OGF MIF Statistics 2022 Sessions 1-4 v2

MASTER IN INTERNATIONAL FINANCE
Statistics
Óscar Gil Flores
October-November 2022
MASTER IN INTERNATIONAL FINANCE 1

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Index
SS1: Descriptive Statistics 3

SS2: Introduction to Probability 37
SS3: Random Variables 56
SS4: Probability Distributions 64

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Descriptive Statistics
Study session I

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Probability and Statistics Applied to Finance
• Descriptive Statistics
– Descriptive statistics
– Frequency distributions
– Graphical distributions
– Numerical methods for summarizing quantitative data
– Measures of central tendency: mean, median, mode
– Measures of variation: range, variance, standard deviation
– Measures of skewness and kurtosis

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• Descriptive Statistics
– Other measures for quantitative data
– z-score, percentiles, deciles, quartiles
– Value at risk
– First approach to risk measurement

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• Descriptive Statistics try to summarize a set of data (sample) in a
few numbers (statistics) or graphics that retain the main features
• Statistics will be different measuring each characteristic data:
central tendency, dispersion, symmetry ...
• Statistics can explain, summarize and analyze data, in an ex-post
basis. On the other hand, probability will try to work with an ex-
ante basis.

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Histogram
• Histogram is a graph, where we summarize the data, grouped in
classes, and the frequency (number of observations) is plotted for
each of these classes. It was first introduced by Karl Pearson.
• So, a histogram is a graphical representation of the distribution of
data.

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Histograms, how to construct them?
•We recommend that classes always have the same length
•We recommend class boundaries easy to understand (in the highest, use the
class from 1.50 to 1.60 and not like from 1.5132 to 1.6132)
•You need to make it clear if a class includes the limits or not (if we have
classes from 1.40 to 1.50 and from 1.50 to 1.60, where we count the 1.50?)
•They are not recommended open classes.

•It is impera ve that classes collect all values, and the values are only
counted in one of the classes

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Measures of central tendency
•Is a central value or a typical value for a distribution
•Tries to measure the tendency of quantitative data to cluster around
some central value
•We will include
– Arithmetic mean (or simply, mean) – the sum of all measurements divided by
the number of observations in the data set
– Median – the middle value that separates the higher half from the lower half
of the data set. The median and the mode are the only measures of central
tendency that can be used for ordinal data, in which values are ranked
relative to each other but are not measured absolutely.
– Mode – the most frequent value in the data set.

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Arithmetic Mean / Average
• Arithmetic mean (or simply, mean) – the sum of all measurements
divided by the number of observations in the data set
n n
x1  x 2  ..... x i
x1 f 1  x 2 f 2  ..... x i  fi
X   i 1
X   i 1
n n f 1  f 2  ...... n
X  arithmetic mean 800
700 Arithmetic Mean: 1.45
xi  observations (i  1 to n) 600
500
n  number of observations 400

300
fi  frequency of observation i 200

100
0
0 1 2 3 4 5 6 7

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Median
• Median – the middle value that separates the higher half from
the lower half of the data set.
• The median and the mode are the only measures of central
tendency that can be used for ordinal data, in which values are
ranked relative to each other but are not measured absolutely.
120 Median: 11 Arithmetic Mean: 12.60 120 Median: 11 Arithmetic Mean: 14.41
100 100
80 80 Extreme
Values
60 60
40 40
20 20
0 0
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
32
34
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
32
34
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Mode
• Mode – the most frequent value in the data set.
• It has sense if it is really representative. We can also find
multimode distributions
120 Mode: 5
100
80
60
40
20
0
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
32
34

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Quartiles and percentiles
•As median divided distributions into two halves, there exist
values that divide the distribu on into quarters [these values are
called quartiles] or ten parts [these values are called deciles].
•In general, we speak of x% percentile as the value that leaves x%
of the distribution below it.

