ECON10005 Quantitative Methods 1: Conditional Expectations

ECON10005
Quantitative Methods 1
Conditional Expectations
Faculty of Business and Economics

Department of Economics
Summary
E(Z) = $108
Var(Z)=216
sd(Z) = $14.70
Z
90 120 E(T) = $108
86 0.1 0.4 0.5 Var(T)=484
T sd(T) = $22
130 0.3 0.2 0.5
0.4 0.6
cov(Z, T)=-132
cor(Z, T) = -0.41
We know marginal and joint distribution properties, now time for the conditional one…
2
Conditional Probability
Definition
For two discrete random variables and , the conditional

probability that takes a value conditional on knowing that
has taken the value is
It is similar to Week 2, which is about ONLY two events
4
𝑃 ( 𝑍 =90 , 𝑇=130) 0.3

𝑃 ( 𝑍=90|𝑇 =130 )= = =0.6
Z 𝑃 (𝑇 =130) 0.5
90 120
86 0.1 0.4 0.5
T
130 0.3 0.2 0.5
0.4 0.6
5
𝑃 ( 𝑍 =90 , 𝑇=130) 0.3

𝑃 ( 𝑍=90|𝑇 =130 )= = =0.6
Z 𝑃 (𝑇 =130) 0.5
90 120 𝑃 (𝑍 =120 , 𝑇 =130) 0.2
𝑃 ( 𝑍=120|𝑇 =130 )= = =0.4
86 0.1 0.4 0.5 𝑃 (𝑇 =130) 0.5
T
130 0.3 0.2 0.5
0.4 0.6
6
𝑃 ( 𝑍 =90 , 𝑇=130) 0.3

𝑃 ( 𝑍=90|𝑇 =130 )= = =0.6
Z 𝑃 (𝑇 =130) 0.5
90 120 𝑃 (𝑍 =120 , 𝑇 =130) 0.2
𝑃 ( 𝑍=120|𝑇 =130 )= = =0.4
86 0.1 0.4 0.5 𝑃 (𝑇 =130) 0.5
T
130 0.3 0.2 0.5
0.4 0.6
Conditional probability distribution of Z given T=130:
Marginal probability distribution of Z
z 90 120
z 90 120
P(Z=z | T=130) 0.6 0.4
P(Z=z) 0.4 0.6
7
𝑃( 𝑍 =90 , 𝑇 =86 ) 0.1

𝑃 ( 𝑍=90|𝑇 =86 ) = = =0.2
Z 𝑃 (𝑇 =86) 0.5
90 120 𝑃 ( 𝑍=120 ,𝑇 =86) 0.4
𝑃 ( 𝑍=120|𝑇 =86 )= = =0.8
86 0.1 0.4 0.5 𝑃 (𝑇 =86) 0.5
T
130 0.3 0.2 0.5
0.4 0.6
Marginal probability distribution of Z
z 90 120
z 90 120
P(Z=z | T=86) 0.2 0.8
P(Z=z) 0.4 0.6
8
Summary so far
z 90 120
Marginal probability distribution of Z P(Z=z) 0.4 0.6
z 90 120
P(Z=z | T=86) 0.2 0.8
Conditional probability distribution of Z given T=130: z 90 120

P(Z=z | T=130) 0.6 0.4
 They are different, because they are dependent (heuristically, T provides information to Z, and vice versa) 9
Independence
Definition
Two random variables and are independent if
For every and .

From the previous example, are Z and T independent?
 Independence means “conditional = marginal”
For every y, and for every x for which
For every x, and for every y for which

10
Conditional Expected Values
Definition Week 3: random variables X and Y
are discrete with possible outcomes
The expected value of conditional on taking the value is and .
 Recall: the unconditional expected value: . Can you identify any difference?
• The conditional expected value weights the outcomes by the conditional probabilities.
• E(Y ∣X = x) can be different for different values of x.
• If X and Y are independent, then .
11
Example: Conditional Expected Value
Conditional probability distribution of Z given T=86: Conditional probability distribution of Z given T=130:
z 90 120 z 90 120
P(Z=z | T=86) 0.2 0.8 P(Z=z | T=130) 0.6 0.4
𝐸 ( 𝑍|𝑇 =86 ¿=90 × 0.2+120 × 0.8=$ 114 𝐸 ( 𝑍|𝑇 =130 ¿=90 ×0.6 +120 × 0.4=$ 102
12
Summary
z 90 120
P(Z=z) 0.4 0.6 E(Z)=$108
z 90 120
P(Z=z | T=86) 0.2 0.8 E(Z | T=86) = $114
Z has higher expected value if T is lower!
z 90 120
E(Z | T = 130) = $102
P(Z=z | T=130) 0.6 0.4
13
ECON10005
Conditional Variance

