DCU MT5154: Session 2 Discrete Probability Andreas Robotis

DCU MT5154
Session 2
Discrete Probability
Andreas Robotis
Statistics for Managers Using Microsoft Excel®7e Copyright ©2014 Pearson Education, Inc. Chap 4-1
Types Of Variables
Types Of
Variables
Ch. 5 Discrete Continuous Ch. 6

Random
Variable
Variable Random
Variable
Variable
Statistics for Managers Using Microsoft Excel® 7e Copyright ©2014 Pearson Education, Inc. Chap 5-2
Discrete Random Variables
 Can only assume a countable number of values
Examples:
 Roll a die twice

Let X be the number of times 4 occurs
(then X could be 0, 1, or 2 times)
 Toss a coin 5 times.

Let X be the number of heads
(then X = 0, 1, 2, 3, 4, or 5)
Probability Distribution For A
Discrete Random Variable
 A probability distribution for a discrete random
variable is a mutually exclusive listing of all
possible numerical outcomes for that variable and
a probability of occurrence associated with each
outcome.
Number of Classes Taken Probability
2 0.20
3 0.40
4 0.24
5 0.16
Example of a Discrete Random
Variable Probability Distribution
Experiment: Toss 2 Coins. Let X = # heads.

4 possible outcomes
Probability Distribution
T T X Value Probability
0 1/4 = 0.25
T H 1 2/4 = 0.50
2 1/4 = 0.25
H T
Probability 0.50
H H 0.25
0 1 2 X
Discrete Variables
Expected Value (Measuring Center)
 Expected Value (or mean) of a discrete
variable (Weighted Average)
N
  E(X)   X i P ( X  X i )
i 1
X P(X=Xi)
 Example: Toss 2 coins, 0 0.25
X = # of heads, 1 0.50
compute expected value of X: 2 0.25
E(X) = ((0)(0.25) + (1)(0.50) + (2)(0.25))

= 1.0
Measuring Dispersion
 Variance of a discrete random variable
N
σ 2   [X i  E(X)]2 P(X  X i )
i 1
 Standard Deviation of a discrete random variable

N
σ  σ2   i
[X 
i 1
E(X)] 2
P(X  X i )
where:
E(X) = Expected value of the discrete random variable X
Xi = the ith outcome of X
P(X=Xi) = Probability of the ith occurrence of X
Measuring Dispersion
(continued)
 Example: Toss 2 coins, X = # heads,

compute standard deviation (recall E(X) = 1)
σ  i
[X  E(X)]2
P(Xi )
σ  (0  1)2 (0.25)  (1 1)2 (0.50)  (2  1)2 (0.25)  0.50  0.707
Possible number of heads

= 0, 1, or 2
Covariance
 The covariance measures the strength of the

linear relationship between two discrete random
variables X and Y.
 A positive covariance indicates a positive

relationship.
 A negative covariance indicates a negative

relationship.
The Covariance Formula
 The covariance formula:
N
σ XY   [ X i  E ( X )][(Yi  E (Y )] P ( X  X i , Y  Yi )
i 1
where: X = discrete random variable X

Xi = the ith outcome of X
Y = discrete random variable Y
Yi = the ith outcome of Y
P(X=Xi,Y=Yi) = probability of occurrence of the
ith outcome of X and the ith outcome of Y
Investment Returns
The Mean
Consider the return per $1000 for two types of

investments.
Investment
Economic Condition
Prob. Passive Fund X Aggressive Fund Y
0.2 Recession - $25 - $200
0.5 Stable Economy + $50 + $60
0.3 Expanding Economy + $100 + $350
Investment Returns
The Mean
E(X) = μX = (-25)(.2) +(50)(.5) + (100)(.3) = 50
E(Y) = μY = (-200)(.2) +(60)(.5) + (350)(.3) = 95
Interpretation: Fund X is averaging a $50.00 return

and fund Y is averaging a $95.00 return per $1000
invested.
Investment Returns
Standard Deviation
σ X  (-25  50) 2 (.2)  (50  50) 2 (.5)  (100  50) 2 (.3)

 43.30
σ Y  (-200  95) 2 (.2)  (60  95) 2 (.5)  (350  95) 2 (.3)

 193.71
Interpretation: Even though fund Y has a higher

average return, it is subject to much more variability
and the probability of loss is higher.
Investment Returns
Covariance
σ XY  (-25  50)(-200  95)(.2)  (50  50)(60  95)(.5)

