Statistics for Managers

Using Microsoft Excel

(3rd Edition)

Chapter 4
Basic Probability and Discrete
Probability Distributions

© 2002 Prentice-Hall, Inc. Chap 4-1

 Chapter Topics

 Basic probability concepts

 Sample spaces and events, simple probability, joint
probability
 Conditional probability
 Statistical independence, marginal probability
 Bayes’s Theorem

© 2002 Prentice-Hall, Inc. Chap 4-2

 Chapter Topics
(continued)

 The probability of a discrete random variable

 Covariance and its applications in finance
 Binomial distribution
 Poisson distribution
 Hypergeometric distribution

© 2002 Prentice-Hall, Inc. Chap 4-3

 Sample Spaces

 Collection of all possible outcomes

 e.g.: All six faces of a die:

 e.g.: All 52 cards in a deck:

© 2002 Prentice-Hall, Inc. Chap 4-4

 Events

 Simple event
 Outcome from a sample space with one
characteristic
 e.g.: A red card from a deck of cards
 Joint event
 Involves two outcomes simultaneously
 e.g.: An ace that is also red from a deck of
cards

© 2002 Prentice-Hall, Inc. Chap 4-5

 Visualizing Events

 Contingency Tables
Ace Not Ace Total
Black 2 24 26
Red 2 24 26
Total 4 48 52

 Tree Diagrams Ace

Red
Full Cards Not an Ace
Deck Black Ace
of Cards Cards
© 2002 Prentice-Hall, Inc.
Not an Ace Chap 4-6
 Simple Events
The Event of a Triangle

There are 5 triangles in this collection of 18 objects

© 2002 Prentice-Hall, Inc. Chap 4-7
 Joint Events
The event of a triangle AND blue in color

Two triangles that are blue

© 2002 Prentice-Hall, Inc. Chap 4-8
 Special Events
Null Event

 Impossible event 
e.g.: Club & diamond on one card
draw
 Complement of event
 For event A, all events not in A
 Denoted as A’
 e.g.: A: queen of diamonds
A’: all cards in a deck that are
not queen of diamonds

© 2002 Prentice-Hall, Inc. Chap 4-9

 Special Events
(continued)
 Mutually exclusive events
 Two events cannot occur together
 e.g.: -- A: queen of diamonds; B: queen of clubs
 Events A and B are mutually exclusive
 Collectively exhaustive events
 One of the events must occur
 The set of events covers the whole sample space
 e.g.: -- A: all the aces; B: all the black cards; C: all the
diamonds; D: all the hearts
 Events A, B, C and D are collectively
exhaustive
 Events B, C and D are also collectively

© 2002 Prentice-Hall, Inc. exhaustive Chap 4-10

 Contingency Table
A Deck of 52 Cards
Red Ace
Not an Total
Ace
Ace
Red 2 24 26
Black 2 24 26
Total 4 48 52
Sample Space
© 2002 Prentice-Hall, Inc. Chap 4-11
 Tree Diagram

Event Possibilities
Ace
Red
Cards Not an Ace
Full
Deck
Ace
of Cards
Black
Cards Not an Ace
© 2002 Prentice-Hall, Inc. Chap 4-12
 Probability

 Probability is the numerical 1 Certain

measure of the likelihood
that an event will occur
 Value is between 0 and 1
.5
 Sum of the probabilities of
all mutually exclusive and
collective exhaustive events
is 1
0 Impossible
© 2002 Prentice-Hall, Inc. Chap 4-13
 Computing Probabilities

 The probability of an event E:

number of event outcomes
P( E ) 
total number of possible outcomes in the sample space
X

T e.g. P( ) = 2/36
(There are 2 ways to get one 6 and the other 4)

 Each of the outcomes in the sample space is

equally likely to occur
© 2002 Prentice-Hall, Inc. Chap 4-14
 Computing Joint Probability

 The probability of a joint event, A and B:

P(A and B) = P(A  B)
number of outcomes from both A and B

total number of possible outcomes in sample space

E.g. P(Red Card and Ace)

2 Red Aces 1
 
52 Total Number of Cards 26
© 2002 Prentice-Hall, Inc. Chap 4-15
 Joint Probability Using
Contingency Table

Event
Event B1 B2 Total
A1 P(A1 and B1) P(A1 and B2) P(A1)

