MECU 6551

Assignment #4 – Solutions
Due: Monday, November 8th, 2012 @ 5th floor PLAZU N by 6pm.
Question 1 A badminton player is going to play both Men’s Singles and Men’s Doubles
in the upcoming Badminton Championships. Based on his performance in the past, the
probability that he will become the champion in either Men’s Singles or Men’s Doubles
or both is 0.9, and that he will become the champion in Men’s Singles is 0.8, and that he
will become the champions in both Men’s Singles and Men’s Doubles is 0.4. What is the
probability that he will become the champion in Men’s Doubles?
It is given that P(Singles or Doubles) = 0.9, P(Singles) = 0.8, P(Singles and Doubles) =
0.4. To find P(Doubles), we must find an equation to relate it to the given probabilities.
For this, we use P(Singles or Doubles) = P(Singles) + P(Doubles) – P(Singles and
Doubles). This gives us 0.9 = 0.8 + P(Doubles) – 0.4 or P(Doubles) = 0.5.
Question 2 Among the users of the University of Manitoba Gym facilities, 200 students
were surveyed. The survey results were as follows:
• 30 students like all three activities of swimming, badminton and basketball,
• 15 students like only swimming and badminton, and dislike basketball,
• 45 students like only badminton and basketball, and dislike swimming,
• 20 students like only swimming and basketball, and dislike badminton,
• 25 students like swimming only, and dislike both badminton and basketball,
• 15 students like badminton only, and dislike both swimming and basketball,
• 20 students like basketball only, and dislike both swimming and badminton.
1) Draw a Venn diagram of the given information.
2) Randomly select a student from this group of 200 students surveyed, what
is the probability that the selected student
(a) likes either badminton or basketball, or both?
(b) likes badminton but not swimming?
(c) likes neither swimming, nor badminton, nor basketball?
(1) The Venn diagram is as follows:

badmonton  

swimming   15  
15  

25   30  

45  
20  

basketball  
20   30  

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MECU 6551 Assignment #4 – Solutions 2012

(2) Randomly select a student,

(a) P(either badminton, or basketball, or both)

= (15 + 15 + 30 + 45 + 20 + 20)/200 = 0.725
(b) P(badminton, not swimming)
= (15 + 45)/200 = 0.3
(c) P(neither swimming, nor badminton, nor basketball)
= (200 – 25 – 15 – 30 – 20 – 15 – 45 – 20)/200 = 30/200 = 0.15

Question 3 Independence of events is not always obvious. Toss two balanced coins
independently. The four possible combinations of heads and tails in order each have
probability 0.25. The events:
A = head on the first toss
B = both tosses have the same outcome
may seem intuitively related. Show that P(B|A) = P(B), so that A and B are in fact
independent.

S = {HH, HT, TH, TT}

A = {HH, HT} so that P(A) = P(HH or HT) = P(HH) + P(HT) = 0.25 + 0.25 = 0.50
B = {HH, TT} so that P(B) = P(HH or TT) = P(HH) + P(TT) = 0.25 + 0.25 = 0.50

P(B|A) = the probability of seeing B {HH, TT} happen if A {HH, HT} already happened.
The chance of A happening is 0.5 and out of the possible outcomes in A, HH is also an
outcome in B.
Using our definition of conditional probability:
P(A and B) 0.25
P(B | A) = = = 0.5
P(A) 0.5
Since P(B) = 0.5 then P(B|A) = P(B) which implies that the event A happening does not
affect the probability that B will happen. This is the same thing as saying that A and B are
independent.

S  
A   B  
HH  
HT   TT  
A  and  B  
TH  

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MECU 6551 Assignment #4 – Solutions 2012

Question 4 A random variable X has a uniform distribution on the interval (0, 2) what
is the probability that X is between 0.5 and 1.5?

     0                          0.5                                                                  1.5                          2  

First find the height of the entire density curve (rectangle).

