Introduction to

Probability and Statistics

Sayantan Banerjee
IPS Session 12
Conditional distributions

Define the joint pmf of (X, Y ) by

p(0, 10) = p(0, 20) = 2/18, p(1, 10) = p(1, 30) = 3/18,

p(1, 20) = 4/18, p(2, 30) = 4/18.

1. Compute the conditional pmf of Y | X for each of the

possible values of X, x = 0, 1, 2.
2. Compute P (Y > 10 | X = 0).

Sayantan Banerjee 1
Conditional distributions

Consider the joint pmf of (X, Y ),

p(10, 1) = p(20, 1) = p(20, 2) = 1/10,

p(10, 2) = p(10, 3) = 1/5, p(20, 3) = 3/10.

Are X and Y independent?

Sayantan Banerjee 2
Conditional expectation

Let X and Y be jointly discrete random variables. Then, if

P (Y = y) > 0,then

P (X = x, Y = y)
pX|Y =y := P (X = x | Y = y) =
P (Y = y)

is the conditional pmf of X given Y = y. The conditional

expectation of X given Y = y is given by
X
E(X | Y = y) = x pX|Y =y .
x

Similarly we can define E(Y | X = x), if P (X = x) > 0.

Sayantan Banerjee 3
Conditional variance

In the previous situation, conditional variance of X | Y = y is

given by

V ar(X | Y = y) = E[{X − E(X | Y = y)}2 | Y = y].

Sayantan Banerjee 4
Two identities

If X and Y be any two random variables, then,

E(X) = E[E(X | Y )],

V ar(X) = E[V ar(X | Y )] + V ar[E(X | Y )],

provided the expectations exist.

Sayantan Banerjee 5
Problem

Can you solve the problem in the last slide of Session 11 now?

Sayantan Banerjee 6
Problems

Suppose that the random variable Y has a Binomial distribution

with parameters n and θ, where θ ∼ U (0, 1). Find E(Y ) and
V ar(Y ).

Sayantan Banerjee 7
Linear function of random variables

Consider n random variables X1 , . . . , Xn . Suppose

E(Xi ) = µi , i = 1, . . . , n.

A linear combination of these variables is given by

L(X1 , . . . , Xn ) = a1 X1 + · · · + an Xn ,

where ai , i = 1, . . . , n are real numbers. Then,

E[L(X1 , . . . , Xn )] = a1 µ1 + · · · + an µn .

Sayantan Banerjee 8
Linear function of random variables

Suppose further that Xi are mutually independent random

variables. Then,

V ar[L(X1 , . . . , Xn )] = a21 V ar(X1 ) + · · · + a2n V ar(Xn ).

If Xi are not independent, then

n
X X
V ar[L(X1 , . . . , Xn )] = a2i V ar(Xi ) + aj ak Cov(Xj , Xk ).
i=1 j6=k

Sayantan Banerjee 9
Application: Portfolio optimization

Suppose you have invested in a stock. Let Pi,1 be the price of the
ith stock on maturity day, and let your investment amount on that
stock be Pi,0 . The return on the ith stock is given by

Pi,1 − Pi,0
Xi = , i = 1, . . . , n.
Pi,0

If you have bought ai shares for stock i, then total return on

maturity is given by

L(X1 , . . . , Xn ) = a1 X1 + · · · + an Xn .

Sayantan Banerjee 10
Application: Portfolio optimization

• Other things being equal, investors prefer higher expected

return.
• Other things being equal, investors prefer lower risk.
• We measure risk with the standard deviation of the rate of
return.

Sayantan Banerjee 11
Application: Portfolio optimization

Asset information
Expected return Risk (%)
Exxon 11.2 13.9
Boeing 9.1 16.5
GM 12.1 15.8

The correlation matrix is given by

Exxon Boeing GM
Exxon 1 0.41 0.13
Boeing 1 -0.22
GM 1

Sayantan Banerjee 12
Application: Portfolio optimization

Given the choice to invest all money in one of these three, rational
investors would not choose Boeing: it has lower expected return
and more risk.
Most of us are risk-averse about certain investment decisions, some
more than others (as we have seen in various decision examples).

Sayantan Banerjee 13
Application: Portfolio optimization

• Given expected return find optimum proportion for minimum

var from a portfolio of two assets.
• Given risk appetite find optimum proportion for maximum
return.

Sayantan Banerjee 14
Problem for practice

The following table gives information on the expected return and

standard deviations of stocks of the three chocolate companies —
‘Godiva’, ‘Ghirardelli’ and ‘Amul’.
Company Country Expected return SD of return
Godiva Belgium 9.8% 3.6%
Ghirardelli USA 8.2% 2.1%
Amul India 7.8% 1.4%

An open trade market of cocoa beans (the main ingredient of dark

chocolate) between Europe and the USA has prompted a positive
correlation of 0.62 between the stocks of Godiva and Ghirardelli,
while both of these two are uncorrelated with stock prices of Amul.
Willy Wonka, the Chocolate baron, has invested 40% of his money
in stocks of Godiva and the rest in Ghirardelli. [Contd...]
Sayantan Banerjee 15
 1. Find the expected return and sd of return of Mr. Wonka’s
portfolio.
2. Inspired by the growth of dark chocolate market in India, Mr.
Wonka decides to diversify his portfolio by investing 40% in
Godiva, 50% in Ghirardelli and 10% in Amul. Find the
expected return and standard deviation of the return of Mr.
Wonka’s portfolio.

Sayantan Banerjee 16