Probability Distributions

Characteristics of a Probability Distribution

CHARACTERISTICS OF A PROBABILITY
DISTRIBUTION
1. The probability of a particular outcome is between
0 and 1 inclusive.
2. The outcomes are mutually exclusive events.
3. The list is exhaustive. So the sum of the probabilities
of the various events is equal to 1.
 What is a Probability
Distribution?

PROBABILITY DISTRIBUTION A listing of all the outcomes of

an experiment and the probability associated with each outcome.

Experiment:
Toss a coin three times.
Observe the number of
heads. The possible
results are: Zero heads,
One head,
Two heads, and
Three heads.
What is the probability
distribution for the
number of heads?
Probability Distribution of Number of
Heads Observed in 3 Tosses of a Coin
 Introduction to Probability
Distributions
 Random Variable
 Represents a possible numerical value from

a random event
Random
Variables

Discrete Continuous
Random Variable Random Variable
 Random Variables

 Random variable
 A function that assigns numerical values to the
outcomes of a random experiment.
 Denoted by uppercase letters (e.g., X ).

 Values of the random variable are denoted by

corresponding lowercase letters.
 Corresponding values of the random variable:
x 1, x 2, x 3, . . .
 Random Variables

RANDOM VARIABLE A quantity resulting from an experiment

that, by chance, can assume different values.
 Types of Random Variables

 Random variables may be classified as:

 Discrete : A random variable that can assume only certain

clearly separated values

 The random variable assumes a countable number of
distinct values.
 It is usually the result of counting something

 Continuous : A random variable that can assume an

infinite number of values within a given range.

 The random variable is characterized by (infinitely)
uncountable values within any interval.
 It is usually the result of some type of measurement
 Discrete Random Variables

DISCRETE RANDOM VARIABLE A random variable that can assume

only certain clearly separated values. It is usually the result of counting
something.

EXAMPLES
1. The number of students in a class.
2. The number of children in a family.
3. The number of cars entering a carwash in a hour.
4. Number of home mortgages approved by Coastal Federal
Bank last week.
 Discrete Random Variables
 Can only assume a countable number of values
Examples:

 Roll a die twice

Let x be the number of times 4 comes up
(then x could be 0, 1, or 2 times)

 Toss a coin 5 times.

Let x be the number of heads
(then x = 0, 1, 2, 3, 4, or 5)
 Discrete Probability Distribution

Experiment: Toss 2 Coins. Let x = # heads.

4 possible outcomes Probability Distribution
T T x Value Probability
0 1/4 = .25
T H 1 2/4 = .50
2 1/4 = .25
H T
Probability

.50
.25
H H
0 1 2 x
 Discrete Probability Distribution

 A discrete probability distribution may be viewed

as a table, algebraically, or graphically.
 For example, consider the experiment of rolling a
six-sided die. A tabular presentation is:

 Each outcome has an associated probability of 1/6.

Thus, the pairs of values and their probabilities form
the probability mass function for X.
 Discrete Probability Distribution

 Another tabular view of a probability distribution is

based on the cumulative probability distribution.
 For example, consider the experiment of rolling a six-
sided die. The cumulative probability distribution is

 The cumulative probability distribution gives the

probability of X being less than or equal to x.
For example, P ( X ≤ 4 ) = 46
 Discrete Probability Distribution

 A probability distribution may be expressed

algebraically.
 For example, for the six-sided die experiment, the
probability distribution of the random variable X is:

