ero Coen erie cites rs a eon elt MLN APSO L(e cy Ce ey irl)Learning Outcomes (1/2) LOS: Define a probability distribution and compare and contrast discrete and continuous random variables and their probability functions. LOS: Calculate and interpret probabilities for a random variable, given its, cumulative distribution function. LOS: Describe the properties of a discrete uniform random variable. LOS: Describe the properties of the continuous uniform distribution, and calculate and interpret probabilities given a continuous uniform distribution. LOS: Describe the properties of a Bernoulli random variable and a binomial random variable, and calculate and interpret probabilities given the binomial distribution function. LOS: Explain the key properties of the normal distribution. LOS: Contrast a multivariate distribution and a univariate distribution, and explain the role of correlation in the multivariate normal distribution.Learning Outcomes (2/2) LOS: Calculate the probability that a normally distributed random variable lies inside a given interval. LOS: Explain how to standardize a random variable. LOS: Calculate and interpret probabilities using the standard normal distribution. LOS: Define shortfall risk, ca/culate the safety-first ratio, and identify an optimal portfolio using Roy’s safety-first criterion. LOS: Explain the relationship between normal and lognormal distributions and why the lognormal distribution is used to model asset prices. LOS: Calculate and interpret a continuously compounded rate of return, given a specific holding period return. LOS: Describe the properties of the Student's t-distribution, and calculate and interpret its degrees of freedom. LOS: Describe the properties of the chi-square distribution and the F- distribution, and ca/culate and interpret their degrees of freedom. LOS: Describe Monte Carlo simulation.LOS: Define a probability distribution and compare and contrast discrete and continuous random variables and their probability functions The probability distribution of a random variable “X” is a graphical representation of the probabilities associated with the possible outcomes of X. It gathers all the outcomes and goes a step further to indicate the probability associated with each outcome. > For example, suppose we rolled a dice. Each outcome would occur with a probability of 1/6 (16.7%). Consequently, the probability distribution would be a straight line. 6 lllLOS: Define a probability distribution and compare and contrast discrete and continuous random variables and their probability functions What’s a discrete random variable? * Any variable that takes on a finite number of outcomes. * It can take on any value from a discrete set of values. » Examples: The outcomes of rolling a dice, number of CFA charterholders at any given time, number of mutual funds in the U.S. See eee ec UR CUCL te * Any variable that can take on an infinite number of outcomes. > Agood example can be the rate of return on a stock. For instance, the return can be 6% or between 6% and 7%, in which case it can take on 6.4%, 6.41%, 6.412% or even 6.412325%, i.e., infinite values.LOS: Define a probability distribution and compare and contrast discrete and continuous random variables and their probability functions Probability Function: => A probability function gives the probability of a random variable X taking on a value “x” => Fora discrete variable, the probability function is expressed as p(x) while for a continuous variable, the function is expressed as f (x). @= There are two key properties of a probability function 0 < p(x) < 1,since probability must always be between 0 and 1. Sum of all probabilities must equal 1. - - The cumulative distribution function, or distribution function gives the probability that a random variable X is less than or equal to a particular value x, P(X < x), ie, F(x) = P(X The difference between the two values gives the desired probability. SCA Eee RuCl eke eek CeutaLOS: Calculate and interpret probabilities for a random variable given its cumulative distribution function P(X = 2) = F(2) — F(A) = 0.45 — 0.15 = 0.30 P(X = 3) = F(3) — F(2) = 0.80 — 0.45 = 0.35, Therefore, P(X = 2 or 3) = 0.30 + 0.35 = 0.65 Note: We could also do 0.80 — 0.15 = 0.65LOS: Describe the properties of a discrete uniform random variable, and calculate and interpret probabilities given the discrete uniform distribution function A discrete uniform random variable is one for which the probabilities for all possible