# STAT7055: LECTURE 2

Probability

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STAT7055 Financial Statistics Lecture 2

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Terminology

A random experiment is a process that results in a number of possible outcomes, none of which can be predicted with certainty. Examples include:

**Rolling a die: Possible outcomes are 1, 2, 3, 4, 5 or 6. Tossing a coin: Possible outcomes are heads or tails.
**

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Terminology

The sample space of a random experiment is a list of all possible outcomes. Usually denoted by 𝑆. For example, when rolling a die, the sample space is: 𝑆 = {1,2,3,4,5,6}. Outcomes must be mutually exclusive and exhaustive.

Mutually exclusive: No two outcomes can both occur at the same time on any one trial. Exhaustive: All possible outcomes must be included in the sample space.

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Terminology

A simple event is an individual outcome in a sample space. Usually

denoted by 𝐸𝑖 or 𝑂𝑖.

theif sample have space possible denoted by outcome So we 𝑛 𝑆 = {𝐸1,𝐸2,…,𝐸𝑛}.

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Terminology

occurring on a single trial is written

Two important rules:

2.

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**Three Approaches to Assigning Probabilities
**

The classical approach is based on the assumption that the outcomes of an experiment are equally likely to happen. The classical probability utilises rules and laws. The relative frequency approach defines probability as the long-run relative frequency with which an outcomes occurs. The subjective approach is based on personal judgment, accumulation of knowledge, and experience.

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Classical Approach

Suppose we roll a die once. Q: What is the probability we get a 5? Possible outcomes are 𝑆 = {1,2,3,4,5,6}. Assume all six outcomes are equally likely.

A: Probability we get a 5 is 1/6.

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**Relative Frequency Approach
**

I decide to start a door-to-door recruitment for ANU undergraduate students. We sample 200 final year undecided high school graduates, and 120 say “yes” to my sales pitch. Q: As I approach the house of an undecided HS grad, what is the probability that I am successful? A: Probability I am successful is 120/200=0.6.

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Subjective Approach

Suppose I am an investor and I’m trying to decide whether or not to invest in a particular stock. Q: What is the probability that this stock will increase in value? A: Based on past experience, my knowledge of the stock market and this particular stock, I assign a probability of 0.3.

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Probability of an Event

**An event is a collection of one or more simple (individual) events.
**

For example, when rolling a die, let 𝐴 denote the event that an odd number comes up. Then 𝐴 = {1,3,5}.

**The probability of a favourable event occurring is equal to: number of favourable outcomes total number of outcomes
**

STAT7055 Financial Statistics Lecture 2

So 𝑃(𝐴) = 3/6 = 0.5.

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**Terminology and Notation
**

We can also combine events. There are some important combinations of events that we will encounter repeatedly throughout the course. Suppose we have two events, 𝐴 and 𝐵.

For example, when rolling a die, let 𝐴 = {1,3,5} denote getting an odd number and 𝐵 = {3} denote getting a 3.

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**Terminology and Notation
**

Intersection:

𝐴

∩ 𝐵; 𝐴 and 𝐵; 𝐴 intersection with 𝐵. It means 𝐴 and 𝐵 both occur. E.g., 𝐴 ∩ 𝐵 = {3}.

Union:

𝐴

**∪ 𝐵; 𝐴 or 𝐵; 𝐴 union with 𝐵. It means 𝐴 occurs, 𝐵 occurs or both occur. E.g., 𝐴 ∪ 𝐵 = {1,3,5}.
**

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**Terminology and Notation
**

Complement:

𝐴𝐶

; 𝐴 complement. It means 𝐴 does not occur or the opposite of 𝐴. E.g., 𝐴𝐶 = {2,4,6}.

Conditional:

𝐴

|𝐵; 𝐴 given 𝐵. It means 𝐴 occurs given that 𝐵 has occurred.

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**Important Facts Regarding Probability
**

For Something has to happen. = 1. the sample space 𝑆, 𝑃(𝑆)

For All probabilities must lie between 0 and 1. any event 𝐴, 0 ≤ 𝑃 𝐴 ≤ 1.

**If 𝐴 and 𝐵 are mutually exclusive, then 𝑃 𝐴 ∩ 𝐵 = 0.
**

𝐴

∩ 𝐵 = ∅, the empty set. E.g., 𝐴 is 2. They can’t both1 and 𝐵 is the event we roll a the event we roll a happen.

