‘ Probability Concepts dutors READING PROBABILITY CONCEPTS Define a random variable, an outcome, and an event. Random Arandom variable is one whose possible values or results are uncertain. Variable ‘example: Runs that Rohit Sharma will score in today’s matcht ‘An outcome is the observed value of a random variable. rd ‘Example: Runs that Rohit Sharma has actualy scored in today’s match! An event could be a single outcome or a set of outcomes. — Example: A match ora series could be considered an event, Identify the two defining properties of probability, including mutually exclusive and exhaustive events, and compare and contrast empirical, subjective, and a priori probabilities. Mutually Mutually exclusive events are events that cannot happen simultaneously Exclusive | The occurrence of one precludes the occurrence of the other. Events | Example: Head & To exhaustive | east events cove the ane ofl posible uzomes of an event. 1. The probability of any event, E, is anumber from 0 to 1. Therefore, 0 < P(E) <1, where P(E) is the probability of event, i, occurring 2. The sum of the probabilities of mutually exclusive exhaustive events equals 1. Thus 2P(E} Properties of Probability EMPIRICAL PROBABILITY ‘An empirical probability estimates the probability of an event based on the frequency of its occurrence in the past. Example: itt has rained for 20 days on average in June forthe past S years, the probability of rain on any particular day this June is 67%, Methods of | SUBJECTIVE/PROBABILITY Estimating | A subjective probability draws on subjective reasoning and personal Probabil judgment to estimate probabilities. If you think the probability of rain on a particular day is 80%, you are stating a subjective probability PRIORI PROBABILITY ‘Ana priori probability is based on formal analysis and reasoning rather than personal judgment.P dutors eA tev ol, Cech & pow By Gouray Kabra Describe the probability of an event in terms of odds for and against the event. The odds for an event are stated as the probability of the event occurring to the probability of the event not occurring. “Odds For” an Event Formula: The odds against an event are stated as the probability of the event not ‘occurring to the probability of the event occurring “Odds Against” ‘an Event | Formula: Teta cata ee FR dnd koe nus Independent events refer to events for which the occurrence of one has no Influence on the occurrence of the others. Events A and B are independent if Independent & | and ony i P(AlB) = P(A), or equivalent, P(S/A) = PB) Dependent Events | Dependent events refer to events for which the occurrence of one has influence on the occurrence of the others. Events A and B are dependent if P(A|B) # P(A), or equivalently, P(BIA) # P(B) Unconditional probability (a.k.a, marginal probability) refers to the Unconditional | probability of an event regardless of the past or future occurrence of other Probability | events. Example: Probability thot India will win today's ericket match (P(Win} A conditional probability is one where the occurrence of one event affects the probability of the occurrence of another event. Example: Likelihood of Inaa’s win provided that Vrat wil score a century [P(Win| Century] Conditional Probability‘ Probability Concepts dutors Eee ee The multiplication rule of probability can be used to determine the joint probability of two events (the probability that both events will occur). Multiplication Rule | \utipication rule is applied to calculate joint probabilities. of Probability Formula: P{AB) = P(A/B) x P(B) — [For, Dependent Events} Forma: (48) = (A) (8) Thor, independent vents] Formula (of conditional probability): P(A) 8) = P(AB) / P(B) The addition rule of probability is used to determine the probability that at least one of two events will occur. Formula: P(A or 8) = P(A) + (8) ~ PAB) Addition Rule of Probability learning | Calculate and interpret an unconditional probability using the total probability rule. Se eo RCT eC mC eeu eu Explain the use of conditional expectation in investment applications. Total Probal Rule IY | ta) = P(alsi) x PtSs) + P(AIS2)« P(So) ++ PAIS) PSs) Expected Value | E(x) = (KIX + PUKa)Ke + sae PUK een Devigea = (Variance)! aaa E(x iseacasnata (01S:) « P(S:) + E(X1So) x P(Se) ++ E(K1Sa) x PCS) Se Explicitly not covered in the notes here, follow class discussion, \eersing | Calculate and interpret the expected value, variance, standard deviation, covariances, Seated oa Kat | Calculate and interpret the covariances of portfolio returns using the joint probability function, Explicitly not covered in the notes here, follow class discussion,& Edutors cr eve Cee cue Eee ey Bayes! formula is used to update a given set of prior probabilities for a given event in response to the arrival of new information. The rule for updating prior probability of an event is: (information | Event) P(Event) (Event | Information) (updated probability) = Panformatoa) Identify the most appropriate method to solve a particular counting problem and analyse counting problems using factorial, combination, and permutation concepts. ‘Suppose there are k tasks that must be done. The first one can be done inn ways; Mulapeon | spe second, gn how te ist was one con be done in ways, atthe hi of | gen how the fist two tasks wore dane, cam be done nm way The numberof counting different ways that the k tasks can be done equals ns x m2 13x Mk. These refer to situations where there are n items, each of which can receive one Labelling | of k different labels. We give each object in the group a label to place it ina problems | category: n: items can be given the first label, nz receive the second label, and so The combination formula is used in a special case of the labeling problem, Specifically, the combination formula is used when the number of labels that can be assigned, k, equals 2. In such a situation, any item can only be labeled as one or the other, son: + n= n. Suppose the number of objects that receive the first label, n:, equals r. The number of objects that receive the second label will then equal n-r. Using the same formula as the one we used for labeling problems and Inserting r and n-r in the denominator, the formula for combinations can be Combination | stated as: IMPORTANT NOTE: Remember! The combination formula is used when the order in which the items are assigned the labels is NOT important. When the order in which labels are assigned to two groups is an important consideration, the permutation formula is used. The number of permutations of objects from n items equals: Permutations