A2 P(A2 and B1) P(A2 and B2) P(A2)

Total P(B1) P(B2) 1

Joint Probability Marginal (Simple) Probability

© 2002 Prentice-Hall, Inc. Chap 4-16

 Computing Compound
Probability
 Probability of a compound event, A or B:
P( A or B)  P( A  B)
number of outcomes from either A or B or both

total number of outcomes in sample space
E.g. P(Red Card or Ace)
4 Aces + 26 Red Cards - 2 Red Aces

52 total number of cards
28 7
 
52 13
© 2002 Prentice-Hall, Inc. Chap 4-17
 Compound Probability
(Addition Rule)
P(A1 or B1 ) = P(A1) + P(B1) - P(A1 and B1)
Event
Event B1 B2 Total
A1 P(A1 and B1) P(A1 and B2) P(A1)

A2 P(A2 and B1) P(A2 and B2) P(A2)

Total P(B1) P(B2) 1

For Mutually Exclusive Events: P(A or B) = P(A) + P(B)

© 2002 Prentice-Hall, Inc. Chap 4-18

 Computing Conditional
Probability

 The probability of event A given that event B

has occurred:
P( A and B)
P( A | B) 
P( B)
E.g.
P(Red Card given that it is an Ace)
2 Red Aces 1
 
4 Aces 2
© 2002 Prentice-Hall, Inc. Chap 4-19
 Conditional Probability Using
Contingency Table
Color
Type Red Black Total
Ace 2 2 4
Non-Ace 24 24 48
Total 26 26 52

Revised Sample Space

P(Ace and Red) 2 / 52 2
P(Ace | Red)   
P(Red) 26 / 52 26
© 2002 Prentice-Hall, Inc. Chap 4-20
 Conditional Probability and
Statistical Independence

 Conditional probability:
P( A and B)
P( A | B) 
P( B)
 Multiplication rule:

P( A and B)  P( A | B) P( B)
 P( B | A) P( A)
© 2002 Prentice-Hall, Inc. Chap 4-21
 Conditional Probability and
Statistical Independence
(continued)

 Events A and B are independent if

P( A | B)  P( A)
or P( B | A)  P( B)
or P( A and B)  P( A) P( B)
 Events A and B are independent when the
probability of one event, A, is not affected by
another event, B

© 2002 Prentice-Hall, Inc. Chap 4-22

 Bayes’s Theorem
P  A | Bi  P  Bi 
P  Bi | A  
P  A | B1  P  B1       P  A | Bk  P  Bk 
P  Bi and A 

P  A Adding up
the parts
Same of A in all
Event the B’s

© 2002 Prentice-Hall, Inc. Chap 4-23

 Bayes’s Theorem
Using Contingency Table
Fifty percent of borrowers repaid their loans. Out of those
who repaid, 40% had a college degree. Ten percent of
those who defaulted had a college degree. What is the
probability that a randomly selected borrower who has a
college degree will repay the loan?

P  R   .50 P  C | R   .4 P  C | R   .10
PR | C  ?

© 2002 Prentice-Hall, Inc. Chap 4-24

 Bayes’s Theorem
Using Contingency Table
(continued)

Repay Repay Total

College .2 .05 .25

College .3 .45 .75

Total .5 .5 1.0

P C | R  P  R 
PR | C 
P C | R  P  R   P C | R  P  R 


 .4 .5 

.2
 .8
.4 .5  .1.5  .25
© 2002 Prentice-Hall, Inc. Chap 4-25
 Random Variable

 Random Variable
 Outcomes of an experiment expressed numerically
 e.g.: Toss a die twice; count the number of times
the number 4 appears (0, 1 or 2 times)

© 2002 Prentice-Hall, Inc. Chap 4-26

 Discrete Random Variable

 Discrete random variable

 Obtained by counting (1, 2, 3, etc.)
 Usually a finite number of different values
 e.g.: Toss a coin five times; count the number of
tails (0, 1, 2, 3, 4, or 5 times)

© 2002 Prentice-Hall, Inc. Chap 4-27

 Discrete Probability
Distribution Example
Event: Toss two coins Count the number of tails