Conditional Variance
Definition
The conditional variance of given that takes the value x is Recall the unconditional variance
Use
Steps:
 Use the conditional
probability instead of the
1. for each possible value Use marginal probability of Y
15
Example
z 90 120
P(Z=z | T=86) 0.2 0.8
Steps:
1. 1.
2. for each possible value 2. Two possible outcomes of Z (n=2)
3. Var
3.
16
Example
z 90 120
P(Z=z | T=130) 0.6 0.4
Steps:
1. 02
1. for each possible value 2. Two possible outcomes of Z (n=2)
324
3. Var
4.7
17
Summary
Unconditional of Z
𝐸 ( 𝑍 ) =$108
When T performs poorly, Z tends to be better with
14 higher expected value and lower risk.
Z | T = 86
This is a key motivation for portfolio management
2
Z | T=130
18
ECON10005
Law of Iterated Expectations

Law of Iterated Expectations
𝐸 ( 𝑌 )=𝐸 [ 𝐸(𝑌 ∨ 𝑋)] Two expectations (E), so “iterated”
Outside E add up terms Inside E fixes and add up terms.
The conditional Expected value

Fix , then compute the weighted sum of Y values
Then,
This is a weighed sum of values of .
 You may imagine as a random variable, where the random source comes from .
20
Example: the LIE is True
E(Z) = $108.
E(Z | T = 86) = $114

z 90 120
E(Z | T = 130) = $102
P(Z=z) 0.4 0.6
𝐸 [ 𝐸 ( 𝑍|𝑇 ) ]=𝐸 ( 𝑍|𝑇 =86 ) × 𝑃 ( 𝑇 =86 ) +𝐸 (𝑍 ∨𝑇 =130)× 𝑃 (𝑇=130)
¿114 × 0.5+102 × 0.5

t 86 130
P(T=t) 0.5 0.5 ¿ $ 108
21
Example: Bull and Bear
Suppose an investment return R has conditional expected values:
and
Then,
22
A simple Proof of LIE
Two random variables X and Y, where X may take value and Y may take value . Their
joint probability is denoted by as usual.
𝑛 𝑛
𝐸 ( 𝑌 )=∑ 𝑦 𝑖 𝑃 (𝑌 = 𝑦 𝑖 ) 𝐸 ( 𝑌 | 𝑋=𝑥 )=∑ 𝑦 𝑖 𝑃 (𝑌 = 𝑦 𝑖 ∨ 𝑋=𝑥)
𝑖=1 𝑖=1
[∑ ]
𝑚 𝑛
𝐸 [ 𝐸 ( 𝑌 | 𝑋=𝑥 ) ]= ∑ 𝑦 𝑖 𝑃 ( 𝑌 = 𝑦 𝑖| 𝑋 =𝑥 ) 𝑃 ( 𝑋=𝑥 𝑗 )
𝑗=1 𝑖=1
23
[∑ ]
𝑚 𝑛
𝐸 [ 𝐸 ( 𝑌 | 𝑋=𝑥 ) ]= ∑ 𝑦 𝑖 𝑃 ( 𝑌 = 𝑦 𝑖| 𝑋 =𝑥 ) 𝑃 ( 𝑋=𝑥 𝑗 )
𝑗=1 𝑖=1
𝑚 𝑛
¿ ∑ ∑ 𝑦 𝑖 𝑃 ( 𝑌 =𝑦 𝑖| 𝑋=𝑥 ) 𝑃 ( 𝑋 =𝑥 𝑗 )
𝑗=1 𝑖=1
𝑚 𝑛
𝑃 ( 𝑌 = 𝑦 𝑖 , 𝑋 =𝑥 𝑗 )
¿∑ ∑ 𝑦𝑖 𝑃( 𝑋=𝑥 𝑗 )
𝑗=1 𝑖=1 𝑃 ( 𝑋=𝑥 𝑗 )
𝑚 𝑛
¿ ∑ ∑ 𝑦 𝑖 𝑃 ( 𝑌 =𝑦 𝑖 , 𝑋=𝑥 𝑗 )
𝑗=1 𝑖=1
24
𝑚 𝑛
𝐸 [ 𝐸 ( 𝑌 | 𝑋=𝑥 ) ]= ∑ ∑ 𝑦 𝑖 𝑃 ( 𝑌 = 𝑦 𝑖 , 𝑋 =𝑥 𝑗 )
𝑗=1 𝑖=1
𝑛 𝑚
¿ ∑ ∑ 𝑦 𝑖 𝑃 ( 𝑌 =𝑦 𝑖 , 𝑋=𝑥 𝑗 )
𝑖=1 𝑗=1
𝑛 𝑚
¿ ∑ 𝑦 𝑖 ∑ 𝑃 ( 𝑌 =𝑦 𝑖 , 𝑋=𝑥 𝑗 )
𝑖=1 𝑗=1
𝑛
¿ ∑ 𝑦 𝑖 𝑃 ( 𝑌 =𝑦 𝑖 )
𝑖=1
¿ 𝐸(𝑌 )
25
More Examples
𝐸 ( 𝑌 )=𝐸 [ 𝐸(𝑌 ∨ 𝑋)]
1. Wanted: the worldwide average income. We have the average income of each country.
What are Y and X?
2. Wanted: the probability of a party winning the federal election (a randomly selected seat’s
winning probability). We have the probability of winning each seat in the House of
representatives. (simple average will do)
3. The average additional revenue per shop after an advertisement was cast in Australia. We
have the average additional revenue per shop in each state/territory.
26
ECON10005
Binomial Distribution