1 6 if x = 1,2,3,4,5,6
P(X ) 
= x=
0 otherwise

 Using this formula we can find

P ( X= 5=
) 16 P ( X= 7=
) 0
 Discrete Probability Distribution
 A probability distribution may be expressed
graphically.
 The values x of X are placed on the horizontal axis and
the associated probabilities on the vertical axis.
 A line is drawn such that its height is associated with the
probability of x.
 For example, here is the
graph representing the
six-sided die experiment:
 This is a uniform distribution
since the bar heights are all
the same.
 Discrete Probability Distribution
 Example: Consider the probability distribution
which reflects the number of credit cards that
Bankrate.com’s readers carry:
 Is this a valid probability
distribution?
 What is the probability that a
reader carries no credit cards?
 What is the probability that a
reader carries less than two?
 What is the probability that a reader carries at least two
credit cards?
 Discrete Probability Distribution
 Consider the probability distribution which reflects
the number of credit cards that Bankrate.com’s
readers carry:
 Yes, because 0 < P(X = x) < 1
and ΣP(X = x) = 1.
 P(X = 0) = 0.025
 P(X < 2) = P(X = 0) + P(X = 1)
= 0.025 + 0.098 = 0.123.
 P(X > 2) = P(X = 2) + P(X = 3)
+ P(P = 4*) = 0.166 + 0.165 + 0.546 = 0.877.
Alternatively, P(X > 2) = 1 − P(X < 2) = 1 − 0.123 = 0.877.
 Expected Value, Variance, and Standard
Deviation

 Summary measures for a random variable

include the
 Mean (Expected Value)

 Variance

 Standard Deviation
 The Mean of a Probability
Distribution

 Expected Value Population Mean

E(X) µ
 E(X) is the long-run average value of the random
variable over infinitely many independent
repetitions of an experiment.
 For a discrete random variable X with values
x1, x2, x3, . . . that occur with probabilities
P(X = xi), the expected value of X is
E ( X=
) µ= ∑ x P ( X=
i xi )
 The Mean of a Probability Distribution

MEAN
•The mean is a typical value used to represent the
central location of a probability distribution.
•The mean of a probability distribution is also
referred to as its expected value.
 The Variance and Standard
Deviation of a Probability Distribution

 Variance and Standard Deviation

 For a discrete random variable X with values
x1, x2, x3, . . . that occur with probabilities
P(X = x ),
i

Var ( X ) = ∑ ( xi − µ ) P ( X =
xi )
2
σ =
2

= ∑ i
x 2
P ( =
X x i ) − µ 2

 The standard deviation is the square root of the

variance.
SD ( X =
) σ= σ 2
 The Variance and Standard
Deviation of a Probability Distribution

VARIANCE AND STANDARD DEVIATION

• Measures the amount of spread in a distribution
• The computational steps are:
1. Subtract the mean from each value, and square this
difference.
2. Multiply each squared difference by its probability.
3. Sum the resulting products to arrive at the variance.

The standard deviation is found by taking the positive

square root of the variance.
 The Variance and Standard
Deviation of a Probability Distribution
(continued)

 Standard Deviation of a discrete distribution

σx = ∑ {x − E(x)} P(x) 2

where:
E(x) = Expected value of the random variable
x = Values of the random variable
P(x) = Probability of the random variable having
the value of x
 Example : The Mean of a
Probability Distribution
 Expected Value of a discrete distribution
(Weighted Average)

E(x) = Σxi P(xi)

 Example: Toss 2 coins,
x P(x)
x = # of heads, 0 .25
compute expected value of x: 1 .50
2 .25
E(x) = (0 x .25) + (1 x .50) + (2 x .25)
= 1.0
 Example : The Variance and Standard
Deviation of a Probability Distribution
(continued)
 Example: Toss 2 coins, x = # heads,
compute standard deviation (recall E(x) = 1)

σx = ∑ {x − E(x)} P(x) 2

σ x = (0 − 1)2 (.25) + (1 − 1)2 (.50) + (2 − 1)2 (.25) = .50 = .707

Possible number of heads =

0, 1, or 2
 Exercise 1

 Example: Brad Williams, owner of a car dealership

in Chicago, decides to construct an incentive
compensation program based on performance.

 Calculate the expected value of the annual bonus amount.

 Calculate the variance and standard deviation of the
annual bonus amount.
 Exercise 1

 Solution: Let the random variable X denote the

bonus amount (in $1,000s) for an employee.

