Cfa L1 Session02

Study Session 2 Quantitative Methods (I)
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Study Session 2
Quantitative Methods (I)

A. ~The Time Value of Money

a. calculate the future value (FJ) and present value (PJ) of a single sum of money,
an ordinary annuity, and an annuity due.

The time value oI money (TVM) reIers to the Iact that $1 today is worth more than $1
in the Iuture. This is because the $1 today can be invested to earn interest immediately.
The TVM reIlects the relationship between present value, Iuture value, time, and
interest rate.

There are three ways to interpret interest rates:
Required rate oI return: this is the return required by investors or lenders to
postpone their current consumption.
Discount rate: this is the rate used to discount the Iuture cash Ilows to allow
Ior the time value oI money (that is, to bring Iuture value equivalent to present
value).
Opportunity cost: this is the most valuable alternative investors give up by
choosing what they could do with the money.

When you make a single investment today, its Iuture value that will be received N
years Irom now is as Iollows:
FV
N
PV ( 1 + r )
N

FV: Iuture value at time n.
PV: present value.
r: interest rate per period.
N: number oI years.

A key assumption oI the Iuture value Iormula is that interim interest earned is
reinvested at the given interest rate (r). This is known as compounding.

In order to receive a single Iuture cash Ilow N years Irom now, you must make an
investment today in the Iollowing amount:

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PV FV
N
/(1 + r)
N

Notice that the Iuture cash Ilow is discounted back to the present. ThereIore the
interest rate is called the discount rate.

When you solve these problems, make sure that periodic interest rates must
correspond to the number oI compounding periods in the year. For example, iI time
periods are quoted in quarters, quarterly interest rates should be used.

Annuity: a Iinite set oI sequential cash Ilows, all with the same value. In another
word, the payments occur at the end oI each period.

Ordinary annuity: it has a Iirst cash Ilow that occurs one period Irom now (indexed
at t 1).

Future value oI a regular annuity:
FV A x (1 + r)
N
- 1] / r]
A: annuity amount.
N: number oI regular annuity payments.
r: interest rate per period.

Present value oI a regular annuity:
PV A x 1 - 1 / (1 + r)
N]
/ r]

Annuity due: it has a Iirst cash Ilow that is paid immediately (indexed at t 0). In
another word, the payments occur at the beginning oI each period.

Future value oI an annuity due:
It consists oI two parts: the Iuture value oI one annuity payment now, and the
Iuture value oI a regular annuity oI (N -1) period. Calculate the two parts and
add them together.

Alternatively you can use this Iormula:

FV A x (1 + r)
N
- 1]/r] x ( 1 + r)
Note that, all else equal, the Iuture value oI an annuity due is equal to the
Iuture value oI an ordinary annuity times (1 r).

Present value oI an annuity due:
It consists oI two parts: an annuity payment now and the present value oI a
regular annuity oI (N - 1) period. Use the above Iormula to calculate the
second part, and add the two parts together.

PV A x 1 - 1/(1 + r)
N
]/r] x ( 1 + r)

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Note that, all else equal, the present value oI an annuity due is equal to the
present value oI an ordinary annuity times (1 r).

You'd better remember the two Iormulas above. You can use them to solve
annuity-related questions directly, or to double-check your answers given by your
calculator.

b. calculate the PJ of a perpetuity.

A perpetuity is a perpetual annuity: an ordinary annuity that extends indeIinitely. In
another word, it is an inIinite set oI sequential cash Ilows that have the same value,
with the Iirst cash Ilow occurring one period Irom now.

PV A / r
This equation is valid Ior a perpetuity with level payments, positive interest rate r. The
Iirst payment occurs one period Irom now (like a regular annuity).

See basic questions Ior examples.

c. calculate an unknown variable, given the other relevant variables, in single-sum
problems, annuity problems, and perpetuity problems;

Single-sum:
FV
N
PV ( 1 + r )
N

As can be seen the present value calculation involves discounting the Iuture cash
Ilows to a present value. To save space here and to save time on the test you should be
able to calculate PVs and FVs using your calculator.
N Number oI periods
I/Year Yield in market place or the Required Rate oI Return
PV Present value
PMT Payment amount per period
FV The Iuture value oI the investment

One can solve Ior any oI the above variables. Just input the other variables and solve
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Ior the unknown. Using the calculator on the test will prove to be a very time eIIicient
manner oI calculating present values and Iuture values.