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Joint Probabilities

Suppose we are investigating the relationship between how well a mutual fund performs and where the fund managers earns his or her MBA. Let events be known as follows:

𝐴

1 = Fund manager graduated from a top−20 MBA program. 𝐴2 = Fund manager did not graduate from a top−20 MBA program. 𝐵1 = Fund outperforms the market. 𝐵2 = Fund does not outperform the market

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**Joint Probabilities Continued
**

Probabilities :MutualFund 𝐵1 outperforms Market P(and)=0.11 P(and)=0.06 𝐴 𝐵 :MutualFund doesnotoutperform 𝐵2 Market P(and)=0.29 P(and)=0.54 𝐴 𝐵

:Top-20MBA :NotTop-20MBA 𝐴

Joint probabilities: P(Mutual fund P(Mutual fund P(Mutual fund P(Mutual fund

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Marginal Probabilities

Probabilities :MutualFund outperforms1Market 𝐵 :MutualFund doesnot 𝐵2 outperformMarket Totals

:Top-20MBA

:NotTop-20MBA Totals

P(and)=0.11

P(and)=0.06 P()=0.17 𝐵1

P(and)=0.29

P(and)=0.54 P()=0.83 𝐵2

P()=0.40

P()=0.60 1.00

Marginal probabilities:

Computed by adding across rows or down columns. Named because they are calculated in the margins of the table. P(𝐴1) = P(𝐴1 and 𝐵1) + P(𝐴1 and 𝐵2) = 0.11 + 0.29 = 0.40 P(𝐴2) = P(𝐴2 and 𝐵1) + P(𝐴2 and 𝐵2) = 0.06 + 0.54 = 0.60

**P(𝐵1) = P(𝐵1 and 𝐴1) + P(𝐵1 and 𝐴2) = 0.11 + 0.06 = 0.17 P(𝐵2) = P(𝐵2 and 𝐴1) + P(𝐵2 and 𝐴2) = 0.29 + 0.54 = 0.83
**

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Conditional Probability

Conditional probability: the probability of one event given the occurrence of another event. Definition (Bayes’ Theorem):
𝑃

𝐴 ∩ 𝐵 𝑃 𝐴 𝐵 = 𝑃 𝐵

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**Conditional Probability Example
**

Probabilities :MutualFund outperforms1Market 𝐵 :MutualFund doesnot 𝐵2 outperformMarket Totals

:Top-20MBA

:NotTop-20MBA Totals

P(and)=0.11

P(and)=0.06 P()=0.17 𝐵1

P(and)=0.29

P(and)=0.54 P()=0.83 𝐵2

P()=0.40

P()=0.60 1.00

What is the probability that a mutual fund with a manager who graduated from a top-20 MBA program outperforms market? 𝑃 𝐵1 𝐴1 = 𝑃 𝐵1 and 𝐴1 𝑃 𝐴1 0.11 = = 0.275 0.4

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STAT7055 Financial Statistics Lecture 2

**Conditional Probability Example
**

Probabilities :MutualFund outperforms1Market 𝐵 :MutualFund doesnot 𝐵2 outperformMarket Totals

:Top-20MBA

:NotTop-20MBA Totals

P(and)=0.11

P(and)=0.06 P()=0.17 𝐵1

P(and)=0.29

P(and)=0.54 P()=0.83 𝐵2

P()=0.40

P()=0.60 1.00

For a randomly selected mutual fund which underperforms the market, What is the probability that a graduate of a top-20 MBA program manage it? 𝑃 𝐴1 𝐵2 = 𝑃 𝐴1 and 𝐵2 𝑃 𝐵2 0.29 = = 0.3494 0.83

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STAT7055 Financial Statistics Lecture 2

Independence

Two events are independent if:
𝑃

(𝐴|𝐵) = 𝑃(𝐴) or 𝑃(𝐵|𝐴) = 𝑃(𝐵)

In other words, two events are independent if the probability of one event is not affected by the occurrence of the other event.

**If 𝐴 and 𝐵 are independent, then:
**

𝑃

𝐴 and 𝐵 = 𝑃 𝐴 𝑃(𝐵) 𝑃 𝐴 𝐵 = 𝑃 𝐴 and 𝐵 /𝑃 𝐵 = 𝑃 𝐴 𝑃 𝐵 /𝑃 𝐵 = 𝑃(𝐴)

**The above ONLY holds if 𝐴 and 𝐵 are independent.
**

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Example

A store sells 2 brands of a particular product – one expensive and the other inexpensive. Let expensive brand be called “A”, inexpensive brand be called “B”. A survey of 1000 sales gives the following: Brand

GenderA Male132

BTotal 147279

Female516

Total648

205721

3521000

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Example

GenderA

Male132 Female516 Total648 Brand BTotal 147279 205721 3521000

P(Customer is male) = 279/1000 = 0.279 P(Purchase brand A) = 648/1000 =0.648 P(Purchase brand A AND female) = 516/1000 = 0.516

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Example

Brand

GenderA

Male132 Female516 Total648

BTotal

147279 205721 3521000

P(Purchase brand A GIVEN female) = P(Purchase brand A AND female)/P(female) = (516/1000)/(721/1000) = 516/721

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**Example – Are Gender and Brand Purchased Independent?
**

Brand

GenderA

Male132 Female516 Total648

BTotal

147279 205721 3521000

If independent: P(Purchase brand A GIVEN female) = P(Purchase brand A) LHS = 516/721 RHS = 648/1000 LHS ≠ RHS Therefore gender and brand purchased are NOT independent!

