Reading 3 - Probability Concepts

Quantitative Methods
Probability Concepts
Study Session 1
Reading No – 3
Version 2022
Learning Outcome Statements
The candidate Should be able to:
a. define a random variable, an outcome, and an event;
b. identify the two defining properties of probability, including mutually exclusive and exhaustive events, and compare and contrast empirical,
subjective, and a priori probabilities;
c. describe the probability of an event in terms of odds for and against the event;
d. calculate and interpret conditional probabilities;
e. demonstrate the application of the multiplication and addition rules for probability;
f. compare and contrast dependent and independent events;
g. calculate and interpret an unconditional probability using the total probability rule;
h. calculate and interpret the expected value, variance, and standard deviation of random variables;
i. explain the use of conditional expectation in investment applications;
j. interpret a probability tree and demonstrate its application to investment problems;
k. calculate and interpret the expected value, variance, standard deviation, covariances, and correlations of portfolio returns;
l. calculate and interpret the covariances of portfolio returns using the joint probability function;
m. calculate and interpret an updated probability using Bayes’ formula;
n. identify the most appropriate method to solve a particular counting problem and analyze counting problems using factorial, combination, and
permutation concepts
www.mentormecareers.com
All Rights Reserved -Mentor Me Careers
Los a,b: Introduction to probability
Random Variable, Outcome & Event
Probability of any of these three
events happening has to between
0% or 100% or 0 ≤ P(E) ≤ 1.
Possible Outcome
Nifty 50 Value Can
be 19000 Tomorrow Since out of these three outcomes only 1
can actually happen, its called as
Random Variable mutually exclusive event, however if our
EVENT Nifty 50 Value can be three scenarios included all possible
15000 Tomorrow scenarios then we would also call it
exhaustive
The Value of NIFTY
50 Tomorrow Nifty 50 Value can be
17000 Tomorrow If this was exclusive and
exhaustive then the sum of
probabilities of all scenarios
would be 1 or 100%
Los a,b: Types of probability
Empirical- Based on historical data and relationships.

For eg stating that 10 out 20 stocks in Nifty represent 80% of the index performance
Subjective- Pure judgement based on personal experience
Priori- Based on logic of the event happening, and not based on historical data or judgement
Objective
Probabilities
Los c: ODDS FOR OR AGAINST
In Simple terms, its an expression of
Notice the Odds against, if we say odds against is
6 to 4. and we look at the odds against expression
1. Odds For E = [1 − P(E)]/P(E),
• Chances of it Happening / Changes of it Not Happening
6/4=(1 − P(E)]/P(E),
E = P(E)/[1 − P(E)].
E is the event P(E) probability of the event Solving both sides you will get P(E)= 40%, the
probability of the passing event itself
2. Odds Against
E = [1 − P(E)]/P(E),
Example Further instead of Odds if someone told us that the

Your Friend has a 40% probability odds of your classmate passing is 1 to 4
of passing the CFA level 1 exam. Then in actuality the probability of the event is around
What are his odds for passing and 12.5%. So the odds for it happening would be
what are his odds against passing? =12.5%/(1-12.5%)= 14.25% but we could also write this
• Odds For: 0.4/(1-0.4)= as BASED on the odds for equation
66.6% E= 1/(1+8) / (1-(1/(1+8)= 1/7 ( Probability of the event
• Odds against=(1-0.4)/(0.4) happening expressed )
or 6 to 4
CFA Curriculum Question
1.After six months, the growth portfolio that Rayan Khan manages has outperformed its benchmark. Khan
states that his odds of beating the benchmark for the year are 3 to 1. If these odds are correct, what is the
probability that Khan’s portfolio will beat the benchmark for the year?
A 0.33
B 0.67
C 0.75
Solution
• C is correct. The odds for beating the benchmark = P(beating benchmark) / [1 – P(beating benchmark)]. Let
P(A) = P(beating benchmark). Odds for beating the benchmark = P(A) / [1 – P(A)]. 3 = P(A) / [1 – P(A)]
• Solving for P(A), the probability of beating the benchmark is 0.75.
b. identify the two defining properties of probability, including mutually exclusive and exhaustive events, and compare and contrast empirical, subjective,
and a priori probabilities;
Los d: Conditional Probability
Probability of Probability of
NIFTY NIFTY
Unconditional
Conditional
Earning > Risk Earning > Risk
Free rate Free
Given NIFTY
P(A) generates +ve
Returns
P(A) P(A|B)
Los d: Conditional Probability Background
In order to understand conditional
probability you need to understand
Stock Earns Positive Returns Joint probability First.
P(A) If we have two outcomes and are
interested in knowing the possibility of
both these outcomes A & B happening,
then probability of happening is equal
to probability of A happening
Stock Earns Greater than Rf P(AB)= P(A)

