Solution Exercise 8.

1
a. Probability distribution: overview of the probabilities of all X-events
Cdf: the function F with F(x) = P( X  x) for all real numbers x
Pdf: the function f with f(x) = P( X  x) for all outcomes x of X
F yields a sub-overview of the probability distribution; the same holds for f.
However, each probability P(A) from the overview of the probability
distribution can be calculated with F and also with f. Furthermore:
F(a) =  f ( x) ,
x a
and f(a) = F(a) – F (a' ) if a'  a are two subsequent

outcomes of X
b. Probability distribution: overview of the probabilities of all X-events
Cdf: the function F with F(x) = P( X  x) for all real numbers x
Pdf: a non-negative function f such that the total area under its graph is 1, in
such a way that for all intervals (a, b) the probability that the actual outcome
of X will fall in (a, b) is just the area of the graph of f above (a, b). That is:
b
P(a  X  b) =  f ( x)dx
a

Again, both F and f are equivalent in the sense that the one follows from the
other. This is because f is the derivative of F and F(x) is the area up to x under
the graph of f.

Solution Exercise 8.2

a. E (X )   =  xf ( x) ; V ( X )  
x
2
=  (x  )
x
2
f ( x) ;

SD(X ) =  2 . Here f is the (discrete) pdf.


b. E (X )   =  xf ( x)dx = total area under the function

xf (x)


V (X )   2 =  (x  ) f ( x)dx = total area under the function ( x   )2 f ( x)
2



SD(X ) =  2 . Here f is the (continuous) pdf.

Solution Exercise 8.3

a. For a population variable, there is no random experiment involved.
b. If a population variable X has population mean , population variance 2 and
population standard deviation , then there exists a special random variable
such that its expectation, variance and standard deviation are just , 2 and .
This random experiment is: the random observation of X.

1
 Hence, in this chapter the concepts of Chs 1 – 5 are generalised.

Solution Exercise 8.4

a. F is an non=decreasing step-function; it jumps at an outcomes x with jump-
size f(x) to a higher level. F(x) = 0 for x < 0; F(x) = 1 for x  6.
b. P(2  X  5) = f(3.5) + f(5) = 0.55
c. P(2  X  5) = F(5) – F(2) = 0.55
d. E (X ) = 0  0.20    6  0.20 = 3.6

V (X ) = (0  3.6)2  0.20    (6  3.6)2  0.20 = 4.365

SD(X ) = 2.0893

Solution Exercise 8.5

a. f(x) = 1/9 for 1 < x < 10; f(x) = 0 otherwise.
b. For x between 1 and 10, F(x) = P(1  X  x) is the area under f above the
interval (1, x]. With the rectangle-construction it follows that:
1
F(x) = ( x  1)  = (x – 1)/9
9
For x < 1, it holds that F(x) = 0; for x  10 that F(x) = 1.
c. P(2  X  5) = F(5) – F(2) = 4/9 – 1/9 = 1/3
d. It follows from symmetry arguments that E(X) is the centre of (1, 10), which is
5.5.
10
1 1
e.  =  9 ( x  5.5) dx = [ 27 ( x  5.5) ]
3 x 10
2 2
x 1 = 3.375 – (3.375) = 6.75
1

 = 2.5981
Solution Exercise 8.6
a. Continuous, since F is a continuous function.
2
f(x) = F ' ( x) = x if 0 < x < 3; f(x) = 0 otherwise
9
b. Discrete, since F is a step-function. The pdf follows from the table:
x 0 1 2 3
f(x) 0.25 0.35 0.20 0.20

Solution Exercise 8.7

a. On a Monday, randomly choose a customer. X = ‘(rounded) amount spend by
that customer’.

2
 b. E (X ) = 50.08 + 100.15 +    + 2000.07 = 54.90;
V (X ) = (5 – 54.90)20.08 + (10 – 54.90)20.15 +    +(200 – 54.90)20.07
= 2632.99;
SD(X ) = 51.3127

Solution Exercise 8.8

a. Experiment: flipping three fair coins;
sample space: {(H, H, H), (H, H, T), (H, T, H), (T, H, H), (H, T, T), (T, H, T),
(T, T, H), (T, T, T)};
a value is attached to each outcome: respectively 3, 2, 2, 2, 1, 1, 1, 0;
discrete.
b. Experiment: measuring the number of tests needed;
Sample space: {1, 2, 3,   }; a value is attached to each outcome, namely the
outcome itself; discrete.
c. Experiment: randomly drawing an employee from that company;
Sample space: the set of all employees of the company; at each outcome
(employee) his/her age is attached; discrete.
d. Experiment: measuring next week’s sales of the shop;
Sample space: set of all positive real numbers; a value is attached to each
outcome, namely the outcome itself; continuous.
e. Experiment: measuring tomorrow’s value of the Down Jones Index;
Sample space: set of all positive real numbers; a value is attached to each
outcome, namely the outcome itself; continuous.