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Quartiles and percentiles

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Returns
•Return formula r=(Xn+1 – Xn)/Xn is consistent with a
simple/compounded interest rate for one time period. So,
Xn+1=Xn*(1+r)
•If we modify the formula and assume R=ln(Xn+1/Xn), then we
obtain, Xn+1=Xn*Exp(r), and the implied capitalization is continuous.
R is also call log-return.
•Additionally, thanks to Taylor's formula we can obtain that
R=ln(Xn+1/Xn)= ln(1+(Xn+1-Xn/Xn))=ln(1+r) is similar to r

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Returns
•Return formula r=(Xn+1 – Xn)/Xn gives non-symmetric, non-additive
returns (weekly return is not the sum of daily returns)
•If we use continuous returns R=ln(Xn+1/Xn), we obtain additive and
symmetric returns. If consecutive log-returns are r and –r,
Xn+2=Xn+1*Exp(-r)=Xn*Exp(r)*Exp(-r)=Xn*Exp(0)=Xn
•So, in log-returns, weekly log-return is the sum if daily log-returns.

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Geometric Mean
• The geometric mean is defined as the nth root of the product of
n numbers.
X g  n x1.x2 ...xn
• In finance the geometric mean of growth rates is known as the

compound annual growth rate. The geometric mean of growth
over periods yields the equivalent constant growth rate that
would yield the same final amount.

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Returns and Arithmetic / Geometric Mean
• The geometric mean of returns (r) take into account the laws of
capitalization and therefore is appropriate if returns follow one
after the other
• The arithmetic mean of returns ignores capitalization laws, and
therefore, is suitable in returns that are generated during the
same moment of time
• Finally, for log-returns, thanks to its additivity, the average that
takes into account the capitalization is the arithmetic mean.

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Measures of dispersion
• A measure of statistical dispersion is a nonnegative real number
that is zero if all the data are the same, and increases as the data
become more diverse.
• Denotes how stretched or squeezed is a distribution
• We will include
– Range
– Avegare absolute deviation
– Variance
– Standard deviation

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Range
• Range is defined as the difference between the largest and
smallest values of a distribution.
range  max ( x i )  min ( xi )

i i
60
50
40
30
20
10
0
0 1 2 3 4 5 6 7 8 9
range

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Average (or Mean) absolute deviation
• The average absolute deviation, or simply average deviation of a
data set is the average of the absolute deviations from a central
point and is a summary statistic of statistical dispersion or
variability.
n
 x X i
DX  i 1
n

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Standard deviation
• A change in the formula for the mean absolute deviation leads to
the standard deviation, which in many cases is interpreted like the
mean absolute deviation: average distance of the observations to
its central value.
n
(x  X)
i
2
S i1
n 1
140 140 Mean: 10
Mean: 10
120 Standard deviation: 5.29 120 Standard deviation: 3.16
100 100
80 80
60 60
40 40
20 20
0 0
0
10
12
14
16
18
20
0
10
12
14
16
18
20

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Variance
• The variance is defined as the square of the standard deviation,
and is used mainly in probabilistic contexts, while the standard
deviation is more often used in statistics
n
 i
(x  X) 2
Var(X)  SX2  i1

n 1
140 140 Mean: 10
Mean: 10
120 Variance: 27,98 120 Variance: 9,9856
100 100
80 80
60 60
40 40
20 20
0 0
0
10
12
14
16
18
20
0
10
12
14
16
18
20

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Basic properties of mean, variance and standard deviation
• Var(a+X)=Var(X)
• Var(aX)=a2Var(X)
• StDev(a+X)=StDev(X)
• StDev(aX)=a StDev(X)
• Mean(a+X)=a+Mean(X)
• Mean(aX)=a Mean(X)
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Risk measurements
• One way of measuring risk is to identify the risk to the dispersion
of returns:
– Range
– Avegare absolute deviation
– Variance
– Standard deviation
• Among them, the standard deviation is the most used. It is what

is known as volatility.

