable. Let x denotes the value
that the random variable X takes. We use f(x) to denote the
probability density function.
Properties:
f(x)≥0 for any x
Total area under f(x) is 1, that is, the density function integrate to 1 for
entire real line.

Dilip Kumar 10

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Cumulative distribution function

The cumulative distribution function, F(x), for a continuous
random variable X expresses the probability that X does not
exceed the value of x, as a function of x
F ( x)  P( X  x)
P (a  X  b)  P( X  b)  P( X  a )  F (b)  F (a)
Let X be a continuous random variable. Then, there is a
following relationship between probability density function and
cumulative distribution function.
b
P (a  X  b)  F (b)  F ( a)   f ( u ) du
a

Dilip Kumar 11

Cumulative distribution function

In other words, the cumulative distribution function F(x) is given
by the shaded area.

f(x)

F(x)=P(X≤x)

x x

Dilip Kumar