 E(X) = µ = Σxi P(X = xi) = 4.2 or $4,200

 Var(X) = σ2 = Σ(xi − µ)2P(X = xi) = 9.97 (in $1,000s)2.
 .SD=
(X) = σ2 9.97
= 3.158 or $3,158.
 Portfolio Returns
 Expected return, variance, and standard
deviation of portfolio returns.
 Given a portfolio with two assets, Asset A and
Asset B, the expected return of the portfolio
E(Rp) is computed as:
E ( Rp ) w AE ( RA ) + w B E ( RB )
=

 where
wA and wB are the portfolio weights
wA + wB = 1
E(RA) and E(RB) are the expected returns on assets
A and B, respectively.
 Portfolio Returns
 Expected return, variance, and standard deviation
of portfolio returns.
 Using the covariance or the correlation coefficient of the
two returns, the portfolio variance of return is:
Var ( Rp ) = w A 2σ A 2 + w B 2σ B 2 + 2w Aw B ρ ABσ Aσ B

where σ2A and σ2B are the variances of the returns for
Asset A and Asset B, respectively,
σAB is the covariance between the returns for
Assets A and B
ρAB is the correlation coefficient between the returns
for Asset A and Asset B.
 Portfolio Returns
 Example: Consider an investment portfolio of
$40,000 in Stock A and $60,000 in Stock B.
 Given the following information, calculate the expected
return of this portfolio.

 .
 Portfolio Returns

 Example: Consider an investment portfolio of

$40,000 in Stock A and $60,000 in Stock B.

 Calculate the correlation coefficient between

the returns on Stocks A and B.

 Solution:
 Portfolio Returns
 Example: Consider an investment portfolio of
$40,000 in Stock A and $60,000 in Stock B.

 Calculate the portfolio variance.

 Solution:
 Portfolio Returns
 Example: Consider an investment portfolio of
$40,000 in Stock A and $60,000 in Stock B.

 Calculate the portfolio standard deviation.

 Solution:
Binomial Distributions
Probability Distributions
Probability
Distributions

Discrete Continuous
Probability Probability
Distributions Distributions

Binomial Normal

Poisson Uniform

Hypergeometric Exponential
 Discrete Probability Distributions
 A discrete random variable is a variable that can
assume only a countable number of values
Many possible outcomes:
 number of complaints per day
 number of TV’s in a household
 number of rings before the phone is answered
Only two possible outcomes:
 gender: male or female
 defective: yes or no
 spreads peanut butter first vs. spreads jelly first
 Continuous Probability Distributions

 A continuous random variable is a variable that

can assume any value on a continuum (can
assume an uncountable number of values)
 thickness of an item
 time required to complete a task
 temperature of a solution
 height, in inches

 These can potentially take on any value,

depending only on the ability to measure
accurately.
The Binomial Distribution
Probability
Distributions

Discrete
Probability
Distributions

Binomial

Poisson

Hypergeometric
 Binomial Probability Experiment

1. An outcome on each trial of an experiment is

classified into one of two mutually exclusive
categories—a success or a failure.
2. The random variable counts the number of successes
in a fixed number of trials.
3. The probability of success and failure stay the same
for each trial.
4. The trials are independent, meaning that the outcome
of one trial does not affect the outcome of any
other trial.
 Binomial Probability Distribution
A Widely occurring discrete probability
distribution
Characteristics of a Binomial Probability
Distribution
1. There are only two possible outcomes on a
particular trial of an experiment.
2. The outcomes are mutually exclusive,
3. The random variable is the result of counts.
4. Each trial is independent of any other trial
 Binomial Probability Distribution
 A binomial random variable is defined as the
number of successes achieved in the n trials of a
Bernoulli process.
 A Bernoulli process consists of a series of n
independent and identical trials of an experiment
such that on each trial:
 There are only two possible outcomes:
p = probability of a success
1−p = q = probability of a failure
 Each time the trial is repeated, the probabilities of
success and failure remain the same.
 The Binomial Distribution

 Characteristics of the Binomial Distribution:

 A trial has only two possible outcomes – “success” or
“failure”
 There is a fixed number, n, of identical trials
 The trials of the experiment are independent of each
other
 The probability of a success, p, remains constant from
trial to trial
 If p represents the probability of a success, then
(1-p) = q is the probability of a failure
 Binomial Distribution Settings