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Skewness
• A first approximation of symmetry is the relationship between
the arithmetic mean and the median
• The average is more sensitive to outliers than the median and
therefore outliers drag the arithmetic mean, the median left
unmoved.
60 Median: 7.5
50 Mean: 6
40
30
20
10
0
0 1 2 3 4 5 6 7 8 9

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Skewness
•The skewness is defined as:
(x  X)
i
3
Skewness  i
nS3
•The central moment of order 3, respects the sign of the distances

to the average: ie, high distances to the power of 3 retain the sign.
Posi ve values to the right of the mean, and nega ve values to the le of the
average.
•The final value is determined by outliers, because higher distances
are even greater to the power of 3.
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Kurtosis and excess kurtosis
• Kurtosis is any measure of the "peakedness" of a distribution,
compared to a Normal Distribution.
(x  X)
i
4
Excess Kurtosis K  i
4
3
nS
platykurtic leptokurtic
• Excess kurtosis=kurtosis-3

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Kurtosis
• In the market, returns are clearly leptokurtic ...
• Regardless of the risk, distributions show what are called "fat
tails", that is, outliers more likely than predicted by volatility.
120
120
100
100
80
80
60
60
40
40
20 20
0 0

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Value at Risk (VaR), with probability x%
• VaR is defined as a threshold value such that the probability that
the loss on the portfolio over the given time horizon exceeds this
value (with certain assumptions) is the given probability level.
• So, it is the x% (usually 1% or 5%) percentile of the distribution
of profits&losses.
VaR
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Value at Risk (VaR), with probability x%
•VaR is not coherent risk measure. It is NOT true that
VaR(X+Y)<=VaR(X)+VaR(Y)
•Used in financial markets for the simplicity of its interpretation,
but often wrongly perceived as a maximum level of loss.
•VaR gives you information of the threshold, but not about the
magnitude of the loss…
•If Normal distribution is assumed, -VaR=m-ks where k=1,645 for
5%, or k=2,32 for 1%

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Conditional VaR (CVaR) or expected shortfall (ES)
• The expected shortfall at x% level is the expected return on the
portfolio in the worst x% of the cases.
• This measure is coherent, so CVaR(X+Y)<=CVaR(X)+CVaR(Y)

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Risk measurements. Properties
Possible properties (a constant, y y’ random variables)
•(b1) R(y+a)=R(y)-a Translation invariance
•(b2) R(ay)=aR(y) Positive homogeneity
•(b3) R(y)>E[y] (except if y is constant)
•(b4) R(y+y’)=<R(y)+R(y’) Sub-additivity
•(b3’) if y>=y’, R(y)=<R(y’) Monotonicity
•If (b1) (b2) (b3’) and (b4) holds = coherent measure [1999]
VaR holds (b1) (b2) y (b3’) (is not coherent!)
CVaR holds (b1) (b2) (b3) (b3’) y (b4)
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Descriptive Statistics: Annex
Moments of a distribution
• The k-moment of a distribution is calculated as follows:
n
 i
x k
mk  i 1
n n
 (x i  X )k
• The k-central moment (more used) is mk,X  i 1
• The various moments form one set of values by which the

properties of a probability distribution can be usefully
characterised. m X m  S2
1 2, X

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Additional measurements related to volatility
• Small changes in the expression of volatility give us to
semideviations, that focus only on one of the tails of the
distribution
n n
 max(0, xi ) 2
 ( min(0, xi )) 2
 
Sn1  i1
Sn1  i1
n 1 n 1
• In finance, investors can consider risk only if return falls below an

objective value, so variability in profits is not considered risk.

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Downside Risk / Downside Deviation
• Given a threshold level of profitability K, this modification of the
formula takes into account the volatility risk around that new value
n
 i
( x  K) 2
Sdownside, K  i1
n 1
• For alternative investments, it is used K=0 or K=objective return,
and even, only considering the negative values of the sum:
n
ë i
2
é( x  K)ù
û
Sdownside, K  t1
n 1
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Introduction to Probability
Study session II

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• Introduction to Probability
– Probability space, probability function, sample space, event
– Conditional probability
– Independent events
– The Inclusion-Exclusion Formula, Bayes' theorem
– Prior and posterior probability

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Probability
•Probability is the measure of the likeliness that an event will occur.
•Si nous n'étions pas ignorants, il n'y aurait pas de probabilité, il n'y
aurait de place que pour la certitude [Henri Poincaré]
•Given the fact that we can not predict the possible outcome in a
random event, the probability tries to quantify that uncertainty

