Statistics for Managers

Using Microsoft Excel

Chapter 4
Basic Probability And Discrete
Probability Distributions

© 1999 Prentice-Hall, Inc. Chap. 4 - 1

 Chapter Topics
• Basic Probability Concepts:
Sample Spaces and Events, Simple
Probability, and Joint Probability,
• Conditional Probability
• Bayes’ Theorem
• The Probability of a Discrete Random Variable
• Binomial, Poisson, and Hypergeometric
Distributions
• Covariance and its Applications in Finance
© 1999 Prentice-Hall, Inc. Chap. 4 - 2
 Sample Spaces
Collection of all Possible Outcomes
e.g. All 6 faces of a die:

e.g. All 52 cards of a bridge deck:

© 1999 Prentice-Hall, Inc. Chap. 4 - 3

 Events
• Simple Event: Outcome from a Sample Space
with 1 Characteristic
e.g. A Red Card from a deck of cards.
• Joint or Compound Event: Involves 2 Outcomes
Simultaneously
e.g. An Ace which is also a Red Card from a
deck of cards.
An Ace given that it is a Red Card.
© 1999 Prentice-Hall, Inc. Chap. 4 - 4
 Visualizing Events
•Contingency Tables
Ace Not Ace Total
Black 2 24 26
Red 2 24 26
Total 4 48 52

•Tree Diagrams

© 1999 Prentice-Hall, Inc. Chap. 4 - 5

 Simple Events
The Event of a Happy Face

There are 5 happy faces in this collection of 18 objects

© 1999 Prentice-Hall, Inc. Chap. 4 - 6
 Joint Events
The Event of a Happy Face AND Light Colored

3 Happy Faces which are light in color

© 1999 Prentice-Hall, Inc. Chap. 4 - 7
 Compound Events
The Event of Happy Face OR Light Colored

12 Items, 5 happy faces and 7 other light objects

© 1999 Prentice-Hall, Inc. Chap. 4 - 8
 Special Events

Null Event Null Event

Club & Diamond on

1 Card Draw

Complement of Event
For Event A,
All Events Not In A: A’

© 1999 Prentice-Hall, Inc. Chap. 4 - 9

 Dependent or
Independent Events
The Event of a Happy Face GIVEN it is Light Colored
E = Happy FaceLight Color

3 Items, 3 Happy Faces Given they are Light Colored

© 1999 Prentice-Hall, Inc. 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
© 1999 Prentice-Hall, Inc. Chap. 4 - 11
 Tree Diagram
Event Possibilities
Ace
Red
Cards Not an Ace
Full
Deck
of Cards Ace
Black
Cards
Not an Ace
© 1999 Prentice-Hall, Inc. Chap. 4 - 12
 Probability
•Probability is the numerical 1 Certain
measure of the likelihood
that the event will occur.
•Value is between 0 and 1. .5
•Sum of the probabilities of
all mutually exclusive
events is 1.
0 Impossible
© 1999 Prentice-Hall, Inc. Chap. 4 - 13
 Computing Probability
•The Probability of an Event, E:
Number of Event Outcomes
P (E )  X
Total Outcomes in Sample Space 
T

e.g. P( ) = 2/36
(There are 2 ways to get one 6 and the other 4)

•Each of the Outcome in the Sample Space

equally likely to occur.
© 1999 Prentice-Hall, Inc. Chap. 4 - 14
 Computing
Joint Probability
The Probability of a Joint Event, A and B:
P(A and B) =
Number of Event Outcomes from both A and B
Total Outcomes in Sample Space

e.g. P(Red Card and Ace) =

2 Re d Aces 1

52 Total Number of Cards 26
© 1999 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

© 1999 Prentice-Hall, Inc. Chap. 4 - 16

 Computing
Compound Probability
The Probability of a Compound Event, A or B:

Number of Event Outcomes from either A or B

P ( A or B ) 
Total Outcomes in Sample Space

e.g.
P(Red Card or Ace)


4 Aces  26 Re d Cards  2 Re d Aces 28 7
52 Total Numberof Cards
 
52 13
© 1999 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)

© 1999 Prentice-Hall, Inc. Chap. 4 - 18

 Computing
Conditional Probability
The Probability of the Event:
Event A given that Event B has occurred
P ( A and B )
P(A B) = P( B )

e.g.
2 Re d Aces 1
P(Red Card given that it is an Ace) = 
4 Aces 2

© 1999 Prentice-Hall, Inc. Chap. 4 - 19

 Conditional Probability
Using Contingency Table
Conditional Event: Draw 1 Card. Note Kind & Color

Color
Type Red Black Total Revised
Sample
Ace 2 2 4 Space
Non-Ace 24 24 48
Total 26 26 52
P(Ace AND Red) 2 / 52 2
P(Ace | Red) =  
P(Red) 26 / 52 26
© 1999 Prentice-Hall, Inc. Chap. 4 - 20
 Conditional Probability and
Statistical Independence
P ( A and B )
Conditional Probability: P(AB) =
P( B )
Multiplication Rule: P(A and B) = P(A B) • P(B)

Events are P(A  B) = P(A)

Independent: 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.