For annuity and perpetuity problems, use Iormulas in a and b, and reIer to basic
questions Ior examples.

d. calculate the FJ and PJ of a series of uneven cash flows.

Series oI uneven cash Ilows: the cash Ilow stream is uneven over many time periods.
There is no single Iormula available to compute the present or Iuture value oI a series
uneven cash Ilows.

Present value:
When we have unequal cash Ilows, we must Iirst Iind the present value oI each
individual cash Ilow and then sum the respective present values. (usually with the
help oI a spreadsheet)

Future value:
Once we know the present value oI the cash Ilows, we can easily apply time-value
equivalence by using the Iormula to calculate the Iuture value oI a single sum oI
money (LOS a).


e. solve time value of money problems when compounding periods are other than
annual.

Some investment pay interests more than once a year. Whenever the compounding
periods are other than annual:

FV
N
PV x ( 1 + r
s
/m)
m x N

Note that:
r
s
is the quoted annual interest rate.
m is the number oI compounding periods per year.
N is the number oI years.

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You should change r and N accordingly in all Iormulas presented in previous LOSs
(Iuture value oI a single payment, present value oI a single payment, Iuture value oI
an annuity, etc).

II the number oI compounding periods becomes inIinite, interest is compounding
continuously. Accordingly, the Iuture value N years Irom now is computed as Iollows:

FV
N
PV x e
r
s
x N

f. distinguish between the stated annual interest rate and the effective annual rate.

There are three ways to quote interest rates Ior investments paying interest more than
once a year:

Periodic interest rate: the rate oI interest earned over a single compounding
period. For example, a bank may state that a particular CD pays a periodic
quarterly interest rate oI 3 that compounds 4 times a year.

Stated annual interest rate: also called quoted interest rate, it is the annual
rate oI interest that does not account Ior compounding within the year. It is the
annual interest rate quoted by Iinancial institutions, and equal to the periodic
interest rate times the number oI compounding periods per year. For example,
the stated annual interest rate oI the above CD is 3 x 4 12. It is strictly a
quoting convention, and it does not give a Iuture value directly.

Effective annual rate (EAR): it is the annual rate oI interest that takes Iull
account oI compounding within the year. The periodic interest rate is the
stated annual interest rate divided by m, where m is the number oI
compounding periods in one year: EAR (1 + periodic interest rate)
m
- 1.
Note that the higher the compounding Irequency, the higher the EAC.

For example, a $1 investment earning 8 percent compounded semiannually
actually earns 8.16 percent: (1 0.08/2)
2
- 1 8.16. The annual interest rate is
8 percent, and the eIIective annual rate is 8.16 percent.

g. calculate the effective annual rate, given the stated annual interest rate and the
frequency of compounding.
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ReIer to LOS I please.

h. draw a time line, specify a time index, and solve problems involving the time
value of money as applied to mortgages, credit card loans, and saving for college
tuition or retirement.

Please check the textbook Ior drawing a time line, and basic questions Ior examples.

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B. Statistical Concepts and Market Returns

a. differentiate between a population and a sample.

Statistics can reIer to numerical data. For example, a company's average revenue Ior
the past 20 years. It can also reIer to the methods oI collecting, classiIying, analyzing
and interpreting numerical data. Statistical methods provide a powerIul set oI tools Ior
making decisions in business and other Iields.

Statistics involves two diIIerent processes:
Describing sets oI data: descriptive statistical methods can be used to
describe the important aspects oI data sets that have been collected.
Drawing conclusions (making estimates, judgments, predictions, etc):
inferential statistical methods can be used to draw conclusions about a large
group Irom the smaller group actually observed.

A population consists oI an entire set oI objects, observations, or scores that have
something in common. For example, a population might be deIined as all males
between the ages oI 15 and 18.

Some populations are only hypothetical. Consider an experimenter interested in the
possible eIIectiveness oI a new method oI teaching reading. He or she might deIine a
population as the reading achievement scores that would result iI all six year olds in
the US were taught with this new method. The population is hypothetical in the sense
that there does not exist a group oI students who have been taught using the new
method; the population consists oI the scores that would be obtained iI they were
taught with this method.

The distribution oI a population can be described by several parameters such as the
mean and standard deviation. Estimates oI these parameters taken Irom a sample are
called statistics. Populations can have many parameters, but investment analysts are
usually only concerned with a Iew, such as the mean return, or the standard deviation
oI returns.