Probability Distribution
Values Probability

T 0 1/4 = .25
1 2/4 = .50
T 2 1/4 = .25

T T
© 2002 Prentice-Hall, Inc. Chap 4-28
 Discrete Probability Distribution

 List of all possible [Xj , p(Xj) ] pairs

 Xj = value of random variable
 P(Xj) = probability associated with value
 Mutually exclusive (nothing in common)
 Collectively exhaustive (nothing left out)

0  P X j  1 P X  1 j

© 2002 Prentice-Hall, Inc. Chap 4-29

 Summary Measures

 Expected value (the mean)

 Weighted average of the probability distribution
   E X    X jP X j 
j

 e.g.: Toss 2 coins, count the number of tails,

compute expected value
   X jP X j 
j

  0  2.5  1.5   2 .25  1

© 2002 Prentice-Hall, Inc. Chap 4-30
 Summary Measures
(continued)

 Variance
 Weight average squared deviation about the mean
  E  X        X j    P  X j 
2 2 2

 
 e.g. Toss two coins, count number of tails,
compute variance

   X j    P X j 
2 2

  0  1 .25   1  1 .5    2  1 .25   .5

2 2 2

© 2002 Prentice-Hall, Inc. Chap 4-31

 Covariance and its Application
N
 XY    X i  E  X   Yi  E Y  P  X iYi 
i 1

X : discrete random variable

X i : i th outcome of X
Y : discrete random variable
Yi : i th outcome of Y
P  X iYi  : probability of occurrence of the i th

outcome of X and the i th outcome of Y

© 2002 Prentice-Hall, Inc. Chap 4-32
 Computing the Mean for
Investment Returns
Return per $1,000 for two types of investments

Investment
P(XiYi) Economic condition Dow Jones fund X Growth Stock Y
.2 Recession -$100 -$200
.5 Stable Economy + 100 + 50
.3 Expanding Economy + 250 + 350

E  X    X   100.2  100.5   250.3  $105

E Y   Y   200.2   50.5   350.3  $90

© 2002 Prentice-Hall, Inc. Chap 4-33
 Computing the Variance for
Investment Returns
Investment
P(XiYi) Economic condition Dow Jones fund X Growth Stock Y
.2 Recession -$100 -$200
.5 Stable Economy + 100 + 50
.3 Expanding Economy + 250 + 350

   100  105 .2   100  105 .5    250  105 .3

2 2 2 2
X

 14, 725  X  121.35

   200  90  .2    50  90  .5    350  90  .3
2 2 2 2
Y

 37,900  Y  194.68
© 2002 Prentice-Hall, Inc. Chap 4-34
 Computing the Covariance for
Investment Returns
Investment
P(XiYi) Economic condition Dow Jones fund X Growth Stock Y
.2 Recession -$100 -$200
.5 Stable Economy + 100 + 50
.3 Expanding Economy + 250 + 350

 XY   100  105 200  90 .2   100  105 50  90 .5

  250  105  350  90 .3  23,300
The Covariance of 23,000 indicates that the two investments are
positively related and will vary together in the same direction.
© 2002 Prentice-Hall, Inc. Chap 4-35
 Important Discrete
Probability Distributions

Discrete Probability
Distributions

Binomial Hypergeometric Poisson

© 2002 Prentice-Hall, Inc. Chap 4-36

 Binomial Probability Distribution
 ‘n’ identical trials
 e.g.: 15 tosses of a coin; ten light bulbs taken
from a warehouse
 Two mutually exclusive outcomes on each
trials
 e.g.: Head or tail in each toss of a coin; defective
or not defective light bulb
 Trials are independent
 The outcome of one trial does not affect the
outcome of the other

© 2002 Prentice-Hall, Inc. Chap 4-37

 Binomial Probability Distribution
(continued)

 Constant probability for each trial

 e.g.: Probability of getting a tail is the same each
time we toss the coin
 Two sampling methods
 Infinite population without replacement
 Finite population with replacement

© 2002 Prentice-Hall, Inc. Chap 4-38

 Binomial Probability
Distribution Function
n!
P X   p 1  p 
X n X

X ! n  X !
P  X  : probability of X successes given n and p
X : number of "successes" in sample  X  0,1, , n
p : the probability of each "success"
n : sample size Tails in 2 Tosses of Coin
X P(X)
0 1/4 = .25
1 2/4 = .50

© 2002 Prentice-Hall, Inc.