 A manufacturing plant labels items as

either defective or acceptable
 A firm bidding for a contract will either get
the contract or not
 A marketing research firm receives survey
responses of “yes I will buy” or “no I will
not”
 New job applicants either accept the offer
or reject it
 Counting Rule for Combinations
 A combination is an outcome of an experiment
where x objects are selected from a group of n
objects
n n!
C = x
x! (n − x )!
where:
n! =n(n - 1)(n - 2) . . . (2)(1)
x! = x(x - 1)(x - 2) . . . (2)(1)
0! = 1 (by definition)
 Binomial Distribution Formula

 A binomial random variable X is defined as the

number of successes achieved in the n trials of a
Bernoulli process.
 A binomial probability distribution shows the
probabilities associated with the possible values of
the binomial random variable (that is, 0, 1, . . . , n).
 For a binomial random variable X , the probability of x
successes in n Bernoulli trials is
n!
P(X )
= x= ( )
n p x q n −=
x
x

x ! ( n − x )!
pxq n−x

for x 0,1,2,
= , n. By definition, 0! 1.
 Binomial Distribution Formula

n! x n−x
P(x) = p q
x ! (n − x )!

P(x) = probability of x successes in n trials,

with probability of success p on each trial
Example: Flip a coin four
times, let x = # heads:
x = number of ‘successes’ in sample,
n=4
(x = 0, 1, 2, ..., n)
p = probability of “success” per trial p = 0.5
q = probability of “failure” = (1 – p) q = (1 - .5) = .5
n = number of trials (sample size) x = 0, 1, 2, 3, 4
 Binomial Distribution
 The shape of the binomial distribution depends on the
values of p and n
Mean P(X) n = 5 p = 0.1
.6
.4
.2
 Here, n = 5 and p = .1
0 X
0 1 2 3 4 5

P(X) n = 5 p = 0.5
.6
.4
 Here, n = 5 and p = .5 .2
0 X
0 1 2 3 4 5
 Binomial Distribution
Characteristics
 Mean
μ = E(x) = np
 Variance and Standard Deviation
2
σ = npq
σ = npq
Where n = sample size
p = probability of success
q = (1 – p) = probability of failure
 Binomial Distribution Characteristics

 For a binomial distribution:

 The expected value E ( X=
) µ= np
(E(X)) is:

 The variance (Var(X)) is: Var ( X=

) σ=2
npq

The standard deviation

SD ( X =
)

(SD(X)) is: σ= npq
 Using Binomial Tables
n = 10
x p=.15 p=.20 p=.25 p=.30 p=.35 p=.40 p=.45 p=.50
0 0.1969 0.1074 0.0563 0.0282 0.0135 0.0060 0.0025 0.0010 10
1 0.3474 0.2684 0.1877 0.1211 0.0725 0.0403 0.0207 0.0098 9
2 0.2759 0.3020 0.2816 0.2335 0.1757 0.1209 0.0763 0.0439 8
3 0.1298 0.2013 0.2503 0.2668 0.2522 0.2150 0.1665 0.1172 7
4 0.0401 0.0881 0.1460 0.2001 0.2377 0.2508 0.2384 0.2051 6
5 0.0085 0.0264 0.0584 0.1029 0.1536 0.2007 0.2340 0.2461 5
6 0.0012 0.0055 0.0162 0.0368 0.0689 0.1115 0.1596 0.2051 4
7 0.0001 0.0008 0.0031 0.0090 0.0212 0.0425 0.0746 0.1172 3
8 0.0000 0.0001 0.0004 0.0014 0.0043 0.0106 0.0229 0.0439 2
9 0.0000 0.0000 0.0000 0.0001 0.0005 0.0016 0.0042 0.0098 1
10 0.0000 0.0000 0.0000 0.0000 0.0000 0.0001 0.0003 0.0010 0
p=.85 p=.80 p=.75 p=.70 p=.65 p=.60 p=.55 p=.50 x

Examples:
n = 10, p = .35, x = 3: P(x = 3|n =10, p = .35) = .2522
n = 10, p = .75, x = 2: P(x = 2|n =10, p = .75) = .0004
 Binomial Probability - Example

 Example: Approximately 20% of U.S. workers are

afraid that they will never be able to retire. Suppose
10 workers are randomly selected.
 What is the probability that none of the workers is
afraid that they will never be able to retire?
 Solution: Let X = 10, then
Binomial Probability - Example
There are five flights
daily from Pittsburgh
via US Airways into
the Bradford,
Pennsylvania,
Regional Airport.
Suppose the
probability that any
flight arrives late is
.20.
What is the probability
that none of the
flights are late today?
 Binomial Probability - Example

For the example

regarding the number
of late flights, recall
that π =.20 and n = 5.