Solution Exercise 8.9

a. The two variables have the same set of outcomes: {-0.20, -0.10, 0, 0.10, 0.20}
b. E (X ) = (0.20)  0.02    0.20  0.02 = 0; follows also from symmetry.
E (Y ) = (0.20)  0.01    0.20  0.35 = 0.1140
V (X ) = (0.20  0)2  0.02    (0.20  0)2  0.02 = 0.0056

V (Y ) = (0.20  0.1140)2  0.01    (0.20  0.1140)2  0.35 = 0.0068

SD(X ) = 0.0056 = 0.0748

SD(Y ) = 0.0068 = 0.0825

c. V (X ) = E ( X 2 )  ( E ( X ))2 = (0.20)2  0.02    (0.20)2  0.02  02

= 0.0056 – 0 = 0.0056

3
 V (Y ) = E (Y 2 )  ( E (Y ))2 = (0.20)2  0.01    (0.20)2  0.35  (0.1140)2
= 0.0198 – 0.0130 = 0.0068
d. The probability P( X  3 X  X   X  3 X ) is at least 1 – 1/32 = 8/9. Also
the probability P(Y  3 Y  Y  Y  3 Y ) is at least 8/9.
Since  X = 0 and  X = 0.0748, it follows that  X  3 X = -0.2244 and
 X  3 X = 0.2244. Since there are no outcomes that fall beyond (-0.2244,
0.2244), it follows that P( X  3 X  X   X  3 X ) = 1.
Since Y = 0.1140 and  Y = 0.0825, it follows that Y  3 Y = -0.1335 and
Y  3 Y = 0.3615. Notice that –0.20 is the only outcome that falls beyond the
interval (-0.1335, 0.3615). Hence, P(Y  3 Y  Y  Y  3 Y ) = 1 – 0.01 =
0.99
e. Project II has the largest expected profit per euro. However, project II also has
the largest standard deviation and hence the largest risk.

Solution Exercise 8.10

a.
x -3 0 2 3 4 5 6
f(x) 1/2 1/12 1/12 1/12 1/12 1/12 1/12
F(x) 6/12 7/12 8/12 9/12 10/12 11/12 1

b. See the table above.

c. P(0  X  4) = 3/12; P( X  1) = 7/12; P( X  1.5) = 5/12;
P(2  X  5) = 2/12; P({X  0}  {X  3}) = ½ + 4/12 = 10/12
d. F is a non-decreasing step-function.
1 1 1
e. E (X ) = (3)   0     6  = 2/12 = 0.1667
2 12 12
If the game is played on and on again, then the average payoff per game is
16.67 eurocent.

Solution Exercise 8.11


6
Set f(i) = P( X  i) for i = 1, 2,   , 6. Since i 1
f (i) = 1, it follows that:

1 1
f (1)  f (1)    3 f (1)  4 f (1) = 1
6 6
Hence, 9 f (1) = 4/6 and f (1) = 4/54.

4
 a.
i 1 2 3 4 5 6
f(i) 4/54 4/54 9/54 9/54 12/54 16/54
F(i) 4/54 8/54 17/54 26/54 38/54 1

b. F (x) = 0 if x < 1
= 4/54 if 1  x < 2
= 8/54 if 2  x < 3
= 17/54 if 3  x < 4
= 26/54 if 4  x < 5
= 38/54 if 5  x < 6
=1 if x  1
c. The graph is a non-decreasing step function.
d. P(4  X  6) = P( X  5) + P( X  6) = f (5)  f (6) = 28/54
P(4  X  6) = P( X  6)  P( X  4) = F (6)  F (4) = 1 – 26/54 = 28/54
e. P({X  3}  {1  X  4}) = P( X  2)  P( X  3) = f (2)  f (3) = 13/54
P({X  3}  {1  X  4}) = P({1  X  3}) = F (3)  F (1) = 13/54
f. P({X  3}  {1  X  4}) = f (1)  f (2)  f (3)  f (4) = 26/54
P({X  3}  {1  X  4}) = F (4) = 26/54

Solution Exercise 8.12

a)
(i) Discrete. It has to satisfy (8.1). Hence, a has to be non-negative and  x
f ( x)
= 1. Consequently:

1 = f (0)  f (1)  f (1)  f (2)  f (2)  f (3)  f (3)

a 2 28
= (0  (1)2  12  (2)2  22  (3)2  32 ) = a
20 20

Hence, a = 20/28 = 5/7.