outcomes are equal. > For example, if we throw a die, the probability of any value between 1 and 6 is 1/6. Therefore, the throw of a die takes on a uniform distribution with a discrete random variable. P(X = x)=} k+t 1 aaa Z B Will K-12 me Variance = 2 ‘@® Financial analysts use uniform discrete random variables when they intend to simulate random numbers where each number is equally likely to occur.LOS: Describe the properties of the continuous uniform distribution, and calculate and interpret probabilities given a continuous uniform distribution; The continuous uniform distribution is such that the random variable X takes values between a (lower limit) and B (upper limit). There cannot be an outcome either less than a or greater than B. Following is the probability density function: F200 = Be a 178) 2. Calculate P(100 < Y < 226).LOS: Describe the properties of the continuous uniform distribution, and calculate and interpret probabilities given a continuous uniform distribution; You have been given that Y~U(100,300). Calculate P(Y > 178) and P(100 < Y < 226). o to p(y > 178) = “2% — 300 = 178 _ 9 6 i JA B-a 300-100 ~ % — % _ 226 — 100 POO iS 220) so ercmea 00 =T00) = 0.63LOS: Describe the properties of a Bernoulli random variable and a binomial random variable, and calculate and interpret probabilities given the binomial distribution function © A Bernoulli trial is an experiment that has only two outcomes: success (S) or failure (F). > The words “success” and “failure” are mere labels which may not necessarily carry with them the ordinary meanings. For example, success could represent any return above 10% on a stock. © The probability of success is given by: P{s} = @ © And the probability of failure is: 1— P{s}= 1—@LOS: Describe the properties of a Bernoulli random variable and a binomial random variable, and calculate and interpret probabilities given the binomial distribution function @® Abinomial random variable is the number of successes in n Bernoulli trials where the trials are: i, Independent: the outcome of any trial does not depend on the outcomes of the other trials. ii, Identical: The probability of success is equal for all trials. @ Suppose the probability of a success is 6, n. a P(K=x)= @ e*(1 —@)"* Where x = 0, 1, 2, ...n and0<@<1 reat awe x a ~ (@=xyixt Remember that (") = "CyLOS: Describe the properties of a Bernoulli random variable and a binomial random variable, and calculate and interpret probabilities given the binomial distribution function SS The probability that any investment bank will survive a large-scale financial crisis is 0.8. What is the probability that at least 11 out of a group of 12 tier | banks affected by a crisis will survive?LOS: Describe the properties of a Bernoulli random variable and a binomial random variable, and calculate and interpret probabilities given the binomial distribution function SE The probability that any investment bank will survive a large-scale financial crisis is 0.8. What is the probability that at least 11 out of a group of 12 tier | banks affected by a crisis will survive? a a 0 Oo The no. of survivors is distributed binomially with n = 12 and 6 = 0.8 P(X > 11) = P(X = 11or12) Q P(X =11) = (i i) 0.8"1(1 — 0.8)'2-1" = 0.20616 12 P(X =12)= ( ) 0.812(1 — 0.8)!-12 = 0.06872 Total probability = 0.20616 + 0.06872 = 0.27488LOS: Describe the properties of a Bernoulli random variable and a binomial random variable, and calculate and interpret probabilities given the binomial distribution function ©& A binomial tree is used to predict stock price movements assuming there are two possible outcomes, each of which has a known probability of occurrence. OT t=0 t=1 t=2 t=3 S denotes the stock price today. u denotes 1 plus the rate of return when the stock moves up. Similarly, d denotes 1 plus the rate of return when the stock price moves down.LOS: Explain the key properties of the normal distribution \& Arandom variable is said to have the normal distribution (Gaussian curve) if its values make a smooth curve that assumes a “bell shape.” A normal variable has a mean “1, pronounced as “mu” and a standard deviation “o”, pronounced as “sigma.” Pee cttrai Its shorthand notation is X~N (ut, a). This is read as “the random variable X has a normal distribution with mean wand variance 0,” It has a symmetric shape — it can be cut into two equal halves that are mirror images of each other. As such, skewness = 0. Kurtosis = 3. Kurtosis is a measure of flatness and excess kurtosis is measured