Area = w × h
1=2×h
thus h = ½, where width w = upper – lower end of the entire rectangle = u – l = 2 – 0 = 2.
Then, P( 0.5 < X < 1.5) = w × h = 1 × ½ = ½ , where w = u – l = 1.5 – 0.5 =1.
Question 5 A random variable X has an isosceles triangular distribution with the base
on the interval (0,1). Recall that the area of a triangle is 0.5×b×h, where b is the base of
the triangle and h is the height. What is P(X > 0.75)?

0                                              0.5                0.75            1  

We need to do this problem geometrically since we don’t know the height of the shaded
region.

0                                              0.5                0.75            1  

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MECU 6551 Assignment #4 – Solutions 2012

If we figure out the area of the rectangle created by the dotted line, then out answer is 1/8
of the rectangle’s area (since it is ½ of a ¼ of the rectangle). Area of the rectangle will be
determined by the height of the triangle.

Finding the height of the entire density curve (triangle):

Area = 0.5 × b × h
1 = 0.5 × 1 × h, so h = 2
So the Area of the rectangle = w × h = 0.5 × 2 = 1
Therefore, the shaded triangle has area 1/8.

Question 6 Which of the following variables have a binomial distribution? Indicate the
parameters of each binomial distribution, or suggest a variation that would make the
variable binomial if it is not.
I. The number of 6's in ten rolls of a fair die
II. The number of rolls of a fair die required before 4 shows up for the first time
Ill. The number of 1's or 2's in five rolls of a fair die.

Definition: X is a binomial random variable and has a binomial distribution if it

defined as:

X = # of successes out of n independent trials; X = 0,1,2,…,n

(1) each observation has only one of two possibilities:

either a ‘success’ (what we are looking for) or a ‘failure’;

(2) p = the known probability of observing a ‘success’ is given and p is
the same for each of the n independent trials.
(3) n independent trials where n is a finite, fixed (known) number of
trials.

The only instances that a binomial variable is being described are I and III.

I. X~B(10, 1/6)
II. To be binomial, there needs to be a finite number of trials, and the probability
of success on any trial is the same and must be known.
III. X~B(5, 1/3)

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MECU 6551 Assignment #4 – Solutions 2012

Question 7 The probability that a randomly chosen student at the University of New
Harmony is a woman is 0.62. The probability that the student is studying education is
0.17. The conditional probability that the student is a woman, given that the student is
studying education in 0.8. What is the conditional probability that the student is studying
education, given that she is a woman?

Using the information provided, we can depict some of the probabilities provided:

P(W  and  E)          =  ?  

S  
P(W)=0.62   P(E)  =  0.17  

We can’t draw the conditional probability, but we visualize the conditional probability by
focusing in on one of the events alone, and the intersection of that event with the other.
Note, although we don’t need to use it here, Bayes’ rule works because the two event
share the intersection of events:

P(W and E) = P(E and W)

We are told that P(W|E) = 0.8 which means more women are in education than men. We
can use this to compute the overlapping piece and then find the other conditional
probability.

P(W and E)
P(W | E) =
P(E)
P(W and E)
0.8 =
0.17
P(W and E) = 0.8 × 0.17 = 0.136

So looking for the other conditional probability:

P(E and W )
P(E | W ) =
P(W )
0.136
=
0.62
= 0.21935

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MECU 6551 Assignment #4 – Solutions 2012

Question 8 Cystic fibrosis is a lung disorder that often results in death. It is inherited
but can be inherited only if both parents are carriers of an abnormal gene. In 1989, the CF
gene that is abnormal in carriers of cystic fibrosis was identified. The probability that a
randomly chosen person of European ancestry carries an abnormal CF gene is 1/25. (The
probability is less in other ethnic groups.) The CF20m test detects most but not all
harmful mutations of the CF gene. The test is positive for 90% of people who are carriers.
It is (ignoring human error) never positive for people who are not carriers.
a) Jason tests positive. What is the probability that he is a carrier?
b) Jason knows that he is a carrier of cystic fibrosis. His wife, Julianne, has a brother
with cystic fibrosis, which means the probability is 2/3 that she is a carrier. If
Julianne is a carrier, each child she has with Jason has probability 1/4 of having
cystic fibrosis. If she is not a carrier, her children cannot have the disease. Jason
and Julianne have one child, who does not have cystic fibrosis. This information
reduces the probability that Julianne is a carrier. Use Bayes’ rule to find the
conditional probability that Julianne is a carrier, given that she and Jason have one
child who does not have cystic fibrosis.
(a) Since the test is never positive for people who are not carriers, then, a positive
test, must mean a person is a carrier. Let’s use Bayes’ Rule to show this.