• A random trial/experiment is independently repeated n times. Example: coin tossing
• Each trial has two possible outcomes, "success" or "failure", with • A coin is tossed n times.
. • Each toss can give Heads ("success")
or Tails ("failure").
• A binomial random variable X is the number of "successes". • A binomial random variable X is the
number of Heads in n tosses.
 Is the number of Tails a binomial
Example: quality control random variable?
• A random selection of n assembly line products are tested. Counter-example: street crossing
• Each test can conclude Working ("success") or Defective
• A Kangaroo cross the highway n times
("failure").
• A binomial random variable X is the number of Working • Each time, it “succeeds” if surviving, or
products in the n that were tested. “fails” if hit by a car and die.
 Is the number of defective products a binomial random • The number of success is NOT a binomial
variable? random variable, why? 28
Outcome X Probability x P(X=x)

n=1 F 0 1-p 0 1-p
S 1 p 1 p
Outcome X Probability
n=2 FF 0 x P(X=x)
SF 1 0
FS 1 1
SS 2 2
29
n=3 FFF 0 x P(X=x)
FFS 1 0
FSF 1 1
SFF 1 2
FSS 2 3
SFS 2
SSF 2
SSS 3
30
n=4 FFFF 0
FFFS 1
FFSF 1
FSFF 1 x P(X=x)
SFFF 1 0
FFSS 2 1
FSFS 2
2
FSSF 2
3
SFFS 2
SFSF 2 4
SSFF 2
FSSS 3
SFSS 3
SSFS 3
SSSF 3
SSSS 4 31
Let be the number of “successes” in independent trials,
where on each trial.
Then,
where
are “binomial coefficients”.
 E.g.,
 P(X=2) when n=4 is
32
Bernoulli Random Variable
 Special case of a binomial when n=1.
Define: if success occurs in trial

if failure occurs in trial
Then is a Bernoulli random variable with distribution
x P(X=x) 𝐸 ( 𝑋 𝑖 ) =0 × 𝑃 ( 𝑋 𝑖=0)+1× 𝑃 ( 𝑋 𝑖=1)¿ 0 × (1 − 𝑝 ) +1 ×𝑝 =𝑝

0 1-p
1 p 2 2
var ( 𝑋 𝑖 )= ( 0 − 𝐸( 𝑋 𝑖 ) ) × 𝑃 ( 𝑋 𝑖 =0)+ ( 1 − 𝐸 ( 𝑋 𝑖 ) ) × 𝑃 ( 𝑋 𝑖 =1)
2 2
¿ ( 0 − 𝑝 ) × ( 1 −𝑝 ) + ( 1 −𝑝 ) ×𝑝
¿ 𝑝 (1 −𝑝)
33
Binomial and Bernoulli Variables
 A Binomial random variable can be viewed as the sum of independent Bernoulli random variables.
 E.g., each time tossing a coin (head as success (=1)), it implies a Bernoulli random variable.
After n independent times, the sum of heads is a Binomial random variable.
Formally, a Binomial random variable X with any n can be defined as
where are independent Bernoulli random variables with
𝐸 ( 𝑋 )=𝐸 ( 𝑋 1 + 𝑋 2 +… + 𝑋 𝑛 ) =𝐸 ( 𝑋 1 ) + 𝐸 ( 𝑋 2 ) + … 𝐸 ( 𝑋 𝑛 ) =𝑝 +𝑝 +… +𝑝=𝑛𝑝
Only because of
independence
of ’s
34
Investment over Multiple Periods
Initial investment of $100.
Each week, the value might