relative to 3, the “normal kurtosis.” } continued.LOS: Explain the key properties of the normal distribution The mean, the mode and median are alll equal and lie directly in the middle of the distribution If X~N(u, , 02) and Y~N(y ,0}), then the two variables combined also have anormal distribution. The standard deviation measures the distance from the mean to the point of inflection (the point where the curve changes an “upside-down-bowl” shape to a “right-side-up-bowl” shape). The probability that a value x lies between a and b is given by: b P(a Example: Suppose we wish to model the distribution of returns on a stock; such a model would be a univariate distribution. > Examples of univariate distributions: uniform, binomial, and the normal distribution. \©, Amultivariate distribution describes the probabilities for a group of related continuous random variables particularly if the individual variables follow a normal distribution., e.g., the multivariate normal dist. > Each variable has its own mean and variance. > Correlation defines the strength of the linear relationship between the random variables involved.LOS: Calculate the probability that a normally distributed random variable lies inside a given interval A confidence interval (Cl) gives an “interval estimate” of an unknown population parameter such as the mean. The precision or accuracy of the estimate depends on the width of the interval. For us to define a 100(1 - a@)% confidence interval for @ (true value of a population parameter, say, the mean), we must specify two random variables 8,(X) and 6,(X) such that: P[(X) < 6 < 6,(X)] =1-a (1 - @) gives the level of confidence associated with an interval. > Example: when a = 0.05, there’s a 95% chance of finding the true value of in the interval.LOS: Calculate the probability that a normally distributed random variable lies inside a given interval @ The following statements are true for any random variable that assumes a normal distribution: > 50% Cl: approx. 50% of all observations fall in the range p+ (2/3)o > 68% Cl: approx. 68% of all the observations fall in the range 1 +0 > 95% Cl: approx. 95% of all observations fall in the interval + 20 > 99% Cl: approx. 99% of all the observations fall in the interval + 30 @ However, the intervals indicated here are easy to remember but are only approximate for the stated probabilities. More precise intervals are w + 1.96¢ for 95 percent of the observations and uz + 2.5860 for 99 percent of the observations.LOS: Explain how to standardize a random variable => The standard normal distribution refers to a normal distribution that has been standardized such that it has a mean of 0 and a standard deviation of 1. The shorthand notation used is: N~(0,1) Standardization is the process of converting an observed value for a random variable into a z-value where: __ Observed value - Population mean Standard deviation x- To Using the standard normal distribution table, we can be able to calculate the that a normally distributed random variable Z, with mean 0 and variance 1 is less than or equal toz, ie., P(Z < z) = N(z).LOS: Calculate and interpret probabilities using the standard normal distribution SEE—————_ Refer to the following snapshot of the standard normal distribution table: 03 04 05 08 09 é 5319 551755575596 S714 5753 573 . 5948 ‘ ‘ 6103 6179 6255 6203 6331-6368 6480 6554 E 6664 — .6700 é 6844 6915, 70197054 = 7088 9 7224 A portfolio has an expected mean return of 8% and standard deviation of 14%. What's the probability that its return falls between 11% and 15%?LOS: Explain how to standardize a random variable => The standard normal distribution refers to a normal distribution that has been standardized such that it has a mean of 0 and a standard deviation of 1. The shorthand notation used is: N~(0,1) Standardization is the process of converting an observed value for a random variable into a z-value where: __ Observed value - Population mean Standard deviation x- To Using the standard normal distribution table, we can be able to calculate the that a normally distributed random variable Z, with mean 0 and variance 1 is less than or equal toz, ie., P(Z < z) = N(z).LOS: Calculate and interpret probabilities using the standard normal distribution Bry Refer to the following snapshot of the standard normal distribution table: 03 05 06 7 08 09 5000! . 5239 53195359 5398. 