© 1999 Prentice-Hall, Inc. Chap. 4 - 21

 Bayes’ Theorem
P ( A Bi )  P ( Bi )
P(Bi A) =
P ( A B1 )  P ( B1 )      P ( A Bk )  P ( Bk )

P ( Bi and A )
 Adding up
P( A ) the parts
of A in all
Same
the B’s
Event

© 1999 Prentice-Hall, Inc. Chap. 4 - 22

 Bayes’ Theorem: Contingency Table
What are the chances of repaying a loan,
given a college education?

Loan Status
Education Repay Default Prob.
College .2 .05 .25
No College ? ? ?
Prob. ? ? 1

P ( College and Re pay )

P(RepayCollege) = P ( College and Re pay )  P ( College and Default )
 .08

© 1999 Prentice-Hall, Inc. Chap. 4 - 23

 Discrete Random Variable
• Random Variable: represents outcomes of an
experiment.
e.g. Throw a die twice:
Count the number of times 4 comes up (0, 1, or 2 times)
• Discrete Random Variable:
• Obtained by Counting (0, 1, 2, 3, etc.)
• Usually finite by number of values
e.g. Toss a coin 5 times. Count the number of tails.
(0, 1, 2, 3, 4, or 5 times)
© 1999 Prentice-Hall, Inc. Chap. 4 - 24
 Discrete Probability
Distribution Example
Event: Toss 2 Coins. Count # Tails.
Probability Distribution
Values Probability
T 0 1/4 = .25
1 2/4 = .50
T
2 1/4 = .25
T T
© 1999 Prentice-Hall, Inc. Chap. 4 - 25
 Discrete
Probability Distribution
• List of All Possible [ Xi, P(Xi) ] Pairs
Xi = Value of Random Variable (Outcome)
P(Xi) = Probability Associated with Value
• Mutually Exclusive (No Overlap)
• Collectively Exhaustive (Nothing Left Out)
0  P(Xi)  1
 P(Xi) = 1

© 1999 Prentice-Hall, Inc. Chap. 4 - 26

 Discrete Random Variable
Summary Measures
Expected Value
The Mean of the Probability Distribution Weighted
Average
 = E(X) = Xi P(Xi)
e.g. Toss 2 coins, Count tails, Compute Expected Value:
= 0  .25 + 1 .50 + 2  .25 = 1
Number of Tails
Variance
Weighted Average Squared Deviation about Mean
 = E [ (Xi -  )2]= (Xi -  )2P(Xi)
e.g. Toss 2 coins, Count tails, Compute Variance:
© 1999 Prentice-Hall,  = (0 - 1)2(.25) + (1 - 1)2(.50) + (2 - 1)2(.25) Chap.
= 4.50

Inc. - 27
 Important Discrete Probability
Distribution Models

Discrete Probability
Distributions

Binomial Hypergeometric Poisson

© 1999 Prentice-Hall, Inc. Chap. 4 - 28

 Binomial Probability
Distributions
• ‘n’ Identical Trials, e.g. 15 tosses of a coin,
10 light bulbs taken from a warehouse
• 2 Mutually Exclusive Outcomes,
e.g. heads or tails in each toss of a coin,
defective or not defective light bulbs
• Constant Probability for each Trial,
e.g. probability of getting a tail is the same
each time we toss the coin and each light bulb has
the same probability of being defective

© 1999 Prentice-Hall, Inc. Chap. 4 - 29

 Binomial Probability
Distributions

• 2 Sampling Methods:
Infinite Population Without Replacement
Finite Population With Replacement

• Trials are Independent:

The Outcome of One Trial Does Not Affect the
Outcome of Another

© 1999 Prentice-Hall, Inc. Chap. 4 - 30

 Binomial Probability
Distribution Function
n! X nX
P(X)  p (1  p )
X ! (n  X)!
P(X) = probability that X successes given a knowledge of n
and p
Tails in 2 Toss of Coin
X = number of ‘successes’ in
X P(X)
sample, (X = 0, 1, 2, ..., n) 0 1/4 = .25
p = probability of ‘success’ 1 2/4 = .50
n = sample size 2 1/4 = .25
© 1999 Prentice-Hall, Inc. Chap. 4 - 31
 Binomial Distribution
Characteristics

Mean .6
P(X) n = 5 p = 0.1
  E ( X )  np .4
.2
e.g.  = 5 (.1) = .5 0 X
0 1 2 3 4 5