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Multiplication Rule

𝑃

**𝐴 and 𝐵 = 𝑃 𝐴 𝐵 𝑃 𝐵 = 𝑃 𝐵 𝐴 𝑃(𝐴) Why? From Bayes Theorem for conditional probability we know:
**

𝑃

𝐴 𝐵 =
𝑃

(𝐴∩𝐵) 𝑃(𝐵)

and 𝑃 𝐵 𝐴
𝑃

(𝐵∩𝐴) = 𝑃(𝐴)

**If 𝐴 and 𝐵 are independent, the multiplication rule directly gives us:
**

𝑃

(𝐴 and 𝐵) = 𝑃(𝐴)𝑃(𝐵)

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**Example – Selecting Two Students Without Replacement
**

A finance course has 7 male and 3 female students. The lecturer wants to select two students at random to be his research assistants. What is the probability that the two students chosen are female?

Solution: Let 𝐴 represent the event that the first students event is the and chosen is thechosen W representalso female. that female second find student joint probability: 𝑃(𝐴 and 𝐵) = 𝑃(𝐵|𝐴)𝑃(𝐴)

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**Example – Selecting Two Students Without Replacement
**

The probability that the first student chosen is female is 𝑃(𝐴) = 3/10. What is the probability that the second student chosen is also female? Given that the first female student has been chosen, there are only 2 female students left and there are only 9 students left in the class. Therefore, 𝑃(𝐵|𝐴) = 2/9. Thus, the joint probability is:

𝑃

𝐴 and 𝐵 = 𝑃 𝐵 𝐴 𝑃 𝐴 = 2 9 10

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**Example – Selecting Two Students With Replacement
**

A finance course has 7 male and 3 female students. The lecturer will be away for two classes (2 weeks). Professor Jane will be their replacement for the next two classes. Jane will select one student at random in each class and pick on him or her to answer the questions. What is the probability that the two students chosen are female?

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**Example – Selecting Two Students With Replacement
**

Solution: Let 𝐴 represent the event that the first students chosen is female and 𝐵is also female.event that to second student chosen represent the We want the find the joint probability: 𝑃 𝐴 𝑎𝑛𝑎 𝐵 = 𝑃 𝐵 𝐴 𝑃(𝐴)

However, it is now possible to choose the same student in the each of the two classes. Thus 𝐴 and 𝐵 are independent events, so we apply the multiplication rule for independent events. 𝑃(𝐴 and 𝐵) = 𝑃(𝐴)𝑃(𝐵) = (3/10)(3/10) = 0.09

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Addition Rule

Why? Let A be pink and B be blue.

**If A and B are mutually exclusive events then
**

𝑃

𝐴 ∪ 𝐵 = 𝑃 𝐴 + 𝑃 𝐵

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**Example – Applying the Addition Rule
**

In Canberra, 22% of the households subscribe to the Canberra Times and 35% subscribe to the Australian. A survey reveals that 10% of all households subscribe to both newspapers. What is the probability that a randomly selected household subscribe to at least one of the newspapers? Let:

A = subscribes to the Canberra Times. B = subscribes to the Australia.

Solution: 𝑃 𝐴 or 𝐵 = 𝑃 𝐴 + 𝑃 𝐵 − 𝑃 𝐴 and 𝐵 = 0.22 + 0.35 − 0.1 = 0.47

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Complement Rule

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Complement Rule

Since 𝑃(𝑆 = 1, we know that: 𝐶 𝑃 𝐴 ∪ 𝐴 = 𝑃 𝑆 = 1 Using the Addition Rule for mutually exclusive events we also know that:

𝑃

𝐴 ∪ 𝐴
𝐶

= 𝑃 𝐴 + 𝑃 𝐴𝐶

**Therefore 𝑃 𝐴 + 𝑃 𝐴𝐶 = 1. Interpretation: Either 𝐴 happens or it doesn’t.
**

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**Example – Coin Tossing
**

**An unbiased coin is tossed twice.
𝑆**

= {𝐻𝐻,𝐻𝐻,𝐻𝐻,𝐻𝐻}; all equally likely (prob=1/4) Find the probability of at least 1 tail. Let event 𝐴 = At least 1 tail = {𝐻𝐻,𝐻𝐻,𝐻𝐻}.

𝑃

(𝐴) = 3/4.