• Increase by $1 with probability 0.55
• Decrease by $1 with probability 0.45
After 1 year, what is the expected value and standard

deviation of the investment?
A “binomial price tree” 5 103

0.5
5 102 0.4
0.5 5
5 101 0.4 101
0.5 5 5
0.50 … for 52 periods (weeks)!
100 0.4 5 100 .4 5
5 0.5
99 0.4 5 99
5 0.5
98 0.45 35
97


 Each week has only two outcomes and can be viewed as a Bernoulli.
• Need to define “success”
 1 year gain is the sum of 52 weeks’ result and can be viewed as a Binomial.
• Need to link the outcome to the investment
36


Let be the number of $1 increase over the 52 weeks. X has a Binomial distribution with
n=52 and p=0.55
 This means “success” is “$1 increase” (probability is
0.55)
Hence, and
 Each week, “$1 increase” or not is independent from any
other week
37


Let be the number of $1 increase over the 52 weeks. The number of “$1 decrease” weeks must be
The investment value after a year is the initial value $100
It has a Binomial distribution with n=52 and p=0.55
• plus the number of $1 increases
with and
• minus the number of $1 decreases
𝑉 =100+ 𝑋 − ( 52 − 𝑋 )=48+2 𝑋
38


with and
The expected value:
The variance:
And standard deviation

39

ECON10005 Quantitative Methods 1: Conditional Expectations

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

ECON10005 Quantitative Methods 1: Conditional Expectations

Uploaded by

Copyright:

Available Formats

ECON10005

Faculty of Business and Economics

For two discrete random variables and , the conditional

It is similar to Week 2, which is about ONLY two events

𝑃 ( 𝑍 =90 , 𝑇=130) 0.3

𝑃 ( 𝑍 =90 , 𝑇=130) 0.3

𝑃 ( 𝑍 =90 , 𝑇=130) 0.3

𝑃( 𝑍 =90 , 𝑇 =86 ) 0.1

Conditional probability distribution of Z given T=130: z 90 120

Two random variables and are independent if

For every and .

For every y, and for every x for which

For every x, and for every y for which

• E(Y ∣X = x) can be different for different values of x.

• If X and Y are independent, then .

Z has higher expected value if T is lower!

Faculty of Business and Economics

2. for each possible value 2. Two possible outcomes of Z (n=2)

1. for each possible value 2. Two possible outcomes of Z (n=2)

Faculty of Business and Economics

Outside E add up terms Inside E fixes and add up terms.

The conditional Expected value

E(Z | T = 86) = $114

𝐸 [ 𝐸 ( 𝑍|𝑇 ) ]=𝐸 ( 𝑍|𝑇 =86 ) × 𝑃 ( 𝑇 =86 ) +𝐸 (𝑍 ∨𝑇 =130)× 𝑃 (𝑇=130)

¿114 × 0.5+102 × 0.5

Suppose an investment return R has conditional expected values:

𝐸 ( 𝑌 )=𝐸 [ 𝐸(𝑌 ∨ 𝑋)]

Faculty of Business and Economics

• A random trial/experiment is independently repeated n times. Example: coin tossing

Outcome X Probability x P(X=x)

 P(X=2) when n=4 is

Define: if success occurs in trial

Then is a Bernoulli random variable with distribution

x P(X=x) 𝐸 ( 𝑋 𝑖 ) =0 × 𝑃 ( 𝑋 𝑖=0)+1× 𝑃 ( 𝑋 𝑖=1)¿ 0 × (1 − 𝑝 ) +1 ×𝑝 =𝑝

Formally, a Binomial random variable X with any n can be defined as

where are independent Bernoulli random variables with

Each week, the value might

After 1 year, what is the expected value and standard

A “binomial price tree” 5 103

Each week, the value might

After 1 year, what is the expected value and standard

Each week, the value might

After 1 year, what is the expected value and standard

Each week, the value might

After 1 year, what is the expected value and standard

Each week, the value might

After 1 year, what is the expected value and standard

The expected value:

And standard deviation

You might also like