 (100  50)(350  95)(.3)
 8,250
Interpretation: Since the covariance is large and

positive, there is a positive relationship between the
two investment funds, meaning that they will likely
rise and fall together.
The Sum of
Two Random Variables
 Expected Value of the sum of two random variables:
E(X  Y)  E( X)  E( Y )
 Variance of the sum of two random variables:
Var(X  Y)  σ 2X Y  σ 2X  σ 2Y  2σ XY
 Standard deviation of the sum of two random variables:
σ X  Y  σ 2X  Y
Portfolio Expected Return and Expected
Risk
 Investment portfolios usually contain several

different funds (random variables)
 The expected return and standard deviation of

two funds together can now be calculated.
 Investment Objective: Maximize return (mean)

while minimizing risk (standard deviation).
Portfolio Expected Return
and Portfolio Risk
 Portfolio expected return (weighted average

return):
E(P)  w E( X)  (1  w ) E( Y )
 Portfolio risk (weighted variability)
σ P  w 2σ 2X  (1  w )2 σ 2Y  2w(1 - w)σ XY
Where w = proportion of portfolio value in asset X

(1 - w) = proportion of portfolio value in asset Y
Portfolio Example
Investment X: μX = 50 σX = 43.30
Investment Y: μY = 95 σY = 193.21
σXY = 8250
Suppose 40% of the portfolio is in Investment X and

60% is in Investment Y:
E(P)  0.4 (50)  (0.6) (95)  77
σP  (0.4) 2 (43.30) 2  (0.6) 2 (193.71) 2  2(0.4)(0.6)(8,250)

 133.30
The portfolio return and portfolio variability are between the values
for investments X and Y considered individually
Decision Trees for Capacity Analysis
 A decision tree is a schematic model of the

sequence of steps in a problem – including the
conditions and consequences of each step.
 Decision trees help analysts understand the
problem and assist in identifying the best
solution.
 Decision tree components include the following:
 Decision nodes – represented with squares
 Chance nodes – represented with circles
 Paths – links between nodes
5-19
Example 5.2: Decision Trees
 Example 5.2: The owner of Hackers Computer Store
is evaluating three options – expand at current site,
expand to a new site, do nothing.
 The decision process includes the following
assumptions and conditions.
 Strong growth has a 55% probability (the growth will last 5
years)
 New site cost is $210,000
 Payoffs: strong growth = $195,000; weak growth = $115,000
 Expanding current site cost is $87,000 (in either year 1 or
2)
 Do nothing
5-20
 Calculate the value of each alternative
5-21
 Diagram the problem chronologically
Events
Decision
Decision
5-22
 Calculate value of each branch
$765,000
$365,000
$863,000
$413,000
$843,000
$850,000
$525,000
5-23
Example 5.2
 Work backwards to calculate the value of each decision/event
$765,000
$365,000
Do nothing has higher
value than expand, so
$660,500 $863,000
choose to do nothing
$413,000
Do nothing = $703,750
$843,000
Do nothing has higher $703,750 Do nothing = $850,000
value than expand or $850,000
move, so choose to do
nothing $525,000
5-24

DCU MT5154: Session 2 Discrete Probability Andreas Robotis

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DCU MT5154

Ch. 5 Discrete Continuous Ch. 6

 Roll a die twice

 Toss a coin 5 times.

Experiment: Toss 2 Coins. Let X = # heads.

compute expected value of X: 2 0.25

E(X) = ((0)(0.25) + (1)(0.50) + (2)(0.25))

 Standard Deviation of a discrete random variable

 Example: Toss 2 coins, X = # heads,

σ  (0  1)2 (0.25)  (1 1)2 (0.50)  (2  1)2 (0.25)  0.50  0.707

Possible number of heads

 The covariance measures the strength of the

 A positive covariance indicates a positive

 A negative covariance indicates a negative

 The covariance formula:

where: X = discrete random variable X

Consider the return per $1000 for two types of

0.2 Recession - $25 - $200

0.5 Stable Economy + $50 + $60

0.3 Expanding Economy + $100 + $350

E(X) = μX = (-25)(.2) +(50)(.5) + (100)(.3) = 50

E(Y) = μY = (-200)(.2) +(60)(.5) + (350)(.3) = 95

Interpretation: Fund X is averaging a $50.00 return

σ X  (-25  50) 2 (.2)  (50  50) 2 (.5)  (100  50) 2 (.3)

σ Y  (-200  95) 2 (.2)  (60  95) 2 (.5)  (350  95) 2 (.3)

Interpretation: Even though fund Y has a higher

σ XY  (-25  50)(-200  95)(.2)  (50  50)(60  95)(.5)

Interpretation: Since the covariance is large and

 Variance of the sum of two random variables:

 Standard deviation of the sum of two random variables:

 Investment portfolios usually contain several

 The expected return and standard deviation of

 Investment Objective: Maximize return (mean)

 Portfolio expected return (weighted average

 Portfolio risk (weighted variability)

Where w = proportion of portfolio value in asset X

Suppose 40% of the portfolio is in Investment X and

σP  (0.4) 2 (43.30) 2  (0.6) 2 (193.71) 2  2(0.4)(0.6)(8,250)

 A decision tree is a schematic model of the

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