2 1/4 = .25 Chap 4-39
 Binomial Distribution
Characteristics
 Mean
   E  X   np
 E.g.   np  5 .1  .5

 Variance and P(X) n = 5 p = 0.1

Standard Deviation .6
.4
  2  np 1  p  .2
0 X

  np 1  p  0 1 2 3 4 5

 E.g.
  np 1  p   5 .11  .1  .6708
© 2002 Prentice-Hall, Inc. Chap 4-40
 Binomial Distribution in PHStat

 PHStat | probability & prob. Distributions |

binomial
 Example in excel spreadsheet

© 2002 Prentice-Hall, Inc. Chap 4-41

 Poisson Distribution
 Poisson Process: P( X  x |
Discrete events in an “interval” - x

e 
 The probability of One Success
in an interval is stable x!
 The probability of More than
One Success in this interval is 0
 The probability of success is
independent from interval to
interval
 e.g.: number of customers arriving in 15 minutes
 e.g.: number of defects per case of light bulbs

© 2002 Prentice-Hall, Inc. Chap 4-42

 Poisson Probability
Distribution Function

e  X
P X  
X!
P  X  : probability of X "successes" given 
X : number of "successes" per unit
 : expected (average) number of "successes"
e : 2.71828 (base of natural logs)
e.g.: Find the probability of 4 e3.6 3.64
customers arriving in 3 minutes P X    .1912
4!
when the mean is 3.6.
© 2002 Prentice-Hall, Inc. Chap 4-43
 Poisson Distribution in PHStat

 PHStat | probability & prob. Distributions |

Poisson
 Example in excel spreadsheet

© 2002 Prentice-Hall, Inc. Chap 4-44

 Poisson Distribution
Characteristics

 Mean
P(X) = 0.5
.6

   EX    .4
.2
N 0 X

  XiP  Xi  0 1 2 3 4 5

i 1
P(X) = 6
 Standard Deviation .6
.4
and Variance .2
  2
  0
0 2 4 6 8 10
X

© 2002 Prentice-Hall, Inc. Chap 4-45

 Hypergeometric Distribution

 “n” trials in a sample taken from a finite

population of size N
 Sample taken without replacement
 Trials are dependent
 Concerned with finding the probability of “X”
successes in the sample where there are “A”
successes in the population

© 2002 Prentice-Hall, Inc. Chap 4-46

 Hypergeometric Distribution
Function
 A   N  A E.g. 3 Light bulbs were
   selected from 10. Of the 10

P X     
X n X
there were 4 defective. What
N
  is the probability that 2 of the
n  3 selected are defective?
P  X  : probability that X successes given n, N , and A
n : sample size  4  6 
  
N : population size
P  2   2 1 
 .30
A : number of "successes" in population 10 
 
X : number of "successes" in sample 3 

X
© 2002 Prentice-Hall, Inc.
 0,1, 2, , n
Chap 4-47
 Hypergeometric Distribution
Characteristics

 Mean
A
   EX   n
N
 Variance and Standard Deviation
nA  N  A N  n Finite


 
2
Population
N2 N 1 Correction
Factor
nA  N  A N  n

N 2
N 1
© 2002 Prentice-Hall, Inc. Chap 4-48
 Hypergeometric Distribution in
PHStat

 PHStat | probability & prob. Distributions |

Hypergeometric …
 Example in excel spreadsheet

© 2002 Prentice-Hall, Inc. Chap 4-49

 Chapter Summary
 Discussed basic probability concepts
 Sample spaces and events, simple probability,
and joint probability
 Defined conditional probability
 Statistical independence, marginal probability
 Discussed Bayes’s theorem

© 2002 Prentice-Hall, Inc. Chap 4-50

 Chapter Summary
(continued)

 Addressed the probability of a discrete

random variable
 Defined covariance and discussed its
application in finance
 Discussed binomial distribution
 Addressed Poisson distribution
 Discussed hypergeometric distribution

© 2002 Prentice-Hall, Inc. Chap 4-51