A sample is a subset oI a population. The sample is comprised oI some oI the
members oI the population. Since it is usually impractical (or too expensive, or too
time consuming) to test every member oI a population, a sample Irom the population
is typically the best approach available.

Inferential statistics generally require that sampling be random although some types
oI sampling (such as those used in voter polling) seek to make the sample as
representative oI the population as possible by choosing the sample to resemble the
population on the most important characteristics.
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A typical statistical procedure:
DeIine the population, and identiIy the parameter(s) oI interest.
Draw a sample Irom the population.
Determine the corresponding statistic(s) oI the sample, and use it (or them) to
estimate the parameter(s) oI the population.

b. explain the concept of a parameter.

A parameter is a numerical quantity measuring some aspect oI a population oI scores.
For example, the mean is a measure oI central tendency. Greek letters are used to
designate parameters. Parameters are rarely known and are usually estimated by
statistics computed in samples.

A statistic is deIined as a numerical quantity (such as the mean) calculated in a
sample. It has two diIIerent meanings. Most commonly, statistics reIers to numerical
data such as a company's earnings per share or average returns over the past Iive years.
Statistics can also reIer to the process oI collecting, organizing, presenting, analyzing,
and interpreting numerical data Ior the purpose oI making decisions.

Statistical methods include descriptive statistics and inIerential statistics. Descriptive
statistics is the study oI how data can be summarized eIIectively to describe important
aspects oI large data sets. Using descriptive statistics to consolidate a mass oI
numerical data into useIul inIormation is the Iocus oI this reading. InIerential statistics
- making Iorecasts, estimates, or judgments about a larger group Irom a smaller group
will be discussed in subsequent sections.

Much oI the Iield oI statistics is devoted to drawing inIerences Irom a sample
concerning the value oI a population parameter.

c. explain the differences among the types of measurement scales.

Measurement is the assignment oI numbers to objects or events in a systematic
Iashion. To choose the appropriate statistical methods Ior summarizing and analyzing
data, we need to distinguish between diIIerent measurement scales or levels oI
measurement:
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Nominal Scale
Nominal measurement represents the weakest level oI measurement.
It consists oI assigning items to groups or categories.
No quantitative inIormation is conveyed and no ordering (ranking) oI the
items is implied.
Nominal scales are thereIore qualitative rather than quantitative.
Religious preIerence, race, and sex are all examples oI nominal scales. Another
example is portIolio managers categorized as value or growth style will have a
scale oI 1 Ior value and 2 Ior growth. Frequency distributions are usually used to
analyze data measured on a nominal scale. The main statistic computed is the
mode. Variables measured on a nominal scale are oIten reIerred to as categorical
or qualitative variables.

Ordinal Scale
Measurements in an ordinal scale are categorized.
The various measurements are then ranked in their categories.
Measurements with ordinal scales are ordered in the sense that higher
numbers represent higher values. However, the intervals between the
numbers are not necessarily equal.
Example 1: on a Iive-point rating scale measuring attitudes toward gun control,
the diIIerence between a rating oI 2 and a rating oI 3 may not represent the same
diIIerence as the diIIerence between a rating oI 4 and a rating oI 5.

Example 2: two categories might be value and growth. Within each categories,
the portIolio managers measured will be weighted according to perIormance on a
scale Irom 1 to 10 with 1 being the best and 10 the worst perIorming manager.
There is no "true" zero point Ior ordinal scales since the zero point is chosen
arbitrarily. The lowest point on the rating scale in the example was arbitrarily
chosen to be 1. It could just as well have been 0 or -5.

Interval Scale
Interval scales are measures that rank the measurements and ensure that the
intervals between the rankings are equal. Scale values can be added and
subtracted Irom each other.

For example, iI anxiety were measured on an interval scale, then a diIIerence
between a score oI 10 and a score oI 11 would represent the same diIIerence in
anxiety as would a diIIerence between a score oI 50 and a score oI 51.

Interval scales do not have a "true" zero point, however, and thereIore it is not
possible to make statements about how many times higher one score is than
another. For the anxiety scale, it would not be valid to say that a person with a
score oI 30 was twice as anxious as a person with a score oI 15. True interval
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measurement is somewhere between rare and nonexistent in the behavioral
sciences. No interval-level scale oI anxiety such as the one described in the
example actually exists. A good example oI an interval scale is the Fahrenheit
scale Ior temperature. Equal diIIerences on this scale represent equal diIIerences
in temperature, but a temperature oI 30 degrees is not twice as warm as one oI 15
degrees.