Let C+ = person is a carrier

1
P(C + ) = = 0.04 ⇒ P(C − ) = 0.96, P(T + | C + ) = 0.9, P(T + | C − ) = 0
25

P(C + and T + ) P(T + | C + )P(C + )

P(C + | T + ) = =
P(T + ) P(T + | C + )P(C + ) + P(T + | C − )P(C − )
 
0.9(0.04)
= =1
0.9(0.04) + 0(0.96)
   
So if someone has a positive test, there is no doubt that the person is a carrier.
With the information of the test result, the probability of being a carrier went from
4% to 100%.

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MECU 6551 Assignment #4 – Solutions 2012

Alternatively, we can take the information and fill in the table of information:

C+ C–

T+ Step 1 Step 2

T–

0.04 0.96 1

Step 1: Since not being a carrier means that the test will NEVER be positive,
P(T + | C − ) = 0 , there is no chance to see a person who is a carrier and has a
positive test result. So also, P(T +and C − ) = 0 .  
Step 2: Given
1
P(C + ) = = 0.04 ⇒ P(C − ) = 0.96, P(T + | C + ) = 0.9, P(T + | C − ) = 0
25
  P(T + ) = P(T + | C + )P(C + ) + P(T + | C − )P(C − ) = 0.9(0.04) + 0(0.96) = 0.036
We only need the first row of the table to answer the question, so Step 3 is to find
P(C +and T + ) = 0.036        

C+ C–

T+ Step 3 0 0.036

T–

0.04 0.96 1

P(C +and T + ) 0.036

P(C + | T + ) = = = 1  
P(T + ) 0.036
   
Again, we have shown that a positive test result means a person must be a carrier.

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MECU 6551 Assignment #4 – Solutions 2012

(b) I am going to use the same symbols, but with different meaning. This problem
involves the events Julianne is a carrier, C+, and Julianne and Jason have a child
with cystic fibrosis, D+.
2 1 1
P(C + ) = ⇒ P(C − ) = , P(D + | C + ) = = 0.25, P(D + | C − ) = 0 ⇒ P(D − | C − ) = 1
3 3 4

P(C + and D − ) P(D − | C + )P(C + )

P(C + | D − ) = =
P(D − ) P(D − | C + )P(C + ) + P(D − | C − )P(C − )

0.75(2 / 3)
= = 0.6
            0.75(2 / 3) +1(1 / 3)

Alternatively, we can take the information and fill in the table of information with
the aim of getting the information in the second row:

C+ C–

D+

D– Step 1 Step 2

2/3 1/3 1

Step 1: P(C + and D − ) = P(D − | C + )P(C + ) = 0.75(2 / 3) = 0.5

Step 2: P(D − ) = P(D − | C + )P(C + ) + P(D − | C − )P(C − ) = 0.75(2 / 3) +1(1 / 3) = 5 / 6
   
P(C + and D − ) 0.5
  P(C + | D − ) = = = 0.6  
P(D − ) 5
6
 
   

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MECU 6551 Assignment #4 – Solutions 2012

Question 9 An online insurance site offers a term insurance policy that will pay $100,000
if a 25-year-old man dies within the next 5 years. The cost is $175 per year. So the
insurance company will take in $875 from this policy if the man does not die within five
years. If he does die, the company must pay $100,000.
According to the current Commissioners’ Standard Ordinary mortality table, adopted by
state insurance regulators in December 2002, a 25 year old man has these probabilities of
dying during the next five years: (Commissioners’ Standard Ordinary Rask Force final
report, 2002, American Academy of Actuaries, found online at:
www.actuary.org/life/cso_htm )

a) Calculate the loss for the company in each year if the man dies. In other words,
complete the table below.
Age at death 25 26 27 28 29
Probability 0.00039 0.00044 0.00051 0.00057 0.00060
Loss ? ? ? ? ?

b) What is the company’s mean cash intake from such policies?

c) It would be quite risky for you to insure the life of a 25-year-old friend under the
terms above. There is a high probability that your friend would live and you
would gain $875 in premiums. But if he were to die, you would lose almost
$100,000. Explain carefully why selling insurance is not risky for an insurance
company that insures many thousands of 25-year-old men.