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Probability
•A probability space is a pair (Ω, P) consisting of a set Ω and a
function P which assigns to each subset A of Ω a real number P(A)
in the interval [0, 1]. Moreover, the following two axioms are
required to hold:
•1. P (Ω) = 1,
•2. P (Un An) = SnP(An) if A1, A2, . . . is a sequence of pairwise disjoint
subsets of Ω.
•The set Ω is called a sample space. The elements ω Ω are called
sample points and the subsets A Ω are called events. The
function P is called a probability function. For an event A, the real
number P (A) is called the probability of A.
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Conditional Probability
•Given two events A and B with P(B) > 0, the conditional probability
of A given B is defined as:
Independent events
•Events A and B are defined to be statistically independent if:
So this is equivalent to

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Law of Total Probability
•In general, it cannot be assumed that P(A) ≈ P(A|B). These
probabilities are linked through the law of total probability:
where the events Bn form a partition of Ω.

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Law of Total Probability
P(A|B1) A P(A B1)
B1
P(B1) P(no A|B1) no A P(no A B1)
P(B2) P(A|B2) A P(A B2)

B2
P(no A|B2) no A P(no A B2)
P(B3) P(A|B3) A P(A B3)
B3
P(no A|B3) no A P(no A B3)

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The inclusion-exclusion formula
•As a measure, probability follows the inclusion-exclusion formula
P(A B) = P(A)+P(B)−P(A∩B)
P(A B C) = P(A)+P(B)+P(C)−P(A∩B)−P(A∩C)−P(B∩C)+P(A∩B∩C)

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Bayes’ Theorem
•In general, it cannot be assumed that P(A|B) ≈ P(B|A). This can be
an insidious error, even for those who are highly conversant with
statistics. The relationship between P(A|B) and P(B|A) is given by
Bayes' theorem:
•This result is usually used to calculate the probability of a cause,

given the consequence. This is called posterior probability, as
opposed to classical prior probability.

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Suppose the following probabilities regarding a specific client and the
probabilities of different products:
P(default credit card / not default mortgage)=0,5

P(default credit card)=0,03
P(not default mortgage / default credit card)=0,2
default
P(default everything)=? mortgage
default not default

0,03 credit card mortgage
not default default

credit card mortgage
not default
mortgage

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default
P(default everything)=? mortgage
default not default

not default default

Total
not default
probabilities
mortgage
should sum 1
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default
mortgage
P(default everything)=? 0,8
default not default
0,2
not default default

not default
mortgage

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default 0,024
mortgage
P(default everything)=? 0,8
default not default 0,006
0,2
not default default

Definition of
conditional probability
P(A and
B)=P(A/B)*P(B) not default
mortgage

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P(default everything)=?
P(not default mortgage)=0,012
Definition of conditional probability: P(A and B)=P(A/B)*P(B)

P(default credit card / not default mortgage)=P(default credit card AND not default
mortgage) / P(not default mortgage)
Substitute the values you already know in the previous equation:
0,5=0,006/P(not default mortgage). So P(not default mortgage)=0,012

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P(default everything)=? Probability of not

P(not default mortgage)=0,012 default mortgage is
also equal to the sum
of:
default
0,80 mortgage 0,024
default not default

0,03 credit card mortgage 0,006
0,20
not default default

0,97 credit card mortgage =0,012
not default
mortgage
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default
0,80 mortgage 0,024
default not default

0,20
not default default Total

0,97 credit card mortgage 0,964 probabilities
should sum 1
not default
mortgage 0,006
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default
Definition of conditional 0,80 mortgage 0,024
probability
P(A/B)=P(A and B)/P(B)
default not default
0,20
P(default mortgage / not default
credit card)=0,964/0,97=0,99381
not default 0,9938 default

0,97 credit card 1 mortgage 0,964
0,0061 not default

9 mortgage 0,006
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P(default everything)= P(default credit card AND default mortgage)=0,024

default
0,80 mortgage 0,024
default not default

0,20
not default 0,99381 default

0,00619 not default

mortgage 0,006
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P(default everything)= P(default credit card AND default mortgage)=0,024

default
mortgage 0,024
The figures that appear in the example, are
0,80
not real… the strange probability here is
defaultcredit card / not default