P(B)
Or the stock can earn greater than risk
free rate only if the stock returns are
positive at the same time
Los d: Conditional Probability
• Definition of Conditional Probability. The conditional probability of A given that B has occurred is equal to
the joint probability of A and B divided by the probability of B (assumed not to equal 0).
P(A | B) = P(AB)/P(B), P(B) ≠ 0
We roll a fair die and
A: Odd number outcome (1,3,5)
B: That the outcome is less or equal to 3 (1,2,3)
What the probability of A|B. Intuitively this means
P(A) P(B) that B has already occurred, but we are interested

only in the yellow area(Sample space) because the
blue area cannot happen with B already occurred,
3,1 hence in the yellow area there are only 3 possible
5 P(AB)
2 outcomes
So P(1,3,5) | (1,2,3)
Hence for 1,3 to happen B has already occurred
Or 2/3 Outcomes
Los e: Additive and Multiplicative Rule
This can be confusing at first but if you spend some time on this you will get it. The equation on the right is more intuitive
because we are trying to remove the probabilities of both happening (the middle common part)
P(AB)=P(A|B) P(B) P(A or B)= P (A)+P(B)-P(AB)
P(A) P(B) P(AB)

P(A) P(AB)
P(B)
In the left equation think of the die example, the probability of 1,3,5(A) and B (1,2,3) Both happening, which is to say that Take the P(A|B) like
we found before and instead of dividing multiple with the probability B. In our die example that is 2/3 x ½ or 1/3 or 33% probability of both
happening www.mentormecareers.com
Los f: Independent or Dependent Events
Simply Put
• Independent event: P(A|B)= P(A), Or P(B|A)= P(B) , which means neither of them have any effect
on each other.
An example would be the probability of the markets crashing tomorrow and the probability
of India winning the world cup. Both are independent events
Of course that would mean that the multiplicative rule would change to:
P(AB) for independent events = P(A|B) P(B) but P(A|B)=P(A)
hence P(AB)= P(A) P(B)
• Dependent Events when P(A|B)<> P(A). Example could be the Probability of markets crashing
tomorrow given the RBI increases rates.
Los g: Total Probability Rule
When we considering all possible outcomes: Exhaustive and
exclusive events ( For eg stock option pay offs), we can analyse
the event using the total probability rule.
S SC
Notation
For eg if S is a scenario then we would use the following
notations
Happening S, Not Happening SC Compliment.
In case of only two scenarios A|S A|SC
P(A)= P(AS)+ P(ASC),
= P(A|S) P(S)+ P(A|SC ) P(SC )
Visual Representation of Total
( Recollect from the previous slides, we are just using the same logic in Probability
forming these equations)
Example
You are continuing your investigation into whether you can predict the direction of changes in BankCorp’s quarterly
EPS. You define four events:
• On inspecting the data, you observe some persistence in EPS changes: Increases tend to be followed by increases
and decreases by decreases. The first probability estimate you develop is P(change in sequential EPS is positive next
quarter | change in sequential EPS is 0 or negative in the prior quarter) = P(A | SC) = 0.40. The most recent
quarter’s EPS (2Q:Year 1) is announced, and the change is a positive sequential change (the event S). You are
interested in forecasting EPS for 3Q:Year 1.
• Write this statement in probability notation: “the probability that the change in sequential EPS is positive next
quarter, given that the change in sequential EPS is positive the prior quarter.”
• Calculate the probability in Part 1. (Calculate the probability that is consistent with your other probabilities or
beliefs.)
Source: CFA Curriculum
Explanation
1. In probability notation, this statement is written P(A | S).
2. The probability is 0.673 that the change in sequential EPS is positive for 3Q:Year 1, given the positive
change in sequential EPS for 2Q:Year 1, as shown below.
According to Equation 5
, P(A) = P(A | S) P(S) + P(A | SC) P(SC).
The values of the probabilities needed to calculate P(A | S) are already known: P(A) = 0.55, P(S) = 0.55, P(SC) =
0.45, and P(A | SC) = 0.40. Substituting into Equation 0.55 = P(A | S)(0.55) + 0.40(0.45) Solving for the
unknown, P(A | S) = [0.55 − 0.40(0.45)]/0.55 = 0.672727, or 0.673. You conclude that P(change in sequential
EPS is positive next quarter | change in sequential EPS is positive the prior quarter) = 0.673.
Any other probability is not consistent with your other estimated probabilities. Reflecting the persistence in
EPS changes, this conditional probability of a positive EPS change, 0.673, is greater than the unconditional
probability of an EPS increase, 0.55.
Los h: Expected Value, Variance
Expected value is nothing but the probability