What is the average

number of late flights?

What is the variance of

the number of late
flights?
Binomial Probability - Example
: Another Solution
 Binomial Probability - Example

Five percent of the worm gears produced by an automatic, high-

speed Carter-Bell milling machine are defective.
What is the probability that out of six gears selected at random
none will be defective? Exactly one? Exactly two? Exactly
three? Exactly four? Exactly five? Exactly six out of six?
Binomial – Shapes for Varying π (n constant)
Binomial – Shapes for Varying n (π constant)
 Binomial Probability Distributions -
Example

A study by the Illinois Department of Transportation

concluded that 76.2 percent of front seat occupants
used seat belts. A sample of 12 vehicles is selected.
What is the probability the front seat occupants in
exactly 7 of the 12 vehicles are wearing seat belts?
 Cumulative Binomial Probability
Distributions - Example

A study by the Illinois Department of Transportation

concluded that 76.2 percent of front seat occupants
used seat belts. A sample of 12 vehicles is selected.
What is the probability the front seat occupants in at
least 7 of the 12 vehicles are wearing seat belts?
 The Five Number Summary

The five numbers that help describe the center, spread

and shape of data are:
 Xsmallest
 First Quartile (Q1)
 Median (Q2)
 Third Quartile (Q3)
 Xlargest
 Relationships among the five-number
summary and distribution shape
DCOVA
Left-Skewed Symmetric Right-Skewed
Median – Xsmallest Median – Xsmallest Median – Xsmallest
> ≈ <
Xlargest – Median Xlargest – Median Xlargest – Median
Q1 – Xsmallest Q1 – Xsmallest Q1 – Xsmallest

> ≈ <

Xlargest – Q3 Xlargest – Q3 Xlargest – Q3

Median – Q1 Median – Q1 Median – Q1

> ≈ <

Q3 – Median Q3 – Median Q3 – Median

 Five Number Summary and
The Boxplot

 The Boxplot: A Graphical display of the data

based on the five-number summary:
Xsmallest -- Q1 -- Median -- Q3 -- Xlargest
Example:

25% of data 25% 25% 25% of data

of data of data

Xsmallest Q1 Median Q3 Xlargest

 Five Number Summary:
Shape of Boxplots
 If data are symmetric around the median then the box
and central line are centered between the endpoints

Xsmallest Q1 Median Q3 Xlargest

 A Boxplot can be shown in either a vertical or horizontal

orientation
 Distribution Shape and
Box and Whisker Plot

Left-Skewed Symmetric Right-Skewed

Q1 Q2 Q3 Q1 Q2 Q3 Q1 Q2 Q3
 Box-and-Whisker Plot Example

 Below is a Box-and-Whisker plot for the following

data:
Min Q1 Q2 Q3 Max
0 2 2 2 3 3 4 5 5 10 27

0 23 5 27
 This data is very right skewed, as the plot depicts
 Methods for Detecting Outliers
 Outlier – an observation that is unusually large
or small relative to the data values being
described
 Causes
 Invalid measurement or misclassified
measurement
 A rare event
 Two detection methods
 Box Plots
 Z-scores
 Box Plots
 A box plot allows you to:
 Graphically display the distribution of a data set.
 Compare two or more distributions.
 Identify outliers in a data set.