(a) The table would be:

Age at death 25 26 27 28 29
Probability 0.00039 0.00044 0.00051 0.00057 0.00060
Loss $99,825 $99,650 $99,475 $99,300 $99,125

(b)

Age at death 25 26 27 28 29 >29

Probability 0.00039 0.00044 0.00051 0.00057 0.00060 0.99749
Revenue -$99,825 -$99,650 -$99,475 -$99,300 -$99,125 $875

E(Revenue) = ∑ pi xi = $623.22

(c) Insuring many thousands of 25-year old men, the probabilities in the table would
be the long run relative frequencies. Therefore, the mean we calculate will likely
be the resulting average per person revenue. Over thousands of people, this is a lot
of money. The premiums provide more than enough money to payout to the few
beneficiaries.

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MECU 6551 Assignment #4 – Solutions 2012

Question 10 Here is a probability distribution for a random variable X:

Value of X 1 2 3
Probability 0.2 0.6 0.2

a) Find the mean and standard deviation for this distribution.

b) Construct a different distribution with the same possible values (i.e., 1, 2, 3) and
the same mean, but different probabilities and a larger standard deviation. Show
your work and report the standard deviation of your new distribution.
c) Construct a different distribution with the same possible values (i.e., 1, 2, 3) and
the same mean, but different probabilities and a smaller standard deviation. Show
your work and report the standard deviation of your new distribution.

(a)

pi xi xi − µ ( xi − µ )
2
pi ( xi − µ )
2

0.2 1 -1 1 0.2
0.6 2 0 0 0
0.2 3 1 1 0.2
Variance = ∑ pi ( xi − µ )
2 0.4

Mean = µ = ∑ pi xi = (0.2)1+ (0.6)2 + (0.2)3 = 2

Standard Deviation = σ = Variance = 0.4 = 0.6325
(b)

pi xi xi − µ ( xi − µ )
2
pi ( xi − µ )
2

0.4 1 -1 1 0.4
0.2 2 0 0 0
0.4 3 1 1 0.4
Variance = ∑ pi ( xi − µ )
2 0.8

Mean = µ = ∑ pi xi = (0.4)1+ (0.2)2 + (0.4)3 = 2

Standard Deviation = σ = Variance = 0.8 = 0.8944

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MECU 6551 Assignment #4 – Solutions 2012

(c)

pi xi xi − µ ( xi − µ )
2
pi ( xi − µ )
2

0.1 1 -1 1 0.1
0.8 2 0 0 0
0.1 3 1 1 0.1
Variance = ∑ pi ( xi − µ )
2 0.2

Mean = µ = ∑ pi xi = (0.1)1+ (0.8)2 + (0.1)3 = 2

Standard Deviation = σ = Variance = 0.2 = 0.4472

Question 11 Here are the means, standard deviation, and correlations for the annual
returns from three Fidelity mutual funds. Because there are three random variables, there
are three correlations. We use subscripts to show which pair of random variables a
correlation refers to.
W = annual return on 500 Index Fund
X = annual return on Investment Grade Bond Fund
Y = annual return on Diversified International Fund

µW = 11.12% σ W = 17.46%
µ X = 6.46% σ X = 4.18%
µY = 11.10% σ Y = 15.62%

ρWX = −0.22 ρWY = 0.56 ρ XY = −0.12

a) Many advisers recommend using roughly 20% foreign stocks to diversify
portfolios of U.S. stocks. You see that the 500 Index (U.S. stocks) and Diversified
International (foreign stocks) Funds had almost the same mean returns. A
portfolio of 80% 500 Index and 20% Diversified International will deliver this
mean return with less risk. Verify this by finding the mean and standard deviation
of returns on this portfolio.

