COMMON PROBABILITY

DISTRIBUTION
CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
A. Define a probability distribution and distinguish between discrete and
continuous random variables and their probability functions

QUESTION : 1

Which of the following statements best describes a feature of any probability

function of a random variable? The probability function:
A. has a value between −1 and +1.
B. has the same value for all outcomes.
C. specifies the likelihood that a particular outcome of a random variable will occur.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

C is correct.
The probability function specifies the probability that the random variable takes on a
specific value.

A is incorrect because one of the key properties of a probability function is that

probability is a number between 0 and 1.

B is incorrect because the distribution function of a continuous random variable can

take a number of forms: uniform, normal, lognormal, etc.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
B. Describe the set of possible outcomes of a specified discrete random variable

QUESTION : 2

When flipping three coins simultaneously, the number of outcomes that contain at
least two heads is most likely:
A. eight.
B. four.
C. three.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

B is correct.
The number of outcomes having at least two heads is four, as indicated in the
following table.
No. of Heads Outcomes (Coin 1, Coin 2, Coin 3) No. of Possible Outcomes

At least 2 (H,H,T), (H,T,H), (T,H,H), and (H,H,H) 4

A is incorrect. The outcome of at least one head is calculated instead.

No. of Head Outcomes (Coin 1, Coin 2, Coin 3) No. of possible outcomes

At least 1 (H,T,T), (T,H,T), (T,T,H), (H,H,T), (H,T,H), 8

(T,H,T), (T,H,H), (H,H,H)

C is incorrect. The outcome of (H,H,H) is not counted.

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 CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
C. Interpret a cumulative distribution function
D. Calculate and interpret probabilities for a random variable, given its cumulative
distribution function

QUESTION : 3

Cumulative Probabilities for a Standard Normal Distribution

P(Z ≤ x) = N(x) for x ≥ 0 or P(Z ≤ z) = N(z) for z ≥ 0

x or z 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09

1.10 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 .08770 0.8790 0.8810 0.8830
1.20 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.30 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
…

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 CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION

x or z 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09

1.90 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.00 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.10 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
…
2.50 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.60 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.70 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
A variable is normally distributed with a mean of 5.00 and a variance of 4.00. Using
the excerpt above from the cumulative distribution function for the standard normal
random variable table, the probability of observing a value of −0.40 or less
is closest to:
A. 2.44%.
B. 8.85%.
C. 0.35%.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

C is correct.
First the outcome of interest, −0.40, is standardized for the given normal distribution:

Z
 X  μ   0.40  5.00   2.70
σ 2
Then use the table to find the probability of a Z value being 2.70 standard
deviations below the mean (i.e., when z ≤ 0).
The value is 1 − P(Z ≤ +2.70). In this problem, the solution is: 1 − 0.9965 = 0.0035 =
0.35%.
A is incorrect; it inverts mean and variance:
 0.40  4.00   1.97 z  value
 
5
The probability is then calculated as: 1 − 0.9756 = 2.44%.
B is incorrect; it divides −5.4 by the variance, 4, and uses 1.35 as the z-value. The
probability is then calculated as: 1 − 0.9115 = 8.85%.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
C. Interpret a cumulative distribution function
D. Calculate and interpret probabilities for a random variable, given its cumulative
distribution function

QUESTION : 4

The following is an excerpt from the cumulative distribution function for the standard
normal random variable table:

Cumulative Probabilities for a Standard Normal Distribution

P(Z ≤ x) = N(x) for x ≥ 0 or P(Z ≤ z) = N(z) for z ≥ 0

x or z 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09

0.10 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.20 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
0.30 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.40 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
…
1.10 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.883
1.20 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.30 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.40 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
…
1.80 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.90 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.00 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
2.10 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
A variable is normally distributed with a mean of 2.00 and a variance of 16.00. Using
the excerpt, the probability of observing a value of 7.40 or less is closest to:
A. 63.3%.
B. 91.2%.
C. 96.8%.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

B is correct.
First the outcome of interest, 7.40, is standardized for the given normal distribution:

Z   X       7.40  2.00  / 16  1.35

Then, the given table of values is used to find the probability of a Z-value being less
than or equal to 1.35 standard deviations above the mean. The value is P(Z ≤ 1.35) =
0.9115 = 91.2%.

A is incorrect; it divides 5.4 (that is the result of 7.4 − 2) by the variance, 16, and uses
0.34 as the z-value: P(Z ≤ 0.34) = 0.6331 = 63.3%.
C is incorrect; it divides the value, 7.4, by the standard deviation, 4, and uses 1.85 as
the Z-value: P(Z ≤ 1.85) = 0.9678 = 96.8%.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
E. Define a discrete uniform random variable, a Bernoulli random variable, and a
binomial random variable

QUESTION : 5

A random variable with a finite number of equally likely outcomes is best described
by a:
A. discrete uniform distribution.
B. binomial distribution.
C. continuous uniform distribution.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

A is correct.
A random variable has a discrete uniform distribution when there are a finite number
of equally likely specified outcomes.

