Chapter 6:

Bayesian Analysis

1
 Reading
• Readings:
―Ch. 6

2
Today’s Topics
 Bayesian Analysis
 History
 Bayes’ Theorem
 Bayesian Networks
 Bayesians vs Frequentists

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Bayes’ Theorem
 History
 Thomas Bayes (1701-1761)
 Pierre-Simon Laplace publishes in 1812
 WW II (1939-1945) code breaking
 Modern Applications
 Medicine
 AI: spam filters, machine translation, machine vision
 Risk management?

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Bayes in the news

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Bayes’ Theorem

𝑃 [ 𝐵| 𝐴 ] 𝑃 [ 𝐴 ]
𝑃 [ 𝐴|𝐵 ] =
𝑃 [ 𝐵]

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Bayes’ Theorem

likelihood prior

𝑃 [ 𝐵| 𝐴 ] 𝑃 [ 𝐴 ]
𝑃 [ 𝐴|𝐵 ] =
𝑃 [ 𝐵]
posterior

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Bond defaults
BOND A Marginal
probability
No Default Default of Bond B

BOND B No 86% 4% 90%

Default
Default 4% 6% 10%

Marginal probability of 90% 10% 100%

 P(A|B)=P(A
BondandA B)/P(B)=6%/10%=60%
 P(A)=10%
 A and B are not independent since P(A|B)≠P(A)

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Disease application

Actual
+ -
Test + 99 99 198
- 1 9,801 9,802
100 9,900 10,000
 If a patient’s test is positive, what is the probability
that he has the disease?
 P(have disease|+) = 99/198=50%

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Mini-Quiz #1
 You are given a bag of coins. 10% of the coins in
the bag are biased, producing heads 75% of the
time. The rest are unbiased.

You pull one coin from the bag, flip it twice and
obtain two heads. What is the probability that the
coin is biased?

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Mini-Quiz #1
 Answer = 20%

( )
2
3 1
( )
𝑃 [ 𝐻𝐻|biased ] 𝑃 [ biased ] 4 1 10
𝑃 [ biased|𝐻𝐻 ]= = =
𝑃 [ 𝐻𝐻 ]
( ) ( 10 ) ( 2 ) 10 5
2 2
3 1 1 9
+ ( )
4
or

P[biased]: 10% → 14% → 20%

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Bayesian Analysis
 Where do prior assumptions come from?

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Simple to Complex
 Coin flipping revisited
 Instead of 2 possible probabilities (biased or unbiased),
what if there where 10? 100? Infinitely many?
 Beta distribution:

𝑥 𝛼− 1 (1− 𝑥 )𝛽 −1
𝑓 ( 𝑥 )=
𝐵(𝛼 , 𝛽)

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Bayesian Networks
 Causality is implicit
 Fewer parameters

P[S2|E]=50%
P[S2|Ē]=35%

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Bayesian Network
 Easier to identify experts
 Conditional probability is often more intuitive

Housing
Bubble
H S M B
H 0.40 0.10 0.33 0.49
Stocks
MBS ↓ S 0.10 0.36 0.27 0.04
↓
M 0.33 0.27 0.08 0.21
B 0.49 0.04 0.21 0.55

Bank
Failure
Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Bayesian Analysis

Frequentists vs Bayesians

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
Further Reading
 Introduction to Bayesian Statistics. William
Bolstad.
 Coherent Stress Testing: A Bayesian Approach to
the Analysis of Financial Stress. Riccardo
Rebonato.
 The Theory That Would Change the World. Sharon
Betsch McGrayne.
 The Signal and the Noise. Nate Silver.

Mathematics and Statistics for Financial Risk Management, 2nd Edition, Copyright © Michael B. Miller, 2014
 Homework 6
Miller chapter 6 (page 132-134): problem 1, 2,
3, 4, 5, 7

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