DISTRIBUTIONS

COMMON PROBABILITY
DISTRIBUTION
• Discreet Distribution
– Binomial Distribution
– Poisson Distribution
• Continuous Distribution
– Uniform Distribution
– Triangular Distribution
– Normal Distribution
– Lognormal Distribution
 BINOMIAL DISTRIBUTION
• ‘N’ identical trials
– Example: 15 tosses of a coin, 10 light bulbs taken from a warehouse
• 2 mutually exclusive outcomes on each trial
– Example: Heads or tails in each toss of a coin, defective or not defective light
bulbs
 BINOMIAL DISTRIBUTIONS

• Constant Probability for each Trial

Example: Probability of getting a tail is the same each time we toss the coin and each light bulb has the
same probability of being defective
• 2 Sampling Methods:
• Infinite Population Without Replacement
• Finite Population With Replacement
• Trials are Independent:
The Outcome of One Trial Does Not Affect the Outcome of Another
 BINOMIAL PROBABILITY DISTRIBUTION
FUNCTION

n! X n X
P(X)  p (1  p )
X ! (n  X)!
P(X) = probability that X successes given a knowledge of n and p
X = number of ‘successes’ in Tails in 2 Tosses of Coin
sample, (X = 0, 1, 2, ..., n)
X P(X)
p = probability of each ‘success’
0 1/4 = .25
n = sample size
1 2/4 = .50
2 1/4 = .25
BINOMIAL DISTRIBUTION
CHARACTERISTICS

Mean .6
P(X) n = 5 p = 0.1
  E ( X )  np .4
.2
e.g.  = 5 (.1) = .5 0 X
0 1 2 3 4 5
Standard Deviation
 
P(X) n = 5 p = 0.5
np (1  p ) .6
.4
.2
e.g.  = 5(.5)(1 - .5) 0 X
0 1 2 3 4 5
= 1.118
 Binomial Probabilities
n 10
p 0.8

Computing Binomial
Probabilities using Excel
Function BINOMDIST
10
x p(x)
0 0.000000
1 0.000004
2 0.000074
3 0.000786
4 0.005505
5 0.026424
6 0.088080
7 0.201327
8 0.301990
9 0.268435
0.107374
 POISSON DISTRIBUTION
• Poisson process is a Discrete events in an ‘interval’
– The probability of one success in an interval is stable
– The probability of more than one success in this interval is 0
– Probability of success is independent from interval to interval
• Examples:
– # Customers arriving in 15 min
– # Defects per case of light bulbs
 POISSON DISTRIBUTION FUNCTION

 X
P (X )  e 
X!
P(X ) = probability of X successes given 
 = expected (mean) number of
‘successes’
e = 2.71828 (base of natural logs)
X = number of ‘successes’ per unit
e.g. Find the probability of 4 -3.6 4
customers arriving in 3 P(X) =
e 3.6 = .1912
4!
minutes when the mean is 3.6
POISSON DISTRIBUTION
CHARACTERISTICS

Mean P(X) = 0.5

  E (X )   .6
.4
N .2
  Xi P( Xi ) 0 X
0 1 2 3 4 5
i 1

.6
P(X) = 6
Standard Deviation .4

   .2
0 X
0 2 4 6 8 10
 Poisson Distribution
Mean 12

Computing Poisson
Probabilities using Excel
Function POISSON
x p(x)
1 0.00007
2 0.00044
3 0.00177
4 0.00531
5 0.01274
6 0.02548
7 0.04368
8 0.06552
9 0.08736
10 0.10484
11 0.11437
12 0.11437
 The Uniform Distribution
• Equally Likely chances of
occurrences of random f(x)
values between a
maximum and a minimum
1/(b-a)
• Mean = (b+a)/2
• Variance = (b-a)2/12
• ‘a’ is a location parameter
a b x
• ‘b-a’ is a scale parameter
• no shape parameter
 The Uniform Distribution

Probability Density Function f(x)

1
f x  if a  x  b
ba 1/(b-a)
Distribution Function
F x  0 if x < a
xa
F x  if a  x  b a b x
ba
F x  1 if b  x
 The Triangular Distribution
• Symmetric or skewed in either direction
• Parameters: Minimum a, maximum b, most likely c
• a location parameter
• (b-a) scale parameter
• c shape parameter
• Mean = (a+b+c) / 3
• Variance = (a2 + b2 + c2 - ab- ac-bc)/18
• Used as rough approximation of other distributions
 The Triangular Distribution
f(x)