Ratio Scale
Ratio scales are like interval scales except they have true zero points. It is the
strongest measurement scale. In addition to permitting ranking and addition /
subtraction, ratio scale allows computation oI meaningIul ratios. A good example
is the Kelvin scale oI temperature. This scale has an absolute zero. Thus, a
temperature oI 300 Kelvin is twice as high as a temperature oI 150 Kelvin. Two
Iinancial examples oI ratio scales are rates oI return and money. Both examples
can be measured on a zero scale where zero represents no return or in the case oI
money, no money.

d. define and interpret a frequency distribution.

A frequency distribution is a tabular display oI data categorized into a small number
oI non-overlapping intervals. An interval, also called a class, is a range oI values
within which an observation Ialls. An interval has a lower and an upper limit.

A Irequency distribution is constructed by dividing the scores into intervals and
counting the number oI scores in each interval. The actual number oI scores as well as
the percentage oI scores in each interval are displayed. It helps in the analysis oI large
amount oI statistical data, and they work with all types oI measurement scales.
absolute frequency: the actual number oI observations in a given interval.
relative frequency: the result Irom dividing the absolute Irequency oI each return
interval by the total number oI observations.
cumulative absolute frequency and cumulative relative frequency: the results
Irom cumulating the absolute and relative Irequencies as we move Irom the Iirst to
the last interval.

The Iollowing steps are required to organize date into a Irequency distribution
together with suggestions on constructing the Irequency distribution.
IdentiIy the highest and lowest values oI the observations.
Setup classes (groups into which the data is divided). The classes must be
mutually exclusive and equal size.
Add up the number oI observations and assign each observation to its class.
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Count the number oI observations in each class. This is called the class
Irequency.

e. define, calculate, and interpret a holding period return.

When analyzing rates oI return, our starting point is the total return, or holding
period return (HPR). HPR measures the total return Ior holding an investment over
a certain period oI time, and can be calculated using the Iollowing Iormula:

Holding Period Return R
t
(P
t
- P
(t-1)
+ D
t
) / P
(t-1)

P
t
: price per share at the end oI time period t.
P
(t-1)
: price per share at the end oI time period t-1, the time period immediately
preceding time period t.
P
t
- P
(t-1)
represents price appreciation oI the investment
D
t
: cash distributions received during time period t: Ior common stock, cash
distribution is the dividend; Ior bonds, cash distribution is the coupon
payment.

It has two important characteristics:
It has an element oI time attached to it: monthly, quarterly or annual returns.
HPR can be computed Ior any time period.
it has no currency unit attached to it: the result holds regardless oI the currency
in which prices are denominated.

Example: A stock is currently worth $60. II you purchased the stock exactly one year
ago Ior $50 and received a $2 dividend over the course oI the year, what is your
holding period return?
R
t
($60 - $50 $2)/$50 0.24 or 24

The return Ior time period t is the capital gain (or loss) plus distributions divided by
the beginning-oI-period price. Note that Ior common stocks, the distribution is the
dividend, and Ior bonds, the distribution is the coupon payment.

The holding period return Ior any asset can be calculated Ior any time period (day,
week, month, or year) simply by changing the interpretation oI the time interval.

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f. define and explain the use of intervals to summarize data.

An interval is a set oI return values within which an observation Ialls. The Irequency
distribution is the list oI intervals together with the corresponding measures oI
Irequency. Note that:
Each observation can only lie in one interval.
The total number oI intervals will incorporate the whole population.
The range Ior an interval is unique. This means a value (observation) can only Iall
into one interval.

It is important to consider the number oI intervals to be used. II too Iew intervals are
used, too much data may be summarized and we may lose important characteristics; iI
too many intervals are used, we may not summarize enough.

Each interval has a lower limit and an upper limit. Intervals must be all-inclusive and
non-overlapping.

g. calculate relative frequencies, given a frequency distribution.

Relative class Irequencies show the percentage number oI observations in each class
relative to the total number oI observations.

The relative Irequency Ior a class is calculated by dividing the number observations in
a class by the total number oI observations and convert to percentage (multiply the
Iraction by 100). Simply, relative Irequency is the percentage oI total observations
Ialling within each interval.

h. describe the properties of data presented as a histogram or a frequency polygon.
A histogram is a bar chart that displays a Irequency distribution. It is constructed as
Iollows:
The class Irequencies are shown on the vertical (y) axis (by the heights oI bars
drawn next to each other) and
The classes (intervals) are shown on the horizontal (x) axis.