P(default not default
0,03 credit card 0,006
mortgage)=0,5 0,20 mortgage
Because if you do not default mortgage, you
not
are 0,9938
default to be
supposed solvent… default
so this
0,97 probability should be1lower for
credit card mortgage 0,964
real clients (for
example, =0,0061)
0,0061 not default
9 mortgage 0,006
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Random Variables
Study session III

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• Random Variables
– Random variables and the distribution function
– Discrete random variables and point probabilities
– Continuous random variables and density functions
– Independent random variables
– Expected value of random variables
– Variance and standard deviation of random variables

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Random Variables
Random Variables
•A random variable, aleatory variable or stochastic variable is a
variable whose value is subject to variations due to chance
(randomness)
•The mathematical function describing the possible values of a
random variable and their associated probabilities is known as a
probability distribution.
•Random variables can be discrete, that is, taking any of a specified
finite or countable list of values, endowed with a probability mass
function; or continuous, taking any numerical value in an interval or
collection of intervals, via a probability density function.

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Random Variables
Discrete Random Variables
• One coin toss Y:
fY (y)  P(Y  y)
FY (y)  P(Y £ y)   fY (i )
i£y
0 £ FY (y) £ 1

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Random Variables
Continuous Random Variables
• One random number between 0 and 1, Y: W  { w Î [0,1]}
ì1 if y Î [0,1]
Y(w)  w fY (y)  í
î0 othercase
b
P(a £ Y £ b)  ò fY (i) di
a
y
FY (y)  P(Y £ y)  ò fY (i)di
¥
0 £ FY (y) £ 1

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Random Variables
Independent Random Variables
• Two random variables X, Y are independent if the realization of
one does not affect the probability distribution of the other. In
other words, if and only if:

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Random Variables
Expected Value for Random Variables
• We define expected value for a random variable Y as:
¥
mY  E[Y]  i  fY (i) mY  E[Y]  ò i f
Y (i)di
i ¥
• Let X, Y be random variables and a, c constants. We obtain that

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Random Variables
Variance for Random Variables
• We define variance for a random variable Y as:
s Y2  Var (Y)  E[(Y  mY )2 ] s Y  s Y2
• Let X, Y be random variables and a constant. We obtain that
Var (Y)  E[Y 2 ]  E[Y]2

Var[X  a]  Var[X]
Var (aX)  a2 Var[X]
Var (X) ³ 0
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Probability Distributions
Study session IV

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• Probability Distributions
– Discrete Probability Distributions
– Uniform
– Bernouilli
– Binomial
– Poisson
– Continuous Probability Distributions
– Uniform
– Exponential
– Normal Distribution

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Discrete Random Variables - Uniform
• We define X » Unif (a, b, c,....) n elements
a  b c ...
ì1 / n if x=a,b,c,... E[X] 
f X (x)  í n
î0 othercase n2 1
Var[X] 
12

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Discrete Random Variables - Bernoulli
• We define X » Bern( p)
ìp if x=1 (succes)
ï E[X]  p
f X (x)  í1 p if x=0
ï0 Var[X]  p(1 p)
î othercase

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Discrete Random Variables - Binomial
•If X1,…Xn are independent, identically distributed as Bern(p), we
define
n
E[X]  np
X   Xi » Bin(n, p) Var[X]  np(1 p)
i1
æ nö k
P(X  k)  ç ÷ p (1 p)nk
èkø
X is often seen as a sucess
counter, when you repeat n
runs of an experiment with
sucess probability equal to p
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Discrete Random Variables - Poisson
• We define X » Poiss(l )
ì l x l
ï e if x=0,1,2,3,4... E[X]  l
f X (x)  í x!
ï0 Var[X]  l
î othercase
X is often seen as an event

counter. [you don’t have maximum
value for this variable!]