B is incorrect. A binomial distribution has only two outcomes, and they need not be
equally likely.

C is incorrect. A finite number of outcomes is consistent with a discrete distribution,

not a continuous distribution.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
F. Calculate and interpret probabilities given the discrete uniform and the binomial
distribution functions

QUESTION : 6

An analyst determines that 60% of all US pension funds hold hedge funds. In
evaluating this probability, a random sample of 10 US pension funds is taken. Using
the binomial probability function, the probability that exactly 6 of the 10 firms in the
sample hold hedge funds is closest to:
A. 60.0%.
B. 11.2%
C. 25.1%

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

C is correct.
The number of trials is 10 (n), the number of successes is 6 (x), and the probability of
success is 0.60 (p). By using the formula:
n!
P X  x  px  1  p 
n x

 n  x  !x!
and the values given,
10!
P X  6   0.6   0.4   25.08%
6 4

 10  6  !6!
A is incorrect. It is the given chance of success, 60%.
B is incorrect. It uses a probability of 0.40 instead than 0.60:
10!
0.4 6  1  0.4 
10  6
 11.15%
 10  6  !6!

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
F. Calculate and interpret probabilities given the discrete uniform and the
binomial distribution functions
G. Construct a binomial tree to describe stock price movement

QUESTION : 7

A stock’s expected price movement over the next two periods is as follows:
Time = 0 Time = 1 Time = 2
S0 = 80 Su = 88 Suu = 96.80
Sd = 72 Sud,du = 79.20
Sdd = 64.80

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
The initial value of the stock is $80. The probability of an up move in any given period
is 75%, and the probability of a down move in any given period is 25%. Using the
binomial model, the probability that the stock’s price will be $79.20 at the end of two
periods is closest to:
A. 37.50%.
B. 56.25%.
C. 18.75%.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

A is correct.
Across two periods, there are four possibilities:

 uu: End Value: $96.80

 ud: End Value: $79.20
 du: End Value: $79.20

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
 dd: End Value: $64.80

where u is an up move and d is a down move.

The probability of an up move followed by a down move is 0.75 × 0.25 = 0.1875.

The probability of a down move followed by an up move is 0.25 × 0.75 also = 0.1875.
Both of these sequences result in an end value of $79.20.

Therefore, the probability of an end value of $79.20 is (0.1875 + 0.1875) = 37.5%.

Alternatively, the following formula could be used:
n!
p  x   P  X  x    nx  p x 1  p   P x 1  p 
nx nx

 n  x  ! x!
Where
n = 2 (number of periods)
x = 1 (number of up moves: ud and du)
p = 0.75 (probability of an up move)

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
2!
p 1   21 0.751 1  0.75 
2 1
  0.751  0.2521  2  0.75  0.25  0.375
 2  1 !|!
B is incorrect because it is the probability of an up move followed by an up move
(0.75 × 0.75 = 0.5625).

C is incorrect because it is does not recognize that there are two branches that end in
$79.20.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
F. Calculate and interpret probabilities given the discrete uniform and the binomial
distribution functions
G. Construct a binomial tree to describe stock price movement

QUESTION : 8

Assume that a stock’s price over the next two periods is as shown below.
Time = 0 Time = 1 Time = 2
S0 = 100 Su = 110 Suu = 121
Sd = 92 Sud,du = 101.20
Sdd = 84.64

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
The initial value of the stock is $100. The probability of an up move in any given
period is 40%, and the probability of a down move in any given period is 60%. Using
the binomial model, the probability that the stock’s price will be $101.20 at the end
of two periods is closest to:
A. 48%
B. 24%
C. 16%

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

A is correct.
Across two periods, there are four possibilities: an up move followed by an up move
($121.00 end value), an up move followed by a down move ($101.20 end value), a
down move followed by an up move ($101.20 end value), and a down move followed
by a down move ($84.64 end value). The probability of an up move followed by a
down move is 0.40 × 0.60 = 0.24. The probability of a down move followed by an up
move is 0.60 ×0.40, which also = 0.24. Both of these sequences result in an end value
of $101.20. Therefore, the probability of an end value of $101.20 is 48%.
Alternatively, the following formula could be used:
n!
p  x   P  X  x    nx  p x  1  p   px  1  p 
n x n x

 n  x  !x!
Where
n = 2 (number of periods)
x = 1 (number of up moves: ud and du)

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
p = 0.40 (probability of an up move)
2!
p  1    12  0.40 1  1  0.40  
2 1
 0.40 1  0.6 1  2  0.40  0.60  0.48
 2  1  !1!
B is incorrect because it is does not recognize that there are two branches that end in
$101.20.