(ii) The pdf is as follows:
x 0 -1 1 -2 2 -3 3
f(x) 0 1/28 1/28 4/28 4/28 9/28 9/28

5
 1 1 4 4 9 9
E (X ) = 0  0  (1)   1  (2)   2   (3)   3 
28 28 28 28 28 28
Hence, E (X ) = 0. This also follows since the pdf is symmetric around 0.
b)
(i) Continuous. The total area under g has to be equal to 1. Since g(4) = 4b, it
follows from the rectangle construction that
1
1=  4  4b , so b = 1/8.
2
(ii) Note that yg ( y) = y 2 / 8 on the interval [0, 4]. Hence:
 4 4
y 1 1 y3
E (Y ) =  yg ( y)dy =

y
0
8
dy =  y 2 dy =  [ ]04
80 8 3
1 64
=  (  0) = 8/3
8 3
c)
 2
3 3 3 v 4 2 3 16
(i) E (V ) =  vh(v)dv =  v dv =  [ ]0 =  (  0) = 1.5

80 8 4 8 4
 2 2
3 3
(ii)  2
V =  (v  1.5) h(v)dv =  (v  1.5)2 v 2dv =  (v 4  3v3  2.25v 2 )dv
2


80 80

3 v5 3 32
=  [  0.75v 4  0.75v3 ]02 =  (  12  6  0) = 0.15
8 5 8 5
2
3 4 3 v5 2 3 32
8 0
(iii) E (V 2 ) = v dv =  [ ]0 =  (  0) = 2.4. Hence:
8 5 8 5

 V2 = E (V 2 )  (1.5)2 = 0.15.

Solution Exercise 8.13

a. E (X ) = 0.50.58 +    +100.05 = 1.89

V (X ) = E ( X 2 )  1.892 = 0.52  0.58    102  0.05  3.5721

V (X ) = 8.77 – 3.5721 = 5.1979
b. F(2.5) = 0.88 and F(5) = 0.95, so the cdf passes the level 0.90 at 5. Hence, the
0.9-quantile is 5.
c. F passes the level 0.25 at 0.5 and the level 0.75 at 2.5. Hence, the IQR is 2.

6
Solution Exercise 8.14
a. E (2 X  7Y  8) = 2E( X )  7 E (Y )  8 = -43.5
1 1
b. E (Z ) = E ( ( X  E ( X )  Y  E (Y )) = E ( X  E ( X )  Y  E (Y ))
2 2
1 1
= E ( X  4  Y  8.5) = ( E ( X )  4  E (Y )  8.5) = 0
2 2
c. E (( X  7)2  3Y  6.5) = E ( X 2  14 X  49  3Y  6.5)

= E ( X 2 )  14E ( X )  49  3E (Y )  6.5 = 29

d.  X2 = E ( X 2 )  ( E ( X ))2 = 17 – 16 = 1

V (4 X  3) = V (4 X ) = (4)2V ( X ) = 161 = 16

e. SD(4 X  3) = SD(4 X ) = 4SD( X ) = 4

Solution Exercise 8.15

a. E (X ) = 2.4; V (X ) = 2.04; SD(X ) = 1.4283

E(C )  460  50E( X ) = 580; V (C ) = (50)2  V ( X ) = 5100;

SD(C ) = 50  SD( X ) = 71.4143
b. P(C  Y ) = P(460  50 X  500 X ) . Notice that:
460  50 X  500 X  450 X  460  X  46 / 45 .
Hence, P(C  Y ) = P( X  46 / 45) = P( X  1) = 0.3.
c. The above ratio 46/45 should become 1 or less. Hence, reducing 460 to 450 is
enough.
d.
x 0 1 2 3 4 5
f(x) 0.1 0.2 0.2 0.3 0.1 0.1
F(x) 0.1 0.3 0.5 0.8 0.9 1

The cdf F reaches the level 0.9 at x = 4. Hence,  0.9 = (4 + 5)/2 = 4.5.