Alternatively: 𝑃 𝐴 = 1 − 𝑃 𝐴𝐶 = 1 − 𝑃 no tails = 1 −

1 = 4 3 4

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Worked Examples

Q6.13 (pg. 180). A survey asks adults to report

their marital status. The sample space is 𝑆 = {single, married, divorced, widowed}. Use set notation to represent the event that the adult is not married.

**Let 𝐴 = {married}. Therefore: 𝐴𝐶 = {unmarried} = {single, divorced, widowed}
**

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Worked Examples

Q6.14 (pg. 180). Suppose that in the city in which the survey is conducted, 50% of adults are married, 15% are single, 25% are divorced, and 10% are widowed. Assignment probabilities to each simple event in the sample space. Which approach did you use in Part (a)?

a)

b)

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Worked Examples

Solution: P(married) = 0.5 P(single) = 0.15 P(divorced) = 0.25 P(widowed) = 0.1 Relative frequency approach. Why?

a)

b)

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Worked Examples

a) b) c)

Q6.15 (pg. 180). Find the probability of each of the following events. The adult is single. The adult is not divorced. The adult is either widowed or divorced.

Solution: P(single) = 0.15. P(divorced) = 0.25. Therefore P(not divorced) = 1-0.25 = 0.75.

a) b)

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Worked Examples

c)

P(widowed or divorced) = P(widowed) + P(divorced) – P(widowed & divorced) Since widowed and divorced are mutually exclusive, then P(widowed & divorced) = 0.

Therefore: P(widowed or divorced) = 0.1 + 0.25 = 0.35

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Worked Examples

Q6.59 (pg. 198). A study undertaken by the Miami-dade Supervisor of Elections in 2002 revealed that 44% of registered voters are Democrats, 37% are Republicans, and 19% are Others. If 2 registered voters are selected at random, what is the probability that both of them have the same party affiliation?

Solution:

Let 𝐴 = {Same Party} = {𝐷𝐷,𝑅𝑅,𝑂𝑂}. Then: 𝑃 𝐷𝐷 = 0.44 × (0.44) = 0.1936 𝑃 𝑅𝑅 = 0.37 × (0.37) = 0.1369 𝑃 𝑂𝑂 = 0.19 × (0.19) = 0.0361

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Worked Examples

Therefore, the probability that both of the registered voters have the same party affiliation is: 𝑃 𝐴 = 𝑃 𝐷𝐷 + 𝑃 𝑅𝑅 + 𝑃 𝑂𝑂 = 0.1936 + 0.1369 + 0.0361 = 0.3666

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Worked Examples

Q6.77 (pg. 208). Bad gums may mean a bad heart. Researchers discovered that 85% of people who have suffered a heart attack had periodontal disease. Only 29% of healthy people have this disease. Suppose that in a certain community heart attacks occur with 10% probability. If someone had periodontal disease, what is the probability that he or she will have a heart attack?

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Worked Examples

Let’s define some events:

**Let 𝐷 = have periodontal disease.
**

Let 𝐻 = have suffered a heart attack.

**We know from the question that 𝑃 𝐻 = 0.1, 𝑃 𝐻𝐶 = 1 − 𝑃 𝐻 = 0.9, 𝑃 𝐷 𝐻 = 0.85 and 𝑃 𝐷 𝐻𝐶 = 0.29. We want to find 𝑃(𝐻|𝐷).
**

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Worked Examples

Using the definition of conditional probability: 𝑃 𝐻 ∩ 𝐷 𝑃 𝐻 𝐷 = 𝑃 𝐷

**We need to find 𝑃(𝐻 ∩ 𝐷) and 𝑃(𝐷). For 𝑃 𝐻 ∩ 𝐷 we can use the Multiplication Rule: 𝑃 𝐻 ∩ 𝐷 = 𝑃 𝐷 𝐻 𝑃 𝐻 = 0.85 × 0.1 = 0.085
**

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Worked Examples

For 𝑃(𝐷), we know from marginal probabilities that: 𝑃 𝐷 = 𝑃 𝐷 ∩ 𝐻 + 𝑃(𝐷 ∩ 𝐻𝐶)

For 𝑃 𝐷 ∩ 𝐻𝐶 we again use the Multiplication Rule: 𝑃 𝐷 ∩ 𝐻𝐶 = 𝑃 𝐷 𝐻𝐶 𝑃 𝐻𝐶 = 0.29 × 0.9 = 0.261

**Therefore, 𝑃 𝐷 = 0.085 + 0.261 = 0.346. Finally, 𝑃 𝐻 𝐷 = 𝑃 𝐻 ∩ 𝐷 /𝑃 𝐷 = 0.085/0.345 = 0.246.
**

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Readings

Chapter 6.

Keller, 9th Edition.

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