INTRODUCTION TO FINANCE

REVIEW OF STATISTICS
A Review of Statistics

In a world with uncertainty, we typically describe possible

future values or rates of return of a security and the relative
likelihoods of these values by means of a probability
distribution over future values or rates of returns.

For example, a continuous distribution is given by:

Probability

% Return

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Discrete distribution - states of the world model

Security Return in %
State Prob. 1 2 3 4
Expansion 0.10 5.00 3.50 6.00 2.50
Normal 0.40 7.00 4.50 5.00 -0.50
Recession 0.30 6.00 4.00 7.00 1.00
Depression 0.20 -2.00 0.00 4.00 13.00

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A Review of Statistics

Expected Return:

~ S ~
E ( R i )  R   p s R i, s
s 1
~
where E ( R i )  R  mean (exp ected ) return
~
R i,s  unknown return of sec urity i in state s

p s  probability of state s

S  total number of states occurring.

Examples:
~ ) = 0.10 (5.0) + 0.40 (7.0) + 0.30 (6.0) + 0.20 (-2.0)
E(R 1
= 4.70%
~
E ( R 2 ) = 0.10 (3.5) + 0.40 (4.5) + 0.30 (4.0) + 0.20 (0)
= 3.35%
~
E ( R 3 ) = 0.10 (6.0) + 0.40 (5.0) + 0.30 (7.0) + 0.20 (4.0)
= 5.50%
~
E ( R 4 ) = 0.10 (2.5) + 0.40 (-0.5) + 0.30 (1.0) + 0.20 (13.0)
= 2.95%.
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 Spread of distribution of outcomes:
1
~  S ~ 2  2
Std (R i )    p s (R i,s  R )   i .
s 1 

Note: Var ( R i )  Std (R i )   2 .

~ ~ 2
i

Examples:
12 = 0.10 (5.0 - 4.7)2 + 0.40 (7.0 - 4.7)2
+ 0.30 (6.0 - 4.7)2 + 0.20 (-2.0 - 4.7)2
= 11.61
  1 = 3.41%.

 22 = 0.10 (3.5 - 3.35)2 + 0.40 (4.5 - 3.35)2

+ 0.30 (4.0 - 3.35)2 + 0.20 (0.0 - 3.35)2
= 2.90.

  2 =1.70%.

 3 = Calculate

 4 = Calculate

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A Review of Statistics

 Covariance:

~ ~  S ~ ~ 
Cov(R i , R j )    p s (R i,s  R i )(R j,s  R j )   i, j.
s 1 

When the returns of securities i and j tend to deviate from

their means in the same direction they are called positively
~ ~
correlated or they covary positively [that is, Cov(R i , R j )  0 ].

When they tend to deviate from their means in opposite

directions, they are negatively correlated or they covary
~ ~
negatively [that is, Cov( R i , R j )  0 ].

When the returns of securities i and j are unrelated with each

~ ~
other, then Cov( R i , R j )  0 and they are uncorrelated.

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Examples:
 1,2 = 0.10 (5.0 - 4.7) (3.5 - 3.35)
+ 0.40 (7.0 - 4.7) (4.5 - 3.35)
+ 0.30 (6.0 - 4.7) (4.0 - 3.35)
+ 0.20 (-2.0 - 4.7) (0.0 - 3.35)
= 5.81.
1, 3 = 0.10 (5.0 - 4.7) (6.0 - 5.5)
+ 0.40 (7.0 - 4.7) (5.0 - 5.5)
+ 0.30 (6.0 - 4.7) (7.0 - 5.5)
+ 0.20 (-2.0 - 4.7) (4.0 -5.5)
= 2.15.

1, 4 = Calculate

 2 ,3 = Calculate

 2 , 4 = Calculate

 3,4 = Calculate

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 Correlation--A “standardized” Covariance:

~ ~
Cov(R i , R j )  i, j
 i, j  ~ ~  ,
Std (R i )Std (R j ) i  j

where  1  i, j  1.

~ ~
Since Std ( R i ) and Std (R j ) are always positive, the sign of
i, j depends on the sign of i, j.

What is the relation between i, j and  j, i ?

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 Regression Analysis:
 The general idea of a regression is that it involves fitting a
line through a set of points. In particular, consider the
following regression model:

~
y    ~
x~

where

~
y = the value of the dependent variable
~
x = the value of the independent variable
~
 = a random error with E( ~
) = 0
 = the Y axis intercept
 = the slope of the line.

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The picture that we are trying to capture is as follows:

Y
Yi
i {



X
X1

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A Review of Statistics

 In general the idea is that there is a linear relationship

between y and x which is not quite exact.

Since we do not know the relationship we want to estimate

 and  that minimize the sum of the deviations squared
from the fitted line.

The best fit is given by the slope:

Cov~y, ~
x   yx
 y, x   .
x2 2
x

 How would you write the relation between security 1 and

2?

 What is the relation between  2,1 and 1,2 ?

 What is the relation between  2,1 and 1,2 ?

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Examples of Correlation and Regression:

Perfect Positive Correlation
1,2 5.81
1,2    1.00.
1  2 3.411.70 
~  1.00  0.50R
Note: R ~ .
2 1

Less Than Perfect Correlation:

1,3 2.15
1,3    0.563.
1  3  3.411.12
~  4.63  0.185R
Note: R ~  ~e .
3 1 3

Perfect Negative Correlation

  1,4   17.42  100 . .
1,4  
1 4  3 .41 
511
.
~  10.00  1.50R
Note: R ~ .
4 1

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