5517 55065636 S714 5753 5793 “ 5967 6026 61036141 61796217 6293 63686406 480.6517 6554 ‘ 6664 6m s 68446879 6915 6950 7019 7088 7123 1190 7224 A portfolio has an expected mean return of 8% and standard deviation of 14%. What's the probability that its return falls between 11% and 15%?LOS: Calculate and interpret probabilities using the standard normal distribution —SSEEE—————__ Refer to the following snapshot of the standard normal distribution table: 5239 5319 5636 5714 5793 “ - 6026 6103 6179 6406 6480 6554 E E ‘ 672s 6844 6915, NB 0 A portfolio has an expected mean return of 8% and standard deviation of 14%. What's the probability that its return falls between 11% and 15%?LOS: Calculate and interpret probabilities using the standard normal distribution —SEEE—————_ Refer to the following snapshot of the standard normal distribution table: 5080 «51205160 5199S 4 5319 5478 S517 5596 S74 5793 5871 5987 A 6103 6255 6368 6480 6554 6628 = 6664 §=.6700 6736 é 6844 6915 6950 6985 70197054 = 7088 90 A portfolio has an expected mean return of 8% and standard deviation of 14%. What's the probability that its return falls between 11% and 15%?LOS: Calculate and interpret probabilities using the standard normal distribution 2.00 Ot 02 03 4 05, 06 J 08 09 0.0 5000 5040 5080 5120 5160 5199 5239 5319 1 5398 S478 S517 55575506 5636 45753 02 57 C582.) 671 S910 59435967 6026 6064 6103 Ee 6179 6S 6203 638163686406 64806517 on 6628 6664 §=—.6700 6736 ~— 6772 68446879 05 Cems 60 gus 719 70st Jom 703 7190 724 P(11% < Portfolio return < 15%) = N(Z corresponding to 15%) — N(Z corresponding to 11%) © Zcorresponding to 15% = =" = — 8% — 0.50 © Zscore corresponding to 11% = *—" — =0.21 Therefore, P(11% < Portfolio return < 15% (0.5) — N(0.21) = 0.6915 — 0.5832 = 0.1083LOS: Define shortfall risk, calculate the safety-first ratio, and identify an optimal portfolio using Roy's safety-first criterion ©@ Shortfall risk Shortfall risk refers to the probability that a portfolio will not exceed the minimum (benchmark) return that has been set by the investor. As such, shortfall risks are downside risks. While shortfall risk focuses on the downside economic risk, the standard deviation measures the overall volatility of a financial asset. Ri=benchmark return E(R,)= expected returnLOS: Define shortfall risk, calculate the safety-first ratio, and identify an optimal Portfolio using Roy's safety-first criterion © Safety-First Ratio © Roy’s safety-first criterion states that the optimal portfolio is the one that minimizes the probability that the expected portfolio return, denoted by E(Rp), falls below the threshold level of return, R,. Writing down this concept in symbols: E(Rp) = Ri SFRatio = © Ifreturns are normally distributed, the optimal portfolio is the one with the highest safety-first ratio.LOS: Explain the relationship between normal and lognormal distributions and why the lognormal distribution is used to model asset prices A variable X is said to have a lognormal distribution if Y = In(X) is normally distributed, where In denotes natural log. © The lognormal distribution is positively skewed with many small values and just a few large values. Consequently, the mean is greater than the mode in most cases. | Why is the lognormal distribution used to model stock prices? © Unlike the normal distribution, the lognormal distribution doesn’t have a negative side, i.e,, it is bound by zero on the lower side. It is, therefore, perfect for modeling asset prices which cannot take negative values. ® While stock returns follow a normal distribution, stock prices follow a lognormal distribution.LOS: Calculate and interpret a continuously compounded rate of return, given a specific holding period return Continuous compounding applies when either the frequency with which we calculate interest is infinitely large or the time interval is infinitely small > Time is viewed as continuous. We can calculate the effective annual rate based on continuous compounding if given a stated annual rate of Rec. the formula used is: Effective annual rate = e®*¢- 1 (where e = 2.7183 ) We can also calculate the continuous compound rate of return if we have the holding period return. The formula used is: Continuous rate = In(1 + HPR) = In(@) 5 Sela el RC A URC eal beginning of the period S, = 100 and S, = 110: In(110/100) = 0.09531 > Therefore, e%-99531 _ 1 =0.10LOS: Describe the properties of the Student's t-distribution, and calculate and interpret its degrees of freedom RU en oe Cues oe) 1. t-distribution is symmetrical, bell-shaped distribution like a normal distribution. t-distribution is defined by one parameter, that is, degrees of freedom (df)=n-1. t-distribution is less peaked and has longer (fatter) tails as compared to a normal distribution. 