weighted random variable denoted by E(X)
This is very similar to weighted mean, the

only difference is that expected value talks
about the future

Los h: Expected Value, Variance
And Just like the mean if we try to find the deviation from the expected value, we would called the
variance. The concept of variance is still the same as the last reading
• In Example 10, you calculated the expected value of BankCorp’s EPS as $2.34, which is your forecast. Using
the probability distribution of EPS, you want to measure the dispersion around your forecast. What are the
variance and standard deviation of BankCorp’s EPS for the current fiscal year? The order of calculation is
always expected value, then variance, then standard deviation. Expected value has already been calculated.
Following the definition of variance above, calculate the deviation of each outcome from the mean or
expected value, square each deviation, weight (multiply) each squared deviation by its probability of
occurrence, and then sum these terms.
1. Variance 0.15 (2.60- 2.34)2 +0.45(2.45-2.34)2+0.24(2.2-2.34)+0.16(2.0-2.34)2 = 3.876%

2. St Dev = 3. 876=19.69%
Los k & I: Covariance and Correlation
Since this los is related to Los H, we have taken this los earlier than the CFA curriculum.
Just like we calculated covariance in the last reading of quant, the concept remains the same but we
just incorporate probability weights here.
Probability Weight
Expected Value (Instead

of the mean)
This is the starting point to understand how this works, you may want to go
back to reading 2 and see what covariance is, if its becoming difficult.
Lets understand how variance of a three asset portfolio can first be
calculated based on probability weights.
2 2
𝜎 𝑅𝑝 = 𝐸 𝑅𝑝 − 𝐸𝑅𝑝
The correlation between two random variables Ri and Rj would denoted as below
• A two-stock portfolio includes stocks with the following characteristics:
Solution
Los i: Conditional expected Value
The los says the use, but doesn’t say calculate hence we will just discuss the creation of this
equation.
Continuing from our previous example if we want to calculate expected value based on condition,
just like our conditional probability concept then.
Condition
Probability Random Value

Los j: Probability Tree
Lets look at a case first: Continuing with Bank Corp Example, given in the CFA curriculum
• There is a 60% probability that Bank crop will operate in a declining interest rate environment in the current fiscal
• Probability of EPS Being $2.60 is 25%
• Probability of EPS being $2.45 is 75%
• 40% probability that it will operate in stable interest rate environment this fiscal
Probability
• 60% probability of EPS Being $2.20
• 40% Probability of EPS being $2.0
EPS :$2.60 60% x 25% = 15%
Decline 60% 1 2 3
60% 25% 2.6
EPS: $2.45 60% x 75% = 45% 60% 75% 2.45
40% 60% 2.2
E(EPS)=$2.34 40% 40% 2
EPS 2.3405
$2.20 40% x 60% = 24%
Stable 40%
$2.0 40% x 40 = 16%
f. Compare dependent and independent events;
Los l: Covariance Given Joint Probability
Function
First based on the joint probabilities
mentioned above lets find the expected value
Expected return(B)= 0.2(25%)+0.5(12%)+0.3(10%)=14%

Expected Return(A)= 0.2(20%)+0.5(16%)+0.3(10%)=15%
Covariance using Joint Probability