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Continuous Random Variables - Uniform
• We define X » Unif ([a, b])
ì 1 a b
ï if a £ x £ b E[X] 
f X (x)  í b  a 2
ï
î0 othercase (b  a)2
Var[X] 
12

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Continuous Random Variables - Exponential
• We define X » Exp(l )
E[X]  1 / l
ìle lx
if x ³ 0
f X (x)  í Var[X]  1 / l 2
î0 othercase
P(X £ a)  1 e l a
X is often seen as an waiting

time counter.

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Continuous Random Variables – Normal or Gaussian
•We define X » N(m, s ) or X » N(m, s 2 )
ì
ï 1 
( xm )2
E[X]  m
f X (x)  í e 2s 2
î s 2p
ï Var[X]  s 2
X is widely used to explain lots

of different events

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•The properties of a Normal distribution are:
– It is a continuous, symmetric distribution around its mean.
– It is characterized with two values: the mean value (m) and
variance (s2) (or standard deviation)
– Further, if a random variable X is N(m, s2), then (X-m)/s is
ditributed as a normal distribution N(0,1)
– Its kurtosis and skewness is 0.

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• On the random variable N(0,1) probability of any interval can be
given (using tables). These probabilities can be extended to any
normal random variable, using properties of the normal
distribution.
• For example, if X is followed by a N (m, s2), it holds that:
– Between ms and ms there is 68.3% of the distribution (the data)
– Between m2s and m2s there is 95.5% of the distribution (the data)
– Between m3s and m3s there is 99.7% of the distribution (the data)

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0.45 0.45
0.4 0.4
0.35 0.35
0.3 0.3
0.25 0.25
0.2 0.2
0.15 0.15 95.5%
0.1 99.7% 0.1
0.05
0.05
0 0
-5
-2
-4.4
-3.8
-3.2
-2.6
-1.4
-0.8
-0.2
4
0.4
1.6
2.2
2.8
3.4
4.6
-5
-2
-4.4
-3.8
-3.2
-2.6
-1.4
-0.8
-0.2
4
0.4
1.6
2.2
2.8
3.4
4.6
0.45
0.4
0.35
0.3
0.25
0.2
0.15 68%
0.1
0.05
0
-5
-2
-4.4
-3.8
-3.2
-2.6
-1.4
-0.8
-0.2
4
0.4
1.6
2.2
2.8
3.4
MASTER IN INTERNATIONAL FINANCE 75 4.6 IEB

Probability and finance
• One of the goals in finance is to try to find some regularity in the
data, which allows us to assume a continuity in the [modeling]
future, and predict results under this scenario model.
• The financial returns follow a regular pattern, regardless of the
analyzed asset only changing its dispersion.
• The theoretical model that supports the sample of returns is
normal theoretical model.

IEB
120
100
80
60
40
20

IEB
120
100
80
60
40
20

IEB
Lognormal distribution
• If returns are modeled by a normal distribution, final prices are
modelled by:
Xt  XoeN ( m ,s )
• So, X in this case is said to follow a lognormal distribution
• If X follows a lognormal distribution,
X  eN ( m ,s )
s2
m
E(X)  e 2
s2 2 m s 2
Var (X)  (e 1)  e

IEB

OGF MIF Statistics 2022 Sessions 1-4 v2

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MASTER IN INTERNATIONAL FINANCE

Óscar Gil Flores

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SS1: Descriptive Statistics 3

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– First approach to risk measurement

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•They are not recommended open classes.

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n  number of observations 400

fi  frequency of observation i 200

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•So, in log-returns, weekly log-return is the sum if daily log-returns.

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• In finance the geometric mean of growth rates is known as the

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range  max ( x i )  min ( xi )

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Var(X)  SX2  i1

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• Among them, the standard deviation is the most used. It is what

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•The central moment of order 3, respects the sign of the distances

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• The various moments form one set of values by which the

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• In finance, investors can consider risk only if return falls below an

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where the events Bn form a partition of Ω.

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P(B2) P(A|B2) A P(A B2)

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•This result is usually used to calculate the probability of a cause,

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P(default credit card / not default mortgage)=0,5

default not default

not default default

MASTER IN INTERNATIONAL FINANCE

P(default credit card / not default mortgage)=0,5

default not default