The cdf F passes the level 0.05 at x = 0. Hence, 0.05 = 0.

Solution Exercise 8.16

a. Notice that C can take the outcomes 460, 510, 560, 610, 660, 710; the
corresponding probabilities are the same.

7
 c 460 510 560 610 660 710

fC (c) 0.1 0.2 0.2 0.3 0.1 0.1

FC (c) 0.1 0.3 0.5 0.8 0.9 1

The cdf FC reaches the level 0.9 at c = 660. Hence, 0.9,C = (660 +710)/2 =
685. The cdf FC passes the level 0.05 at c = 460. Hence, 0.05,C = 460.
b. F passes the levels 0.25 and 0.75 at x = 1 and x = 3, respectively. It reaches the
level 0.5 at x = 2. That is:  1 X = 1 and  3 X = 3. Hence,  X = 3 – 1 = 2.
Furthermore,  2 X = 2.5.
FC passes the levels 0.25 and 0.75 at c = 510 and c = 610, respectively. It
reaches the level 0.5 at c = 560. That is:  1C = 510 and  3C = 610. Hence,  C
= 610 – 510 = 100. Furthermore,  2C = (560 + 610)/2 = 585.
c. The quantiles of C follow from the linear transformation c  460  50 x by
substituting the corresponding X-quantile for x. For instance:
460  50 1 = 510, which indeed is the 0.25-quantile of C.
460  50  3 = 610, which indeed is the 0.75-quantile of C.
460  50  4.5 = 685, which indeed is the 0.90-quantile of C.
 C = 50   X

Solution Exercise 8.17

a. P(23  X  27.5) = f (23)  f (24)  f (25)  f (26)  f (27) = 0.9.
b.
x 22 23 24 25 26 27 28
f(x) 0.05 0.1 0.1 0.3 0.2 0.2 0.05
F(x) 0.05 0.15 0.25 0.55 0.75 0.95 1

P(23  X  27.5) = F (27)  F (22) = 0.95 – 0.05 = 0.9

c. E ( X ) = 22  0.05  23  0.1    28  0.05 = 25.3 ºC

V ( X ) = (22  25.3)2  0.05    (28  25.3)2  0.05 = 2.3100

SD( X ) = 1.5199 ºC

8
 d. Notice that the outcomes of Y are: 71.6, 73.4,   , 82.4
y 71.6 73.4 75.2 77 78.8 80.6 82.4

fY ( y ) 0.05 0.1 0.1 0.3 0.2 0.2 0.05

FY ( y ) 0.05 0.15 0.25 0.55 0.75 0.95 1

e. Y = E (Y ) = 71.6  0.05    82.4  0.05 = 77.5400

 Y2 = V (Y ) = (71.6  77.54)2  0.05    (82.4  77.54)2  0.05 =

7.4844
 Y = SD(Y ) = 2.7358
9 9
f. Y =  X  32 =  25.3  32 = 77.5400
5 5
2
9 9
 =    X2 = 7.4844;  Y =   X = 2.7358
2
Y
5 5

Solution Exercise 8.18

a. The graph of f pictures a function that is constant (level 1/16) on (82, 86] and
also constant (level 3/16) on (86, 90). The r.v. X is continuous. Since the total
area under f is equal to 1 and f is nonnegative, it indeed is a pdf.
b. P(83  X  88) is the total area above the interval (83, 88). This area is equal
to 3  1/16 + 2  3/16 = 9/16; make a picture yourself.
c. For x in (82, 86]: F (x ) is just the area under f above the interval (82, x]. This
area is ( x  82) / 16 .
For x in (86, 90): F (x ) = 1  P( X  x) , which is 1  the area under f above
the interval ( x , 90]. Hence:

F (x ) = 0 if x  82
= ( x  82) / 16 if 82  x  86
= 1  3(90  x) / 16 if 86  x < 90
=1 if x  90

P(83  X  88) = F(88) – F(83) = 10/16 – 1/16 = 9/16

d.
x
x f (x ) = if 82  x  86
16

9
 3x
= if 86  x  90
16
= 0 otherwise

E ( X ) = area above (82, 86] + area above (86, 90]