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From a histogram we can see quickly where most oI the observations lie. The shapes
oI histograms will vary depending on the choice oI the size oI the intervals.

The frequency polygon is another means to graphically display data. It is similar to a
histogram but the bars are replaced by a line joined together and is constructed in the
Iollowing manner:
Absolute Irequency Ior each interval is plotted on the vertical (y) axis and
The midpoint oI each class (interval) is shown on the horizontal (x) axis.
Neighboring points are connected with a straight line.

Unlike a histogram, a Irequency polygon adds a degree oI continuitv to the
presentation oI the distribution.

i. define, calculate, and interpret measures of central tendency, including the
population mean, sample mean, arithmetic mean, geometric mean, weighted mean,
median, and mode.
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Measures of central tendency speciIy where the data are centered. They attempt to
use a typical value to represent all the observations in the data set.

population mean: the average Ior a Iinite population. It is unique; that is, a given
population has only one mean.
m (X
i
)/N
N is the number oI observations in the entire population and X
i
is the i
th

observation.
X
i
means add up X
i
, where i is Irom 0 to N.

sample mean: the average Ior a sample. It is a statistic and used to estimate the
population mean. X-bar (X
i
)/n
n is the number oI observations in the sample.

arithmetic mean: it is what is commonly called the average. The population
mean and sample mean are both examples oI the arithmetic mean.
II the data set encompasses an entire population, the arithmetic mean is
called a population mean.
II the data set includes a sample oI values taken Irom a population, the
arithmetic mean is called a sample mean.

It is the most widely used measure oI central tendency. When the word "mean" is
used without a modiIier, it can be assumed that it reIers to the arithmetic mean.
The mean is the sum oI all the scores divided by the number oI scores. It is used to
measure prospective (expected Iuture) perIormance (return) oI an investment over
a number oI periods.
All interval and ratio data sets (e.g. incomes, ages, rates oI return) have an
arithmetic mean.
All data values are considered and included in the arithmetic mean
computation.
A data set has only one arithmetic mean. This says that the mean is
unique.
The arithmetic mean is the only measure oI central tendency where the
sum oI the deviations oI each value Irom the mean is always zero.
Deviation Irom the arithmetic mean is the distance between the mean and
an observation in the data set.

The arithmetic mean has the Iollowing disadvantages:
The mean can be aIIected by extremes, that is, unusually large or small
values.
The mean cannot be determined Ior an open-ended data set (i.e., n is
unknown).

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geometric mean:
G (X
1
x X
2
x X
3
... x X
n
)
(1/n)

It has three important properties:
It exists only iI all the observations are greater than or equal to zero. In
another word, it cannot be determined iI any value oI the data set is zero
or negative.
II values in the data set are all equal, both the arithmetic and geometric
means will be equal to that value.
It is always less than the arithmetic mean iI values in the data set are not
equal.

It is typically used when calculating returns over multiple periods. It is a better
measure oI the compound growth rate oI an investment. When returns are
variable by period, the geometric mean will always be less than the arithmetic
mean. The more disperse the rates oI returns, the greater the diIIerence between
the two. It is not so highly inIluenced by extreme values as is the arithmetic
mean.

weighted mean: It is computed by weighting each observed value according to
its importance. In contrast, the arithmetic mean assigns equal weight to each
value. Notice that the return oI a portIolio is the weighted mean oI the returns oI
the individual assets in the portIolio. The assets are weighted on their market
values relative to the market value oI the portIolio. When we take a weighted
average oI Iorward-looking data, the weighted mean is called expected value.

median: it is the mid-point oI the data when the data is arranged Irom the
smallest to the largest values: halI the scores are above the median and halI are
below the median. To determine the median, arrange the data Irom the highest to
the lowest (or lowest to highest) and Iind the middle observation. II there is an
odd number oI observations in the data set, the median is the middle observation
(n 1)/2 oI the data set. II the number oI observations is even, there is no single
middle observation (there are two actually). To Iind the median, take the
arithmetic mean oI the two middle observations.

Unlike the mean, the median is less sensitive to extreme scores than the mean.
This makes it a better measure than the mean Ior highly skewed distributions. The
median income is usually more inIormative than the mean income, Ior example.
The sum oI the absolute deviations oI each number Irom the median is lower than
is the sum oI absolute deviations Irom any other number.

mode: it is the most Irequently occurring score in a distribution and is used as a
measure oI central tendency. A set oI data can have more than one mode, or even
no mode. When all values are diIIerent, the data set has no mode. When a
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distribution has one value that appears most Irequently, it is said to be unimodal.