Outliers
Whiskers

Box

**
 Box Plots
 Box Plots
• based on quartiles
• Lower Quartile QL – 25th percentile
• Middle Quartile - median
• Upper Quartile QU – 75th percentile
• Interquartile Range (IQR) = QU - QL
 Box Plots (cont.)
Outer fence = Q3 + 3.0 × IQR

* Outlier
Inner fence = Q3 + 1.5 × IQR

Whisker
Q3 75th percentile
Interquartile
Median range
Q1 25th percentile IQR = (Q3 – Q1)
Whisker
Inner fence = Q1 – 1.5 × IQR

Outer fence = Q1 – 3.0 × IQR

 Box Plots

 The box plot displays 5 summary values:

 S = smallest value
 L = largest value
 Q1 = first quartile = 25th percentile
 Q2 = median = second quartile = 50th percentile
 Q3 = third quartile = 75th percentile
 Aggregate Price Indexes
 An aggregate index is used to measure the rate
of change from a base period for a group of items

Aggregate
Price Indexes

Unweighted Weighted
aggregate aggregate
price index price indexes

Paasche Index Laspeyres Index

 Paasche Index

Where
p is the price index
pt is the current price
p0 is the price of the base period
qt is the quantity used in the current period
q0 is the quantity used in the base period

Advantages Because it uses quantities from the current period, it

reflects current buying habits.

Disadvantages It requires quantity data for the current year. Because

different quantities are used each year, it is impossible to attribute
changes in the index to changes in price alone. It tends to overweight
the goods whose prices have declined. It requires the prices to be
recomputed each year.
 Laspeyres Index

Advantages Requires quantity data from only the base period. This
allows a more meaningful comparison over time. The changes in
the index can be attributed to changes in the price.

Disadvantages Does not reflect changes in buying patterns over time.

Also, it may overweight goods whose prices increase.
 Changing Consumption Patterns
 The Laspeyres and Paasche methods provide similar
results if the time periods being compared are not too far
apart.

 Over time, consumers tend to adjust their consumption

patterns. As a result, the Paasche index will tend to
produce a lower estimate than the Laspeyres index if
prices are rising, and a higher estimate than the
Laspeyres index if they are falling.

 However, since the Paasche index requires weights to be

updated each year, in practice the Laspeyres index is
more widely used.
Nominal versus Real Values
CPI Uses - Formulas
 CPI and Real Income
CPI is used to determine real disposable personal income,
to deflate sales or other variables, to find the purchasing
power of the dollar, and to establish cost-of-living
increases.
 CPI and Real Income
The Consumer Price Index is also used to determine
the purchasing power of the dollar.

Suppose the Consumer Price Index this month is 200.0 (1982–84

100). What is the purchasing power of the dollar?
Inflation Rate
 Example
 The CPI for 2006, 2007, and 2008 are reported as
201.59, 207.34, and 215.30, respectively, by the Bureau
of Labor Statistics.

 Let’s use these values to compute the inflation rates for

2007 and 2008:
 Conditional Probability

 A conditional probability is the

probability of a particular event
occurring, given that another event
has occurred.

 The probability of the event A given

that the event B has occurred is
written P(A|B).
 Conditional Probability Example

 Of the cars on a used car lot, 70% have air

conditioning (AC) and 40% have a CD player
(CD). 20% of the cars have both.

 What is the probability that a car has a CD

player, given that it has AC ?

i.e., we want to find P(CD | AC)

 Conditional Probability Example
(continued)
 Of the cars on a used car lot, 70% have air conditioning
(AC) and 40% have a CD player (CD).
20% of the cars have both.
CD No CD Total
AC .2 .5 .7
No AC .2 .1 .3
Total .4 .6 1.0

P(CD and AC) .2

P(CD | AC) = = = .2857
P(AC) .7
 Conditional Probability Example
(continued)
 Given AC, we only consider the top row (70% of the cars). Of these,
20% have a CD player. 20% of 70% is about 28.57%.