Banking Industry Condition Deviations- B Deviations- A Dev A x Dev B Prob Weighted Product
Good =25-14 =20-15 55 0.2 11
Average =12-14 =16-15 -2 0.5 -1
Poor =10-14 =10-15 20 0.3 6
16
Los m: Bayes Formula
Bayes formula is a method of updating our existing probabilities as we get new information.
= 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑛𝑒𝑤 𝑖𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 𝑔𝑖𝑣𝑒𝑛 𝑒𝑣𝑒𝑛𝑡 Τ𝑈𝑛𝑐𝑜𝑛𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑛𝑒𝑤 𝑖𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛
× 𝑃𝑟𝑖𝑜𝑟 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑒𝑣𝑒𝑛𝑡
To write this formally using probability notations
𝑃(𝐸𝑣𝑒𝑛𝑡|𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛) = 𝑃( 𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛|𝐸𝑣𝑒𝑛𝑡) ∖ P(Information) x P( Event)
Using the bayes chart to the left, find what is the

probability of the stock being a tech stock given that the
return is >10%
P ( Tech| R>10%) = P( R>10%| P Tech ) X P ( Tech)

P( R>10%)
= ( 60/100) X ( 100/500)
(160/500)
= 0.375
• In a typical year, 5% of all CEOs are fired for “performance” reasons. Assume that CEO performance is judged
according to stock performance and that 50% of stocks have above-average returns or “good” performance.
Empirically, 30% of all CEOs who were fired had “good” performance. Using Bayes’ formula, what is the
probability that a CEO will be fired given “good” performance? (Hint, let P(A) be the probability of a CEO
being fired, P(B) be the probability of a “good” performance rating, P(B | A) be the likelihood of a “good”
performance rating given that the CEO was fired, and P(A | B) be the likelihood of the CEO being fired given
a “good” performance rating.)
A 1.5%
B 2.5%
C 3.0%
Solution
Los n: Principles of Counting
Investment
Decision making Lets understand this by using this flow
Small Cap chart.
Domestic or
1. In the first step we can classify the
Foreign
Sectors Size Mid Cap stocks in two ways
2. In the next step we can divide it further
Large Cap into 4 sectors
Consumer
3. Further in the last step we can
categorise in three size categories
Energy So the question is in total how many ways
can we categorize the stocks in 2 x 4 x 3=
24 different ways.
Financial
Tech
Los n: Principles of Counting-2
Another example, suppose you want to assign three equity analysts to cover three different
industries. So in the first step you assign the analyst 1, 3 industries and 2nd analyst with two
industries and finally the 3rd analyst in one way. Hence 3x 2 x1 =6 ways or 3! (Factorial)
3 Ways 2 Ways 1 Way
1 Analyst 1 1 Analyst 1 1 Analyst 1
2 Analyst 2 2 Analyst 2 2 Analyst 2
3 3 Analyst 3 3
Analyst 3 Analyst 3
Consider we want to rank 18 equity mutual funds based How?
on their returns of 2021. We have the following labelling 1. We can assign the 18 funds in high risk
categories available
1. High risk( 4 ) 2. Then 17 funds high risk
3. Then 16 in high risk
2. Above Average( 4)
4. Then 15 in high risk….now we have 4 funds for high risk category
3. Average risk (3) 5. Then we can lablel 14,13,12,11 in above average
4. Below average(4) 6. Then 10,9,8 in average risk
7. Then 7,6,5,4, in below average
5. Low Risk(3)
8. Then 3,2,1 in low risk category
You will be shocked to know the answer to that is 13
Billion. Hence the
1. First slot can be assigned in 4! Ways and similarly 4!,3!,4!,3! For all the
Hence to summarize this in an equation( other labels, and we call it as sequences.
Multinomial formula)
2. Now to remove any redundancies we can divide 18!/ 4!4!3!4!3!
3. To get the answer as 12864852000
Combination: A combination is a listing in which the order of the items doesn’t not matter. So lets
say the number of objects with the first label r= n1 and the number with second label =n-r= n2(
There are lets say only two categories so n1+n2=n).
So the number of ways that we can choose r objects from a total of n objects when the order
doesn’t matter is
1. Suppose jurors want to select three companies out of a group of five to receive the first-, second-, and
third-place awards for the best annual report. In how many ways can the jurors make the three awards?
2. On the other hand, if the question were “In how many ways can the jurors choose three winners, without
regard to place of finish?”
• The first question order is important so we cant use combination, so we need permutation
• The second question the order is not important hence combination can be used
Summary of Counting
1. A manager will select 20 bonds out of his universe of 100 bonds to construct a portfolio. Which formula provides the number of possible portfolios?
A Permutation formula
B Multinomial formula
C Combination formula
2.A firm will select two of four vice presidents to be added to the investment committee. How many different groups of two are possible?
A6
B 12
C 24
3 .From an approved list of 25 funds, a portfolio manager wants to rank 4 mutual funds from most recommended to least recommended. Which formula is most appropriate to calculate the number of
possible ways the funds could be ranked?
A Permutation formula
B Multinomial formula
C Combination formula
4. Himari Fukumoto has joined a new firm and is selecting mutual funds in the firm’s pension plan. If 10 mutual funds are available, and she plans to select four, how many different sets of mutual
funds can she choose?
A 210
B 720
C 5,040
1. C is correct. The combination formula provides the number of ways that r objects can be chosen from a
total of n objects, when the order in which the r objects are listed does not matter. The order of the bonds
within the portfolio does not matter.
2. A is correct Here, n = 4 and r = 2, so the answer is 4!/[(4 – 2)!2!] = 24/[(2) × (2)] = 6. This result can be
verified by assuming there are four vice presidents, VP1–VP4. The six possible additions to the investment
committee are VP1 and VP2, VP1 and VP3, VP1 and VP4, VP2 and VP3, VP2 and VP4, and VP3 and VP4.
3. A is correct. The permutation formula is used to choose r objects from a total of n objects when order
matters. Because the portfolio manager is trying to rank the four funds from most recommended to least
recommended, the order of the funds matters; therefore, the permutation formula is most appropriate.
4. A Is correct
Summary
• A random variable is a quantity whose outcome is uncertain.