C is incorrect because it is the probability of an up move followed by an up move (0.4

× 0.4 = 0.16).

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
H. Define the continuous uniform distribution and calculate and interpret
probabilities, given a continuous uniform distribution

QUESTION : 9

A random number between zero and one is generated according to a continuous

uniform distribution. What is the probability that the first number generated will
have a value of exactly 0.30?
A. 70%
B. 0%
C. 30%

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

B is correct.
The probability of generating a random number equal to any fixed point under a
continuous uniform distribution is zero.
C is incorrect because this is the cumulative distribution function of the continuous
uniform distribution. The probability P(0 ≤ x ≤ 0.3) in a continuous uniform
distribution with a = 0 and b = 1 is equal to:
x  a 0.3  0
F  0.3     0.3
ba 10
A is incorrect because this is the probability of a random number x in this continuous
uniform distribution taking a value greater than or equal to 0.3; P(x ≥ 0.3) = 1 − F(0.3)
= 0.7.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
I. Explain the key properties of the normal distribution

QUESTION : 10

Which of the following is the least likely characteristic of the normal probability
distribution? The normal probability distribution:
A. is more suitable as a model for asset prices than for returns.
B. has the same value for mean, median, and mode.
C. has kurtosis of 3.0.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

A is correct.
A normal distribution is less suitable as a model for asset prices than as a model for
returns. The reason is that an asset price has a lower limit that corresponds to zero (it
becomes worthless) and cannot be negative, whereas a normal distribution has no
lower limit. Asset returns, on the other hand, can be negative.
B is incorrect because a normal distribution has the same mean, median, and mode.
C is incorrect because a normal distribution has kurtosis of 3.0.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
J. Distinguish between a univariate and a multivariate distribution and explain the
role of correlation in the multivariate normal distribution

QUESTION : 11

Which statement is most accurate when considering a multivariate normal

distribution for the returns on 10 stocks from different sectors? There are:
A. 45 distinct correlations not equal to one.
B. 90 distinct correlations not equal to one.
C. 100 distinct correlations.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

A is correct.
A multivariate normal distribution for the returns of n stocks is defined
by nmeans, n variances, and n × (n − 1)/2 dis nct correla ons. There should be 45 =
[10 × (10 − 1)]/2 dis nct correla ons in this case.

B is incorrect. There are 90 correlations not equal to one, but there are 45 duplicate
correlations making the number of distinct correlations not equal to one equal to 45
(i.e., 90 − 45 = 45).

C is incorrect. Including correlations equal to one, there are only 55 distinct

correlations, of which ten are equal to one.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
L. Define the standard normal distribution, explain how to standardize a random
variable, and calculate and interpret probabilities using the standard normal
distribution

QUESTION : 12

An analyst develops the following capital market projections.

Stocks Bonds
Mean Return 10% 2%

Standard Deviation 15% 5%

Assuming the returns of the asset classes are described by normal distributions,
which of the following statements is correct?
A. On average 99% of stock returns will fall within ± 30% from the mean.
B. Bonds have a higher probability of a negative return than do stocks.
C. The probability of a bond return ≤ 3% is determined using a Z-score of 0.25.
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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

B is correct.
A negative return is any return that is less than zero. The chance of a negative return
falls in the area to the left of 0% under a standard normal curve. By standardizing the
returns and standard deviations of the two assets, the likelihood of either asset
experiencing a negative return may be determined: Z-score (standardized value) =
(X − μ)/σ Z-score for a bond return of 0% = (0 − 2)/5 = −0.40.

Z-score for a stock return of 0% = (0 − 10)/15 = −0.67.

For bonds, a 0% return falls 0.40 standard deviations below the mean return of 2%. In
contrast, for stocks, a 0% return falls 0.67 standard deviations below the mean return
of 10%. 0.40 of a standard deviation is less than 0.67 of a standard deviation.
Negative returns therefore occupy more of the left tail of the bond distribution than

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
the stock distribution. Thus, bonds are more likely than stocks to experience a
negative return.
A is incorrect because on average 95% of returns will fall in the interval μ ± 2σ (which
is 30%).

