PROBABILITY

The Application of Probability Concept

• Introduction to Probability
a. Fundamental probability concepts
b. Rules of Probability
c. Contingency Tables and Probabilities
d. The total probability rule and Bayes Theorem
e. Counting Rules

• Discrete Probability Distributions

• Types and Examples
Introduction to Probability
A probability is a numerical value that measures the likelihood
that an event occurs.

The value of a probability is between zero (0) and one (1).

Notes:
where a value of zero (0) indicates impossible events and a
value of one (1) indicates definite events..
Terminology and some structure in Probability Concept
• Experiment is a process that leads to one of several possible outcomes. The diversity of
the outcomes of an experiment is due to the uncertainty of the real world.
• When is the repair work needed for our laptop? In 1/2/3rd year.
• Roll of dice will result in a value of 1,2,3,4,5,6
• When will the project be finished? In 1/3/4th months.
• whether the profit will improve, stay the same, or deteriorate; and whether a ball game will
end in a win/loss/tie.
• Sample Space, denoted by S, of an experiment contains all possible outcomes of the
experiment.
• suppose the sample space representing the letter grade in a course is given S = {A, B, C, D, F}.
• The sample space for an experiment need not be unique. For example, in the above
experiment, we can also define the sample space with just P (pass) and F (fail) outcomes; that
is, S = {P, F}.
 Example
• A snowboarder competing in the Winter Olympic Games is trying to assess her probability
of earning a medal in her event, the ladies’ halfpipe. Construct the appropriate sample
space.
SOLUTION: The athlete’s attempt to predict her chances of earning a medal is an
experiment because, until the Winter Games occur, the outcome is unknown. We formalize
an experiment by constructing its sample space. The athlete’s competition has four possible
outcomes: gold medal, silver medal, bronze medal, and no medal. We formally write the
sample space as S = {gold, silver, bronze, no medal}.
PROBABILTY CONCEPT
• Sample space (S) = include all possible outcome
• Event = any subset of outcomes of the experiment.
Example:
grades :
S = {A, B, C, D, E, F}
Event = getting an A
Medals:
S= {Gold, Silver, Bronze, No Medal}
Event= getting Gold
TYPE OF EVENTS
• Exhaustive
✔ If all possible outcomes of an experiment belong to the events.
✔ For example, the events “at least a silver medal” S= {Gold, Silver} and “at most
a silver medal” S={silver, bronze, no medal} in a single Olympic event are
exhaustive.
• Mutually exclusive
✔ If they do not share any common outcome of an experiment.
✔ For example, the events earning “at least a silver medal” S= {Gold, Silver} and
“at most a bronze medal” S={bronze, no medal} in a single Olympic event are
mutually exclusive .
PROBABILITY CONCEPT
•
INTERSECTION

• The intersection of two events (A ∩ B) consists of all

outcomes in A and B.
A∩B

A B
COMPLEMENT

• The complement of event A (i.e., Ac) is the event consisting of

all outcomes in the sample space S that are not in A.

A Ac
EXAMPLE
THE FUNDAMENTAL PROPERTIES OF
PROBABILITY
•

Notes: Since empirical and classical probabilities generally do not vary from person to person, they
are often grouped as objective probabilities.
Example of Subjective Probability
Suppose the snowboarder believes that there is a 10% chance that she will earn a gold medal, a
15% chance that she will earn a silver medal, a 20% chance that she will earn a bronze medal, and
a 55% chance that she will fail to earn a medal. She has assigned a subjective probability to
each of the simple events. She made a personal assessment of these probabilities
without referencing any data.
EVENT PROBABILITY Symbols

Gold 0.10 P({Gold}) = 0.10

Silver 0.15 P({silver}) = 0.15

Bronze 0.20 P({Bronze}) = 0.20

No Medal 0.55 P({No Medal}) = 0.55

Suppose the snowboarder wants to calculate the probability of earning a medal. In the previous example, we
defined “earning a medal” as event A (A = {gold, silver, bronze}, so the probability statement takes the form P(A).
We calculate this probability by summing the probabilities of the outcomes in A, or equivalently,
Next-Subjective Probability
A = {gold, silver, bronze}; that is, event A denotes earning a medal;
B = {silver, bronze, no medal}; that is, event B denotes earning at most a
silver medal;
EVENT PROBABILITY Symbols
C = {no medal};
Gold 0.10 P({Gold}) = 0.10
calculate the following probabilities.
a. P(B ∪ C ) Silver 0.15 P({silver}) = 0.15
b. P(A n C ) Bronze 0.20 P({Bronze}) = 0.20
c. P(Bc)
No Medal 0.55 P({No Medal}) = 0.55
Empirical Probability

The empirical probability of an event is the observed relative

frequency with which an event occurs.

Notes:
The experiment must be repeated a large number of times for
empirical probabilities to be accurate.
 Classical Probability
• A classical probability is based on logical analysis rather than on observation or personal
judgment
• In a more narrow range of well-defined problems, we can sometimes deduce (logical
function) probabilities by reasoning about the problem.
• Classical probabilities are often used in games of chance (Dice Games).
-They are based on the assumption that all outcomes of an experiment are equally likely.