Standard Deviation
P(X) n = 5 p = 0.5
  np (1  p ) .6
.4
.2
e.g.  = 5(.5)(1 - .5) 0 X
= 1.118 0 1 2 3 4 5

© 1999 Prentice-Hall, Inc. Chap. 4 - 32

 Poisson Distribution
Poisson Process:
• Discrete Events in an ‘Interval’ P( X  x | 
 The Probability of One Success in
- x
Interval is Stable
e 
 The Probability of More than One

0
Success in this Interval is
x!
• Probability of Success is
Independent from Interval to
Interval
e.g. # Customers Arriving in 15 min.
# Defects Per Case of Light
Bulbs.
© 1999 Prentice-Hall, Inc. Chap. 4 - 33
 Poisson Probability
Distribution Function
 X
P (X )  e 
X!
P(X ) = probability of X successes given 
 = expected (mean) number of ‘successes’
e = 2.71828 (base of natural logs)
X = number of ‘successes’ per unit
e.g. Find the probability of 4 -3.6 4
customers arriving in 3 minutes P(X) = e 3.6 = .1912
4!
when the mean is 3.6.
© 1999 Prentice-Hall, Inc. Chap. 4 - 34
 Poisson Distribution
Characteristics
Mean P(X) = 0.5
.6
  E (X )   .4
N .2
  Xi P( Xi ) 0 X
0 1 2 3 4 5
i 1

.6
P(X) = 6
Standard Deviation .4
.2
   0 X
0 2 4 6 8 10

© 1999 Prentice-Hall, Inc. Chap. 4 - 35

 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
© 1999 Prentice-Hall, Inc. Chap. 4 - 36
 Hypergeometric Distribution

P ( X )  ( A
X )( ) N-A
n-X

( n )
N

P(X) = probability that X successes given n, N, and A

n = sample size 3 Light bulbs were selected
N = population size from 10. Of the 10 there
A = number of “successes” were 4 defective. What is
in population the probability that 2 of the
X = number of “successes” 3 selected are defective?
42 6
in sample (X = 0, 1, 2, ..., n) P(2) = ( )( 1 ) = .30
( 10
3
)
© 1999 Prentice-Hall, Inc. Chap. 4 - 37
 Hypergeometric Characteristics

Mean
A
  E( X )  n
N
Finite
Population
Standard Deviation Correction

 nA( N  A) N  n
2
N N1

© 1999 Prentice-Hall, Inc. Chap. 4 - 38

 Covariance
N
 XY   X i  E ( X )   Y i  E ( Y )   P ( X iY i )
i 1

X = discrete random variable X

Xi = ith outcome of X
P(XiYi) = probability of occurrence of the
ith outcome of Y
Y = discrete random variable Y
Yi = ith outcome of Y

© 1999 Prentice-Hall, Inc.

i = 1, 2, …, N Chap. 4 - 39
 Covariance Example (can this
two parameters vary
together)
Temperature (X) Ice cream sales (Y)
66 8
72 11
77 15
84 20
83 21
71 11
65 8
70 10

© 1999 Prentice-Hall, Inc. Chap. 4 - 40

 Covariance Example

Covariance
Sxy =Sum [(Xi-X) (Yi-Y)] / (n-1)
Correlation coefficient
Rxy = Sxy/ Sx* Sy
Temp. mean – 73.5 , St.dev (Sx) -7.19
Ice Cream mean – 13 , St.dev (Sy) – 5.13
Sxy = 255/ 7 = 36.43 (Positive relation )
Rxy = 36.43 / 7.19 * 5.13 = 0.99
© 1999 Prentice-Hall, Inc. Chap. 4 - 41
 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
© 1999 Prentice-Hall, Inc. Chap. 4 - 42
 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

Var(X) =  X2 = (.2)(-100 -105)2 + (.5)(100 - 105)2 + (.3)(250 - 105)2

= 14,725, X = 121.35
2

Var(Y) = Y = (.2)(-200 - 90)2 + (.5)(50 - 90)2 + (.3)(350 - 90)2
= 37,900, Y = 194.68
© 1999 Prentice-Hall, Inc. Chap. 4 - 43
 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 = (.2)(-100 - 105)(-200 - 90) + (.5)(100 - 105)(50 - 90)

+ (.3)(250 -105)(350 - 90) = 23,300
The Covariance of 23,000 indicates that the two investments are
strongly related and will vary together in the same direction.
© 1999 Prentice-Hall, Inc. Chap. 4 - 44
 Chapter Summary
•Discussed Basic Probability Concepts:
Sample Spaces and Events, Simple Probability,
and Joint Probability
•Defined Conditional Probability
•Discussed Bayes’ Theorem
•Addressed the Probability of a Discrete Random
Variable
•Discussed Binomial, Poisson, and Hypergeometric
Distributions
• Addressed Covariance and its Applications in Finance
© 1999 Prentice-Hall, Inc. Chap. 4 - 45