• Probability is a number between 0 and 1 that describes the chance that a stated event will occur.
• An event is a specified set of outcomes of a random variable. Mutually exclusive events can occur only one at a time. Exhaustive events cover or contain all possible outcomes.
• The two defining properties of a probability are, first, that 0 ≤ P(E) ≤ 1 (where P(E) denotes the probability of an event E) and, second, that the sum of the probabilities of any set
of mutually exclusive and exhaustive events equals 1.
• A probability estimated from data as a relative frequency of occurrence is an empirical probability. A probability drawing on personal or subjective judgment is a subjective
probability. A probability obtained based on logical analysis is an a priori probability.
• A probability of an event E, P(E), can be stated as odds for E = P(E)/[1 − P(E)] or odds against E = [1 − P(E)]/P(E).
• Probabilities that are inconsistent create profit opportunities, according to the Dutch Book Theorem.
• A probability of an event not conditioned on another event is an unconditional probability. The unconditional probability of an event A is denoted P(A). Unconditional probabilities
are also called marginal probabilities.
• A probability of an event given (conditioned on) another event is a conditional probability. The probability of an event A given an event B is denoted P(A | B), and P(A | B) =
P(AB)/P(B), P(B) ≠ 0.
• The probability of both A and B occurring is the joint probability of A and B, denoted P(AB).
• The multiplication rule for probabilities is P(AB) = P(A | B)P(B).
• The probability that A or B occurs, or both occur, is denoted by P(A or B).
• The addition rule for probabilities is P(A or B) = P(A) + P(B) − P(AB).
• When events are independent, the occurrence of one event does not affect the probability of occurrence of the other event. Otherwise, the events are dependent.
Summary
• The multiplication rule for independent events states that if A and B are independent events, P(AB) =
P(A)P(B). The rule generalizes in similar fashion to more than two events.
• According to the total probability rule, if S1, S2, …, Sn are mutually exclusive and exhaustive scenarios or
events, then P(A) = P(A | S1)P(S1) + P(A | S2)P(S2) + … + P(A | Sn)P(Sn).
• The expected value of a random variable is a probability-weighted average of the possible outcomes of the
random variable. For a random variable X, the expected value of X is denoted E(X).
• The total probability rule for expected value states that E(X) = E(X | S1)P(S1) + E(X | S2)P(S2) + … + E(X |
Sn)P(Sn), where S1, S2, …, Sn are mutually exclusive and exhaustive scenarios or events.
• The variance of a random variable is the expected value (the probability-weighted average) of squared
deviations from the random variable’s expected value E(X): σ2(X) = E{[X − E(X)]2}, where σ2(X) stands for the
variance of X.
• Variance is a measure of dispersion about the mean. Increasing variance indicates increasing dispersion.
Variance is measured in squared units of the original variable.
• Standard deviation is the positive square root of variance. Standard deviation measures dispersion (as does
variance), but it is measured in the same units as the variable.
• Covariance is a measure of the co-movement between random variables.
Summary
• The covariance between two random variables Ri and Rj in a forward-looking sense is the expected value of the
cross-product of the deviations of the two random variables from their respective means: Cov(Ri,Rj) = E{[Ri −
E(Ri)][Rj − E(Rj)]}. The covariance of a random variable with itself is its own variance.
• ■■ The historical or sample covariance between two random variables Ri and Rj based on a sample of past data of
size n is the average value of the product of the deviations of observations on two random variables from their
sample means:
• Correlation is a number between −1 and +1 that measures the co-movement (linear association) between two
random variables: ρ(Ri,Rj) = Cov(Ri,Rj)/[σ(Ri) σ(Rj)].
• If two variables have a very strong (inverse) linear relation, then the absolute value of their correlation will be close
to 1 (-1). If two variables have a weak linear relation, then the absolute value of their correlation will be close to 0.
• If the correlation coefficient is positive, the two variables are positively related; if the correlation coefficient is
negative, the two variables are inversely related.
• To calculate the variance of return on a portfolio of n assets, the inputs needed are the n expected returns on the
individual assets, n variances of return on the individual assets, and n(n − 1)/2 distinct covariances.
Summary
• Portfolio variance of return is
• The calculation of covariance in a forward-looking sense requires the specification of a joint probability function, which gives the
probability of joint occurrences of values of the two random variables.
• ■■ When two random variables are independent, the joint probability function is the product of the individual probability
functions of the random variables.
• ■■ Bayes’ formula is a method for updating probabilities based on new information.
• ■■ Bayes’ formula is expressed as follows: Updated probability of event given the new information = [(Probability of the new
information given event)/(Unconditional probability of the new information)] × Prior probability ofevent.
• ■■ The multiplication rule of counting says, for example, that if the first step in a process can be done in 10 ways, the second step,
given the first, can be done in5 ways, and the third step, given the first two, can be done in 7 ways, then the steps can be carried
out in (10)(5)(7) = 350 ways.
• ■■ The number of ways to assign every member of a group of size n to n slots is n!= n (n − 1) (n − 2)(n − 3) … 1. (By convention, 0! =
1.)
• ■■ The number of ways that n objects can be labeled with k different labels, with n1 of the first type, n2 of the second type, and
so on, with n1 + n2 + … + nk = n, isgiven by n!/(n1!n2! … nk!). This expression is the multinomial formula.
Summary
• A special case of the multinomial formula is the combination formula. The number of ways to choose r
objects from a total of n objects, when the order in which the r objects are listed does not matter, is
• The number of ways to choose r objects from a total of n objects, when the order in which the r objects are
listed does matter, is