Symmetric

a c b x
 The Triangular Distribution
f(x)
Skewed (+) to the Right

a c b x
 The Triangular Distribution
f(x)
Skewed (-) to the Left

a c b x
 The Triangular Distribution
• Probability Distribution Function

2x  a
f x  if a  x  c
b  a c  a 
2 b  x 
f x  if c  x  b
b  a b  c 
f x  0 otherwise
 The Triangular Distribution
•Distribution Function
F x  0 if x  a

 xa 
2

F x  if a  x  c
b  a c  a 
b  x 
2

F  x  1 if c  x  b
b  a b  c 
F x  1 if x  b
THE NORMAL DISTRIBUTION
• Bell Shaped
• Perfectly Symmetrical
f(X)
• Mean, Median and Mode are
Equal
• Location on the value axis is σ
determined by the mean, μ
spread is determined by the  μ +
standard deviation, σ
• The random variable has an Mean
infinite theoretical range: +  = Median
= Mode
to  
What can we say about the distribution of values around the mean? There are
some general rules:
• Probability is measured by the area under the curve

• The total area under the curve is 1.0, and the curve is symmetric, so half is
above the mean, half is below
P(    X  μ)  0.5 P(μ  X  )  0.5
• The height of the curve at a certain value below the mean is equal to the
height of the curve at the same value above the mean

• The area between:

μ ± 1σ encloses about 68% of X’s

μ ± 2σ covers about 95% of X’s
μ ± 3σ covers about 99.7% of X’s
THE NORMAL DISTRIBUTION DENSIT Y FUNCTION:

• The formula for the normal probability density function is:

(the curve is generated by):
2
1  (X μ) 
1  
2  

f(X)  e
2π
Where e = the mathematical constant approximated by 2.71828
π = the mathematical constant approximated by 3.14159
μ = the population mean
σ = the population standard deviation
X = any value of the continuous variable

Note: f (X) is the same concept as P(X).

• By varying the parameters μ and σ, we obtain different
normal distributions. That is to say that any particular
combination of μ and σ, will produce a different normal
distribution. This means that we have to deal with
numerous distribution tables.

Changing μ shifts the distribution left or right.  Skewness

Changing σ increases or decreases the spread.  Kurtosis

SKEWNESS AND KURTOSIS
• Skewness
– If the skewness is between -0.5 and 0.5, the data are fairly symmetrical
– If the skewness is between -1 and – 0.5 or between 0.5 and 1, the data are moderately skewed
– If the skewness is less than -1 or greater than 1, the data are highly skewed

• Kurtosis
– If the kurtosis is close to 0, then a normal distribution is often assumed  mesokurtic distributions.
– If the kurtosis is less than zero, then the distribution is light tails  platykurtic distribution.
– If the kurtosis is greater than zero, then the distribution has heavier tails  leptokurtic distribution.
STANDARD NORMAL DISTRIBUTION
• Any normal distribution (with any mean and standard deviation
combination) can be transformed into the standardized normal
distribution (Z).

• To do so, we need to transform all X units (values) into Z units

(values)

• Then the resulting standard normal distribution has a mean=zero and a

standard deviation =1

• X-Values above the mean of X will have positive Z-value and X-values
below the mean of will have negative Z-values

Xμ
• The transformation equation is: Z 
σ
THE LOGNORMAL DISTRIBUTION

• The lognormal distribution is an asymmetric distribution with interesting applications for

modeling the probability distributions of stock and other asset prices

• A continuous random variable X follows a lognormal distribution if its natural logarithm,

ln(X), follows a normal distribution

• We can also say that if the natural log of a random variable, ln(X), follows a normal
distribution, the random variable, X, follows a lognormal distribution
THE LOGNORMAL DISTRIBUTION

• Interesting observations about the lognormal distribution

– The lognormal distribution is asymmetric (skewed to the right)

– The lognormal distribution is bounded below by 0 (lowest
possible value)
– The lognormal distribution fits well data on asset prices (note
that prices are bounded below by 0)
• Note also that the normal distribution fits well data on asset
returns
f(x)

0 x
THE LOGNORMAL DISTRIBUTION

• The lognormal distribution is described by two parameters: its mean and

variance, as in the case of a normal distribution
• The Lognormal Probability Density Function formula:
1
1  ln x  2 , for x > 0
f (x) 
2
2
e
x 2
0 , for x  0
• The mean of a lognormal distribution is

e  0.50 2 
where  and 2 are the mean and variance of the normal distribution of the
ln(X) variable where e  2.718