82 4 258 12
=(  4  0.5   4)  (  4  0.5   4) = 87
16 16 16 16
5 5 160
e. Y  ( X  32) = X  ;
9 9 9
5 160
E (Y ) = E( X )  = 275/9 = 30.5556 ºC;
9 9
5 5
V (Y ) = ( )2  V ( X ) = 1.3374; SD(Y ) =  SD( X ) = 1.1565
9 9

Solution Exercise 8.19

X = ‘# books’
a. P( X  3) = 0.35 +  + 0.09 = 0.84
b. P( X  3) = 0.09 +  + 0.04 = 0.25
c. P( X  3) = 1 – P( X  3) = 0.16
d. A = { X  5} and B  {X  2}
P(2  X  5)
P( A | B) = = 0.36/0.40 = 0.90
P( X  2)
P(2  X  5)
e. P( B | A) = = 0.36/0.96 = 0.375
P( X  5)

Solution Exercise 8.20

a. F is a non-decreasing step-function that makes jumps at  1 , 0, 2, 3, 10 with
respective jump-sizes 1/6, 1/6, 1/3, 1/6, 1/6.
b. Outcomes of X:  1 , 0, 2, 3, 10
c. P(1  X  2) = P( X  2) = F (2) = 2/3; P( X  0) = 1  F (0) = 2/3.
d.
x 1 0 2 3 10
F(x) 1/6 1/3 2/3 5/6 1
f(x) 1/6 1/6 1/3 1/6 1/6

10
 e. f arises by calculating the jump-sizes of F.
f. F(a) arises by adding up all f(x) for x up to and including a.

Solution Exercise 8.21

a. At each outcome of the sample space, X attaches a value.
b. X only has two possible outcomes: 4 and 7.
x 4 7
f(x) 2/3 1/3
F(x) 2/3 1

f(4) = P( X  4) = P({(1,0,3), (2,1,1)}) = 1/3 + 1/3 = 2/3.

2 1
c. E (X ) = 4   7  = 15/3 = 5;
3 3
2 1
V (X ) = (4  5)2   (7  5)2  = 6/3 = 2; SD(X ) = 2
3 3

Solution Exercise 8.22

a. Continuous, since X can take many values that can lie close together.
b. f(x) = 10 if 2.35 < x < 2.45
=0 otherwise
This pdf is constant on the interval (2.35, 2.45) and 0 beyond.
c. P(2.38  X  2.41) is just the area above the interval (2.38, 2.41) under the
graph of f. With the rectangle-method this area turns out to be 0.0310 = 0.3.
d. This percentage follows from P( X  2.37) , which equals 0.0810 = 0.8.
Hence, the answer is 80%.
e. For x in the interval (2.35, 2.45), F(x) is the area above the interval (2.35, x)
under the graph of f. The suitable rectangle has width x  2.35 and height 10,
so the area is 10( x  2.35) . Hence:
F (x) = 0 if x < 2.35
= 10x – 23.5 if 2.35  x < 2.45
=1 if x  2.45
F is continuous and strictly increasing on the relevant interval (2.35, 2.45).
f. P(2.38  X  2.41) = F (2.41)  F (2.38) = 24.1 – 23.5 – (23.8 – 23.5) = 0.3
P( X  2.37) = 1  F (2.37) = 1 – (23.7 – 23.5) = 0.8; percentage: 80%.

11
Solution Exercise 8.23
a. On the interval [0, 100], the graph decreases linearly from 1/50 to 0.
b. Continuous; outcomes: all elements of the interval [0, 100].
c. f ( x)  0 for all x. Moreover, the rectangle with width 100 and height 1/50 has
area 2. The total area under f is just the half of it, which indeed is 1.
d. P(0  X  10) = total area under f and above the interval [0, 10). When going
from 0 to 10, f decreases linearly from 1/50 = 100/5000 to 0.9/50; make a
picture yourself. The area that is asked for is the area of a rectangle with sides
10 and 0.9/50 and a rectangular triangle with sides 10 and 0.1/10. So, this total
area is 10  0.9/50 + 0.5  10  0.1/50 = 0.19. Hence, P(0  X  10) = 0.19.
e. P( X  40) = P(40  X  100) , which is the total area of f above (40, 100].
When going from x = 40 to x = 100, the pdf f decreases from 0.6/50 to 0; make
a picture yourself. This total area is just the area of a rectangular triangle with
sides 60 and 0.6/50. Hence, P( X  40) = 0.5  60  0.6/50 = 0.36.