CD No CD Total
AC .2 .5 .7
No AC .2 .1 .3
Total .4 .6 1.0

P(CD and AC) .2

P(CD | AC) = = = .2857
P(AC) .7
 Tree Diagrams

A tree diagram is useful for portraying

conditional and joint probabilities. It is
particularly useful for analyzing business
decisions involving several stages.
A tree diagram is a graph that is helpful in
organizing calculations that involve several
stages. Each segment in the tree is one stage of
the problem. The branches of a tree diagram are
weighted by probabilities.
 Elementary Events
 A automobile consultant records fuel type and
vehicle type for a sample of vehicles
2 Fuel types: Gasoline, Diesel
3 Vehicle types: Truck, Car, SUV
e1
6 possible elementary events: e2
Car
e1 Gasoline, Truck e3
e2 Gasoline, Car e4
e3 Gasoline, SUV e5
e6
e4 Diesel, Truck Car
e5 Diesel, Car
e6 Diesel, SUV
 Tree Diagram Example

P(E1 and E3) = 0.8 x 0.2 = 0.16

Car: P(E4|E1) = 0.5 P(E1 and E4) = 0.8 x 0.5 = 0.40

Gasoline
P(E1) = 0.8
P(E1 and E5) = 0.8 x 0.3 = 0.24

P(E2 and E3) = 0.2 x 0.6 = 0.12

Diesel
Car: P(E4|E2) = 0.1
P(E2) = 0.2 P(E2 and E4) = 0.2 x 0.1 = 0.02

P(E3 and E4) = 0.2 x 0.3 = 0.06

 Bayes’ Theorem
 Bayes’ Theorem
 A procedure for updating probabilities based on
new information.
 Prior probability is the original (unconditional)
probability (e.g., P(B) ).
 Posterior probability is the updated
(conditional) probability (e.g., P(B | A) ).
 Bayes’ Theorem
 Bayes’ Theorem
 Given a set of prior probabilities for an event and
some new information, the rule for updating the
probability of the event is called Bayes’ theorem.
P (A  B)
P (B | A) =
(
P ( A  B ) + P A  Bc )
or
P ( A | B ) P (B )
P (B | A) =
( ) ( )
P ( A | B ) P (B ) + P A | Bc P Bc
Bayes Theorem – Example 1
Bayes Theorem – Example 1
Bayes Theorem – Example 1
Bayes Theorem – Example 1
Bayes Theorem – Example 1
 Binomial Distribution Formula

n! x n−x
P(x) = p q
x ! (n − x )!

P(x) = probability of x successes in n trials,

with probability of success p on each trial
Example: Flip a coin four
times, let x = # heads:
x = number of ‘successes’ in sample,
n=4
(x = 0, 1, 2, ..., n)
p = probability of “success” per trial p = 0.5
q = probability of “failure” = (1 – p) q = (1 - .5) = .5
n = number of trials (sample size) x = 0, 1, 2, 3, 4
 Binomial Probability Distribution
 A binomial random variable is defined as the
number of successes achieved in the n trials of a
Bernoulli process.
 A Bernoulli process consists of a series of n
independent and identical trials of an experiment
such that on each trial:
 There are only two possible outcomes:
p = probability of a success
1−p = q = probability of a failure
 Each time the trial is repeated, the probabilities of
success and failure remain the same.
 Cumulative Binomial Probability
Distributions - Example

A study by the Illinois Department of Transportation

concluded that 76.2 percent of front seat occupants
used seat belts. A sample of 12 vehicles is selected.
What is the probability the front seat occupants in at
least 7 of the 12 vehicles are wearing seat belts?
 Expected Probability
 Expected return.
 Given a portfolio with two assets, Asset A and
Asset B, the expected return of the portfolio
E(Rp) is computed as:

= E ( Rp ) w AE ( RA ) + w B E ( RB )
 where
wA and wB are the portfolio weights/probability to invest
w A + wB = 1
E(RA) and E(RB) are the expected returns on assets
A and B, respectively.
 Portfolio Returns
 Expected return, variance, and standard deviation
of portfolio returns.
 Using the covariance or the correlation coefficient of the
two returns, the portfolio variance of return is:
Var ( Rp ) = w A 2σ A 2 + w B 2σ B 2 + 2w Aw B ρ ABσ Aσ B

where σ2A and σ2B are the variances of the returns for
Asset A and Asset B, respectively,
σAB is the covariance between the returns for
Assets A and B
ρAB is the correlation coefficient between the returns
for Asset A and Asset B.