Example:
Suppose our experiment consists of rolling a six-sided dice. Then we can define the appropriate sample
space as S = {1, 2, 3, 4, 5, 6}.
a. What is the probability that we roll a 2?
b. What is the probability that we roll a 2 or 5?
c. What is the probability that we roll an even number?
 ODDS RATIO

• Converting a probability to an odds ratio:

✔ The odds for event A occurring equal:

✔ The odds against A occurring equal:

Rules of Probability
ADDITION RULES
The Addition Rule for Mutually Exclusive Events

For Instance, Samantha Greene, a college senior, contemplates her future

immediately after graduation. She thinks there is a 25% chance that she will
join the Peace Corps and teach English in Madagascar for the next few years.
Alternatively, she believes there is a 35% chance that she will enroll in a full-
time law school program in the United States.
CONDITIONAL VS UNCONDITIONAL (MARGINAL)
PROBABILITY
• Unconditional Probability: The probability of an event without
any restriction.
• For example, P(A) = probability of finding a job, and P(B) = probability of
prior work experience.
• Conditional Probability: The probability of an event given that another event
has already occurred.
• In the conditional probability statement, the symbol “|” means “given.”
• For example, P(A | B) = probability of finding a job given prior work
experience.
CALCULATING CONDITIONAL PROBABILITY
• Calculating Conditional Probability
✔ Given two events A and B, each with a positive probability of
occurring, the probability that A occurs given that B has occurred ( A
conditioned on B ) equals

✔ Similarly, the probability that B occurs given that A has occurred ( B

conditioned on A ) is equal to
Examples
MULTIPLICATION RULE
• The Multiplication Rule: the probability that A and B both
occur is equal to:

✔ Note that when two events are mutually exclusive:

Example Multipication Rule
CONTINGENCY TABLES
✔ A contingency table generally shows frequencies for two qualitative or
categorical variables, x and y.
✔ Each cell represents a mutually exclusive combination of the pair of x
and y values.
 THE TOTAL PROBABILITY RULE
✔ P(A) is the sum of its intersections with some mutually exclusive
and exhaustive events corresponding to an experiment.
✔ Consider event B and its
complement Bc. These
two events are mutually
exclusive and exhaustive.
✔ The circle, representing
event A, consists entirely of
its intersections with B and Bc.

LO 4.5
• The Total Probability Rule conditional on two events
✔ The total probability rule based on two events, B and Bc,
is

✔ or equivalently,

LO 4.5
 b
a c
d
BAYES THEOREM

✔ A procedure for updating probabilities based

on new information.
• Prior probability is the original (unconditional)
probability (e.g., P(B) ).
• Posterior probability is the updated
(conditional) probability (e.g., P(B | A) ).
x
COUNTING RULES
COUNTING RULES

•
•
DISCRETE PROBABILITY
DISTRIBUTION
RANDOM VARIABLES AND DISCRETE
PROBABILITY DISTRIBUTIONS
• A function that assigns numerical values to the outcomes of an experiment.
• Random variables may be classified as:
✔ Discrete
• The random variable assumes a countable number of distinct values.
✔ Continuous
• The random variable is characterized by uncountable values in an
interval.
DISCRETE PROBABILITY DISTRIBUTION
• consider the experiment of rolling a six-sided dice. The probability
distribution is:
x 1 2 3 4 5 6
P(X = x) 1/6 1/6 1/6 1/6 1/6 1/6

• Each outcome has an associated probability of 1/6.

• The cumulative probability distribution gives the probability that X is
less than or equal to x. For example,
the number of homes that a realtor sells over a one-month period:
EXPECTED VALUE, VARIANCE, AND
STANDARD DEVIATION
•
EXAMPLE
• Incentive Compensation Program

• Calculate the expected value of the annual bonus amount.

• Calculate the variance and standard deviation of the annual
bonus amount.
• Let the random variable X denote the bonus amount (in $1,000s) for an employee

• E(X) = 𝜇 = Σ xi P(X = xi) = 4.2, or $4,200

• Var(X) = 𝜎2 = Σ (xi − 𝜇)2P(X = xi) = 9.97, or 9.97 (in ($1,000s)2)
• SD(X) = σ = = 3.158, or $3,158
PORTFOLIO RETURNS
• Investment opportunities often use:
✔ Expected return as a measure of reward.
✔ Variance or standard deviation of return as a measure of risk.
• A portfolio is defined as a collection of assets such as stocks and
bonds.
✔ Let X and Y represent two random variables of interest, denoting the
returns of two assets.
✔ If an investor has invested in both assets, we want to evaluate the return
generated by the portfolio, which is a linear combination of X and Y.
PORTFOLIO RETURNS
✔ Given two random variables X and Y,
• The expected value of their sum is

• The variance of their sum is

where Cov(X,Y) is the covariance between X and Y.

• For constants a, b, the formulas extend to
PORTFOLIO RETURNS

• Expected return, variance, and standard deviation for a

portfolio.
✔ Given a portfolio with two assets, Asset A and Asset B, the
expected return of the portfolio E(Rp) is computed as:

• wA and wB are the portfolio weights (wA + wB = 1).

• E(RA) and E(RB) are the expected returns on assets A and B, respectively.
PORTFOLIO RETURNS
• The portfolio variance Var(Rp) is computed as:

• are the variances for Asset A and Asset B.

• 𝜎AB is the covariance between Asset A and Asset B.
• ρ AB is the correlation coefficient between the returns for
Asset A and Asset B.
• Consider an investment portfolio of $40,000 in Stock A and
$60,000 in Stock B.
✔ Given the following information, calculate the expected return of
this portfolio.
REVIEW-WHY IT MATTERS: PROBABILITY AND
PROBABILITY DISTRIBUTIONS
• Using a sample from population, which
should be random.
• Random– still random
• Probability->quantify how much we
expect random samples to vary
• Probability helps drawing conclusions
about the population in the face of the
uncertainty that is generated by the use
of a random sample.
REVIEW-WHY IT MATTER

• Goal: Inference
• Can we conclude that 62% of the
population favors death penalty?
• We’ll use probability to describe
the likelihood that our sample is
within a level of accuracy
Our confidence level that our
sample is closer to the population