R = 0.8W + 0.2Y
µ R = 0.8µW + 0.2µY
= (0.8 × 0.1112) + (0.2 × 0.1110) = 11.12%

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MECU 6551 Assignment #4 – Solutions 2012
σ R2 = σ 0.8W
2 2
+ σ 0.2Y + 2 ρWY σ 0.8W σ 0.2Y
= 0.82 σ W2 + 0.2 2 σ Y2 + 2 ρWY (0.8 × σ W )(0.2 × σ Y )
= 0.82 (0.1746 2 ) + 0.2 2 (0.1562 2 ) + 2(0.56)(0.8 × 0.1746)(0.2 × 0.1562)
= 0.025373676
σ R = 0.02537367 = 15.93%
b) Diversification works better when the investments in a portfolio have small
correlations. To demonstrate this, suppose that returns on 500 Index Fund and
Diversified International Fund had the means and standard deviations we have
given but were uncorrelated ( ρWY = 0 ).
i) Show that the standard deviation of a portfolio that combines 80% 500 Index
with 20% Diversified International is then smaller than your result from the
previous exercise.

R = 0.8W + 0.2Y
µ R = 0.8µW + 0.2µY
= (0.8 × 0.1112) + (0.2 × 0.1110) = 11.12%
2 2 2
σ R = σ 0.8W + σ 0.2Y + 2 ρσ 0.8W σ 0.2Y
= 0.82 σ W2 + 0.2 2 σ Y2 + 2 ρWY (0.8 × σ W )(0.2 × σ Y )
= 0.82 (0.1746 2 ) + 0.2 2 (0.1562 2 ) + 2(0)(0.8 × 0.1746)(0.2 × 0.1562)
= 0.02048644
σ R = 0.02048644 = 14.31%

ii) What happens to the mean return if the correlation is 0?

Nothing changes.

c) Portfolios often contain more than two investments. The rules for means and
variances continue to apply, though the arithmetic gets messier. A basic well-
diversified portfolio has 60% in 500 Index, 20% in Investment Grade Bond, and
20% in Diversified International.
i) What are the (historical) mean and standard deviation of the annual returns
for this portfolio? What does an investor gain by choosing this diversified
portfolio over 100% U.S. stocks?

R = 0.6W + 0.2X + 0.2Y

µ R = 0.6µW + 0.2µ X + 0.2µY
= (0.6 × 0.1112) + (0.2 × 0.0646) + (0.2 × 0.1110) = 10.184%

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 MECU 6551 Assignment #4 – Solutions 2012
σ R2 = σ 0.6W
2 2
+ σ 0.2 2
X + σ 0.2Y

+2 ρWXσ 0.6W σ 0.2 X + 2 ρWY σ 0.6W σ 0.2Y + 2 ρ XY σ 0.2 Xσ 0.2Y

= 0.6 2 σ W2 + 0.2 2 σ X2 + 0.2 2 σ Y2

+2 ρWX (0.6 × σ W )(0.2 × σ X ) + 2 ρWY (0.6 × σ W )(0.2 × σ Y ) + 2 ρ XY (0.2 × σ X )(0.2 × σ Y )

= 0.6 2 (0.1746 2 ) + 0.2 2 (0.04182 ) + 0.2 2 (0.1562 2 )

 
+2(−0.22)(0.6)(0.1746)(0.2)(0.0418)
+2(0.56)(0.6)(0.1746)(0.2)(0.1562)
+2(−0.12)(0.2)(0.0418)(0.2)(0.1562)

= 0.015237882

σ R = 0.015237882 = 12.34%
σW 17.46%
CV (W ) = = = 1.57
E(W ) 11.12%
σ 12.34%
CV (R) = R = = 1.21
E(R) 10.18%

The investor gains from a lower standard deviation, and a lower coefficient of variation
which reflects a reduction in risk.

ii) What does the investor lose (at least in this time period)?

The expected return does drop from 11.12% to 10.18%.

 

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