4. As the df increase, the shape of a t-distribution becomes more and more like a standard normal distribution. t test used for differences between two means, correlation significance as well as in regression analysis.LOS: Describe the properties of the chi-square distribution and the F-distribution, and calculate and interpret their degrees of freedom What are the properties of the chi-square distribut . Chi-square distribution is a non-symmetrical distribution. . Chi-square distribution is defined by one parameter, that is, degrees of freedom (df) =n—1. Chi-square distribution is the sum of the squares of k independent standard normally distributed random variables. Hence, it is a non- negative distribution. . As the df increase, the shape of a chi-square distribution becomes more and more like a standard normal distribution. Chi-Square used as a test of variance for a normally distributed population.LOS: Describe the properties of the chi-square distribution and the F-distribution, and calculate and interpret their degrees of freedom NESS F-distribution is an asymmetrical distribution (skewed to the right). . F-distribution is defined by two parameters, i.e., degrees of freedom of the numerator (df1) and degrees of freedom of the denominator (df2). Like chi-square distribution, the F-distribution can only have positive values. . As the degrees of freedom for the numerator and for the denominator increase, the F-distribution approximates the normal distribution. F test used to test for difference between two variances.LOS: Describe Monte Carlo simulation Monte Carlo simulation involves the creation of a computer-based model into which the variabilities and interrelationships between random variables are entered. => A spread of results is obtained when the model is run many times ~ 100s. or 1000s. => The method is very useful when the number of random variables is too high making the analysis using ordinary methods very complex. eee CU Mo ane ee Ric a ©, Estimating risk and return. © Valuing complex securities, e.g., European style options, mortgage-backed securities complex embedded options. © Financial modeling.LOS: Describe Monte Carlo simulation What are the limitations of Monte Carlo simulation? It only provides us with statistical estimates of results, not exact figures. It is fairly complex and can only be carried out using specially designed software that may be expensive. The complexity of the process may cause errors leading to ‘wrong results that can be potentially misleading.——————— Learning Objectives (1/2) LOS: Define a probability distribution and compare and contrast discrete and continuous random variables and their probability functions. LOS: Calculate and interpret probabilities for a random variable, given its cumulative distribution function. LOS: Describe the properties of a discrete uniform random variable. LOS: Describe the properties of the continuous uniform distribution, and calculate and interpret probabilities given a continuous uniform distribution. LOS: Describe the properties of a Bernoulli random variable and a binomial random variable, and calculate and interpret probabilities given the binomial distribution function. LOS: Explain the key properties of the normal distribution. LOS: Contrast a multivariate distribution and a univariate distribution, and explain the role of correlation in the multivariate normal distribution.a Learning Objectives (2/2) LOS: Calculate the probability that a normally distributed random variable lies inside a given interval. LOS: Explain how to standardize a random variable. LOS: Calculate and interpret probabilities using the standard normal distribution. LOS: Define shortfall risk, calculate the safety-first ratio, and identify an optimal portfolio using Roy's safety-first criterion. LOS: Explain the relationship between normal and lognormal distributions and why the lognormal distribution is used to model asset prices. LOS: Calculate and interpret a continuously compounded rate of return, given a specific holding period return. LOS: Describe the properties of the Student's t-distribution, and calculate and interpret its degrees of freedom. LOS: Describe the properties of the chi-square distribution and the F- distribution, and calculate and interpret their degrees of freedom. LOS: Describe Monte Carlo simulation.