Mathematics for Economics and Finance (Fall 2023)

Problem Set 8 Solutions: Probability & Statistics

Professor: Norman Schürhoff
You do not need to hand in any solutions!
17 November 2023

1 Coin Problem
There are exactly 64350 gold coins in a chest. One of them is drawn randomly and tossed 5 times. Each
time the outcome is ”heads”.

1. What is the probability of this event ?

2. Now it appears that one of the coins was counterfeit : it had ”heads” on both sides. What is the
probability that the coin that was drawn and tossed initially was actually the counterfeit ?
3. Later on you learn that there were another 29 counterfeits among those in the chest, all of which had
”tails” on both sides. Recalculate the probability that the coin tossed was the one with ”heads” on
both sides.

Answer

1. For each tossing the probability of the outcome “heads” is P (”heads”) = 12 . Outcomes of consecutive
tossings are independent events =⇒ probability of 5 consecutive outcomes “heads” is P (5 ”heads”) =
1
25 .

2. One can apply Bayes’s Theorem:

P (counterf eit) · P (5 ”heads” | counterf eit)

P (counterf eit | 5 ”heads”) =
P (5 ”heads”)

1 1
P (counterf eit) = =
N 64350
P (5 ”heads” | counterf eit) = 1.(Obviously)

P (5 ”heads”) = P (counterf eit) · P (5 ”heads” | counterf eit) + P (normal) · P (5 ”heads” | normal) =

 
1 1 1
= ·1+ 1− · 5.
64350 64350 2

1
64350 ·1 1 1
Therefore, P = = 2011.9 ≈ 2012 .
1
(
64350 ·1+ 1− 64350
1
)· 215
3. Bayes’s formula adjusted for part (c) is as follows:

1
′
64350 1
P = 1 29 30

1 = .
64350 ·1+ 64350 ·0+ 1− 64350 · 25
2011

1
2 Probability events
For events A, B, C, C1 , C2 such that 0 < P (C) < 1 which of the following statements are true?

1. P (A) > P (B) =⇒ P (A ∩ C) > P (B ∩ C)

2. P (A |C ) = P (A) , P (B |C ) = P (B) , P (A) > P (B) =⇒ P (A ∩ C) > P (B ∩ C)

3. P (A |C ) ≥ P (B |C ) , P (A |C c ) ≥ P (B |C c ) =⇒ P (A) ≥ P (B)
4. 0 < P (Ci ) < 1, ∪2i=1 Ci = Ω, P (A |Ci ) ≥ P (B |Ci ) =⇒ P (A) ≥ P (B)

Answer:

1. False. Counterexample: let C = Ac =⇒ P (A ∩ C) = P (A ∩ Ac ) = 0 > P (B ∩ Ac ) which cannot be

true.
2. True. Since A and B are independent from C =⇒ P (A ∩ C) = P (A) P (C) , P (B ∩ C) =
P (B) P (C). Thus from P (A) > P (B) follows P (A ∩ C) > P (B ∩ C).
3. True. We have P (A |C ) P (C) ≥ P (B |C ) P (C) , P (A |C c ) P (C c ) ≥ P (B |C c ) P (C c ) =⇒

P (A) = P (A |C ) P (C) + P (A |C c ) P (C c ) ≥ P (B |C ) P (C) + P (B |C c ) P (C c ) = P (B) .

4. False. Counterexample: Ω = {ω1 , ω2 , ω3 } , P (ωi ) = 1/3, A = {ω1 } , B = {ω2 , ω3 } , C1 = {ω1 , ω2 } , C 2 =

{ω1 , ω3 } .

3 Random Variable
Let’s assume the random variable Xt to be distributed as follows ∀t = 1...T :
 1
2 if x = 1,
P[Xt = x] = 1
2 if x = −1.
Then we rewrite the sum of those independent random variables as:
t
X
Wt = Xi .
i=1

Compute the expectation and variance of the random variable WT .

Answer:
E[Xt ] = 21 × 1 + 21 × (−1) = 0
V[Xt ] = E[Xt2 ] − E[Xt ]2
E[Xt2 ] = 12 × 12 + 21 × (−1)2 = 1, ⇒
V[Xt ] = 1 − 02 = 1
With this, we can compute the expectation and the variance of Wt .
Pt
E[Wt ] = E[ i=1 Xi ]
Pt
= i=1 E[Xi ] = 0
| {z }
Pt =0
V[Wt ] = V[ i=1 Xi ]
Pt
= i=1 V[Xi ] = t
| {z }
=1

2
4 Application
Assume a one-year Treasury bond offers a safe annual rate of return of 10%. You are about to lend $1 million
to a risky company. The loan maturity is one year. Answer:

1. In case you lend the money to the risky company, the

ExpectedPayment = PaymentIfDefault*P(Default)+PaymentIfSolvent*P(Solvent)
= 750, 000 ∗ 0.5 + 1, 100, 000 ∗ 0.5
= 925, 000

925, 000
ExpectedRateOfReturn = − 1 = −7, 5%
1, 000, 000
2.

750, 000 ∗ 0.5 + Y ∗ 0.5 = 1, 100, 000

⇒ Y = 1, 450, 000

The interest rate asked is then 45% (30% default premium, 10% time premium).

1. What is your expected rate of return if you decide to charge 10%, but the company pays $750.000 in
case of default (fails to pay all that it has promised), which happens with probability of 50%, otherwise
the company is solvent (pays back the principal plus interest).
2. What is the interest rate you need to charge to break even.

5 Statistics for Finance

2
1
u2 )
1. Verify that the MGF of a N (µ, σ 2 ) is φ(u) = e(uµ+ 2 σ .
2. Compute E[x] and V[x] using the MGF of N (µ, σ 2 ).

Answer:
1.
+∞
Z +∞
Z
1 (x−µ)2 1 x2 +µ2 −2xµ−2σ 2 ux
ΦX (u) = E(e uX
)= √ eux e− 2σ2 dx = √ e− 2σ 2 dx
2πσ 2πσ
−∞ −∞
+∞ 2 2 +∞ 2
1
Z ( ) (
x2 −2x µ+σ 2 u + µ+σ 2 u ) (
− µ+σ 2 u +µ2 ) 1
Z
−
(x−(µ+σ2 u))  2 2
+ µu+ σ 2u

−
=√ e 2σ 2 dx = √ e 2σ 2 dx
2πσ 2πσ
−∞ −∞
+∞ 2
σ 2 u2 1
Z (x−(µ+σ2 u)) σ 2 u2
= eµu+ 2 √ e− 2σ 2 dx = eµu+ 2 .
2πσ
−∞
| {z }
=1(integral of pdf N (µ+σ 2 u,σ 2 ))

∂Φu (x)
2. EX = ∂u |u=0 = Φx (u) × (µ + σ 2 u)|u=0 = Φx (0) ×µ = µ
| {z }
=1

3
 V X = E(X 2 ) − (EX)2 . (EX)2 = µ2 . We need to compute E(X 2 ).

∂ 2 Φu (x)
E(X 2 ) = |u=0 = µ × Φx (u) × (µ + σ 2 u) + σ 2 × u × Φx (u) × (µ + σ 2 u) + σ 2 × Φx (u)|u=0
∂u2

= µ × Φx (0) × µ + σ 2 × Φx (0) = µ2 + σ 2

V X = µ2 + σ 2 − µ2 = σ 2

6 Computation using Programming Language

Generate a set of 20 numbers randomly between 1 and 10. Compute the mean, mode, median, variance, and
standard deviation of this sample. Plot the PDF and CDF of the sample data.