Solution Exercise 8.24

a. The graph is triangular above the interval (495, 505). Notice that f is close to 0
in the neighbourhood of 495 and 505, and relatively large when close to the
centre of the interval. Hence, this function reflects a small likelihood close to
495 and 505 and a large likelihood close to 500, which is in accordance with
the findings of the study of the 200 packs.
The area under the graph of f is the area of two rectangular triangles, both with
5 and 5a as length of the sides. Hence, the total area under f is 25a. Since the
area under a pdf has to be equal to 1, it follows that a = 1/25.
b. P( X  500) = 0 since X is a continuous r.v.
c. P(498  X  502) is the area above the interval (498, 502) under f. (Make a
picture yourself.) Notice that f (498)  f (502) =3/25. The surface of interest
consists of a rectangle with sides 4 and 3/25 and two rectangular triangles each
with sides 2 and 2/25. Hence, the area asked for is equal to 12/25 + 4/25 =
16/25.
d. E ( X ) = 500, by symmetry.

Solution Exercise 8.25

1 1 1 1
a. E ( X 2 ) = (3)2   02   22     62  = 12
2 12 12 12
Since E (X ) = 1/6, it follows that V (X ) = 12  1 / 36 = 11.9722 and SD(X ) =
3.4601.
If the came is played over and over again, the mean payoff will be 0.1667.
b. E (X ) = 1.0020; V (X ) = 1.5080 – (1.0020)2 = 0.5040; SD(X ) = 0.7099

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Solution Exercise 8.26
a. Let X denote the annual income (in thousands of euros) of this arbitrarily
chosen employee. Solving k in the equation   k  45 yields k = 2. By
Chebyshev’s rule we have:
P(35  X  45)  1 – ¼ = 0.75, so P( X  35) + P( X  45)  0.25
Hence, the upper bound asked for is 0.25, which corresponds to at most 25000
employees with incomes at least 45000 euro.
b. If the additional assumption is valid, P( X  35) and P( X  45) are equal.
Hence, P( X  45)  0.125. At most 12500 employees have incomes of at
least 45000 euro.

Solution Exercise 8.27

4 4
3 3 3 4 x3 x 4 4
32 0 32 0
a.  = E (X ) = x (4  x)dx =
2
(4 x  x )dx =
2 3
[  ]0 = 2
32 3 4
(This also follows from the symmetry of the pdf since the graph is
symmetrical round x = 2.)
4 4
3 3 3 4 x 4 x5 4
32 0 32 0
E( X 2 ) = x 3
( 4  x ) dx = ( 4 x 3
 x 4
) dx = [  ]0 = 4.8;
32 4 5

 2 = E ( X 2 ) - 22 = 0.8 and  = 0.8944

b. This lower bound is 0.75. That is: P(  2  X    2 )  0.75
c.   2 = 0.2111 and   2 = 3.7889. Hence:
P(  2  X    2 ) = P(0.2111  X  3.7889)
3.7889
3
 (4 x  x )dx
2
=
32 0.2111

3 x3 3.7889
=  [2 x  ]0.2111 = … = 0.9839
2

32 3
X 2
d. Z = = 1.1180X  2.2361
0.8944
P(Z  3) = P( X    3 ) = P( X  4.6833) = 1

Solution Exercise 8.28

a.
x 1 2 3 4 5 6
f(x) 1/6 1/6 1/6 1/6 1/6 1/6

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  = 21/6 = 3.5; 2 = E ( X 2 )  (3.5)2 = 91/6 – (3.5)2 = 2.9167;  = 1.7078
b., c., d. Simulation exercises.

Solution Exercise 8.29

The expected payoffs are respectively 1000, 1000 and 1250; the accompanying
standard deviations are 0, 1000 and 1250.
The choice between 1 and 2 is simple: choose option 1 since it has the same expected
payoff but the risk (standard deviation) is 0.
Option 3 will be preferred to option 2 since the probabilities are the same but option 3
promises (with probability 0.5) a larger payoff, 2500 instead of 2000.
However, the choice between 1 and 3 is personal. Option 3 may be preferred to 1 if
you are not too afraid to take a risk.

Solution Exercise 8.30

Option 1: E( X )  20000  0.01  0  0.99 = 200

V ( X )  20000 2  0.01  0 2  0.99  200 2 = 3960000 and

SDX )  1989.9749
Option 2: E ( X )  500 and SD( X )  0
Although the expected loss of option 1 is the smallest, you will probably choose
option 2 since losing €20000 would be a disaster (although the probability is only
0.01).

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