Reading 3 - Probability Concepts

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Reading 3 - Probability Concepts

Uploaded by

Copyright:

Available Formats

Quantitative Methods

Empirical- Based on historical data and relationships.

Subjective- Pure judgement based on personal experience

Example Further instead of Odds if someone told us that the

Stock Earns Greater than Rf P(AB)= P(A)

P(A) P(B) that B has already occurred, but we are interested

P(AB)=P(A|B) P(B) P(A or B)= P (A)+P(B)-P(AB)

P(A) P(B) P(AB)

Expected value is nothing but the probability

This is very similar to weighted mean, the

Source: CFA Curriculum

1. Variance 0.15 (2.60- 2.34)2 +0.45(2.45-2.34)2+0.24(2.2-2.34)+0.16(2.0-2.34)2 = 3.876%

Expected Value (Instead

Probability Random Value

Expected return(B)= 0.2(25%)+0.5(12%)+0.3(10%)=14%

Covariance using Joint Probability

𝑃(𝐸𝑣𝑒𝑛𝑡|𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛) = 𝑃( 𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛|𝐸𝑣𝑒𝑛𝑡) ∖ P(Information) x P( Event)

Using the bayes chart to the left, find what is the

P ( Tech| R>10%) = P( R>10%| P Tech ) X P ( Tech)

3 Ways 2 Ways 1 Way

1 Analyst 1 1 Analyst 1 1 Analyst 1

2 Analyst 2 2 Analyst 2 2 Analyst 2

Source: CFA Curriculum

You might also like