C is incorrect because the Z-score for a 3% bond return is calculated as Z = (X − μ)/σ =

(3 − 2)/5 = 0.20.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
L. Define the standard normal distribution, explain how to standardize a random
variable, and calculate and interpret probabilities using the standard normal
distribution

QUESTION : 13

Which of the following most accurately describes how to standardize a random

variable X?
A. Subtract the mean of X from X, and then divide that result by the standard
deviation of the standard normal distribution.
B. Divide X by the difference between the standard deviation of X and the standard
deviation of the standard normal distribution.
C. Subtract the mean of X from X, and then divide that result by the standard
deviation of X.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

C is correct.
There are two steps in standardizing a random variable X: Subtract the mean
of X from X, and then divide that result by the standard deviation of X. This is
represented by the following formula: Z = (X − μ)/σ.

A is incorrect. There are two steps in standardizing a random variable X: Subtract the
mean of X from X, and then divide that result by the standard deviation of X. This is
represented by the following formula: Z = (X − μ)/σ.

B is incorrect. There are two steps in standardizing a random variable X: Subtract the
mean of X from X, and then divide that result by the standard deviation of X. This is
represented by the following formula: Z = (X − μ)/σ.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
M. Define shortfall risk, calculate the safety-first ratio, and select an optimal
portfolio using Roy’s safety-first criterion

QUESTION : 14

An investor wants to maximize the possibility of earning at least 5% on her

investments each year.

Portfolio Expected Return Standard Deviation Roy’s Safety-First Ratio

1 0.35
2 0.64
3 22% 40% ??

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Using Roy’s safety-first criterion, the most appropriate choice for the investor is
portfolio:
A. 3
B. 2
C. 1

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

B is correct.
The portfolio with the highest safety-first ratio (SFRatio) is preferred. The SFRatio is
calculated by subtracting the threshold return (RL) from the expected return [E(RP)]
and dividing by the standard deviation (σP).

SFRatio = [E(RP) − RL]/σP. For the choices given:

Portfolio 1 Portfolio 2 Portfolio 3
Roy’s Safety 0.35 0.64 0.425 = [(22 − 5)/40]
First Criterion

Portfolio 2 has the highest SFRatio, so it is the most appropriate choice.

C is incorrect because 0.35 is less than 0.64.
A is incorrect because 0.425 is less than 0.64.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
N. Explain the relationship between normal and lognormal distributions and why
the lognormal distribution is used to model asset prices

QUESTION : 15

If a stock’s continuously compounded return is normally distributed, then the

distribution of the future stock price is best described as being:
A. normal.
B. a Student’s t.
C. lognormal.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

C is correct.
If a stock’s continuously compounded return is normally distributed, then the future
stock price is necessarily lognormally distributed.

A is incorrect. If a stock’s continuously compounded return is normally distributed,

then future stock price is necessarily lognormally distributed.

B is incorrect. If a stock’s continuously compounded return is normally distributed,

then future stock price is necessarily lognormally distributed.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
N. Explain the relationship between normal and lognormal distributions and why
the lognormal distribution is used to model asset prices

QUESTION : 16

In contrast to normal distributions, lognormal distributions:

A. are skewed to the left.
B. have random variables that cannot be negative.
C. are more suitable for describing asset returns than asset prices.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

B is correct.
By definition, lognormal random variables cannot have negative values.
A is incorrect because lognormal distributions are right skewed (have long right tails).

C is incorrect because the random variables of a lognormal distribution are bounded

by zero, as are asset prices (they cannot be negative). The lognormal distribution is
therefore more suitable than the normal distribution as a probability model for asset
prices. In contrast, the lognormal distribution is not suitable for describing asset
returns (which can be both positive and negative).

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
P.Explain Monte Carlo simulation and describe its applications and limitations

QUESTION : 17

Monte Carlo simulation is best described as:

A. providing a distribution of possible solutions to complex functions.
B. a restrictive form of scenario analysis.
C. an approach to back-test data.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

A is correct.
Monte Carlo simulation provides a distribution of possible solutions to complex
functions. The central tendency and the variance of the distribution of solutions give
important clues to decision makers regarding expected results and risk.

B is incorrect; scenario analysis shows the changes in key financial quantities that
result from given economic events.

C is incorrect; it more correctly describes historical simulation.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Q. Compare Monte Carlo simulation and historical simulation

QUESTION : 18

Compared with historical simulation, Monte Carlo simulation is most appropriate

when:
A. probability distributions are unavailable.
B. “what if” analysis is required.
C. analytical methods are required.

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CFA LEVEL - 1 COMMON PROBABILITY DISTRIBUTION
Solution

B is correct.
Monte Carlo simulation lends itself to “what if” analysis and requires the user to
provide a probability distribution or distributions. It can be a complement to
analytical methods.

A is incorrect. Monte Carlo simulation requires probability distribution.

C is incorrect. Monte Carlo simulation can be a complement to analytical methods.

Analytical methods provide precise results, whereas Monte Carlo simulation does
not.

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