The advantage oI the mode as a measure oI central tendency is that its meaning is
obvious. Like the median, the mode is not aIIected by extreme values. Further, it
is the only measure oI central tendency that can be used with nominal data. The
mode is greatly subject to sample Iluctuations and is thereIore not recommended
to be used as the only measure oI central tendency. A Iurther disadvantage oI the
mode is that many distributions have more than one mode. These distributions are
called "multimodal."

The mean, median, and mode are equal in symmetric distributions. The mean is
higher than the median in positively skewed distributions and lower than the median
in negatively skewed distributions. Extreme values aIIect value oI mean, while
median is less aIIected by outliers. Mode helps to identiIy shape and skewness oI
distribution.

j. describe and interpret quartiles, quintiles, deciles, and percentiles;

Median is the value that divides the distribution in halI. It is the most commonly used
quantile.

Quartiles divide the distribution into quarters, quintiles into IiIths, deciles into tenths,
and percentiles into hundredths.

Any quantile can be expressed as a percentile. The median is simply the 50th
percentile, and halI oI the observations lie below it. The 6th decile is also the 60th
percentile, and 60 percent oI the observations lie below it.

Inter-quartile range: the distance between lower and upper quartiles.

k. define, calculate, and interpret 1) a portfolio return as a weighted mean, 2) a
weighted average or mean, 3) a range and mean absolute deviation, and 4) a sample
and a population variance and standard deviation.

The weighted mean (average):
The weighted mean is a special case oI the mean that allows diIIerent weights on
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diIIerent observations. A portIolio is composed oI $75 million invested in stocks and
$25 million invested in bonds. The portIolio mean should reIlect the Iact that stocks
have a 75 percent weight and bonds have 25 percent. II we multiply the return on the
stock investment by 0.75 and the return on the bond investment by 0.25, and then sum
the two results, the sum is an example oI a weighted mean.

Dispersion is deIined as the "variability around the central tendency." Investments
Iinance is all about reward versus variability (risk). The central tendency is a measure
oI the reward oI an investment and dispersion is a measure oI investment risk.

There are two types oI dispersions:
Absolute dispersion: the amount oI variability without comparison to any
benchmark. Measures oI absolute dispersion include range, mean absolute
deviation, variance, and standard deviation.
Relative dispersion: the amount oI variability in comparison to a benchmark.
Measures oI relative dispersion include coeIIicient oI variance.

The range is the simplest measure oI spread or dispersion: It is equal to the diIIerence
between the largest and the smallest values. The range can be a useIul measure oI
spread because it is so easily understood. However, it is very sensitive to extreme
scores since it is based on only two values. The range should almost never be used as
the only measure oI spread, but can be inIormative iI used as a supplement to other
measures oI spread such as the standard deviation or semi-inter-quartile range.
Example: The range oI the numbers 1, 2, 4, 6,12,15,19, 26 26 -1 25

The mean absolute deviation is the arithmetic average oI the absolute deviations
around the mean.
MAD |(X
i
- X-bar)| / n
In calculating the MAD we ignore the signs oI the deviations around the mean.
Remember that the sum oI all the deviations Irom the mean is equal to zero. To get
around this zeroing out problem, the mean deviation uses the absolute values oI each
deviation. MAD is superior to the range as a measure oI dispersion since it uses all oI
the observations in the sample. However, the absolute value is diIIicult to work with
mathematically.

The variance is a measure oI how spread out a distribution is. It is computed as the
average squared deviation oI each number Irom its mean.
The Iormula (in summation notation) Ior the variance in a population is

where u is the mean and N is the number oI scores.

When the variance is computed in a sample, the statistic
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(where M is the mean oI the sample) can be used. S
2
is a biased estimate oI s
2
,
however. By Iar the most common Iormula Ior computing variance in a sample is:

which gives an unbiased estimate oI s
2
. Since samples are usually used to estimate
parameters, s
2
is the most commonly used measure oI variance.

The Iormula Ior the sample variance is nearly the same as that Ior the population
variance except Ior the use oI the sample mean, X, and the denominator. In the case oI
the population variance, we divide by the size oI the population, N. For the sample
variance, however, we divided by the sample size minus 1, or n-1. In the math oI
statistics, using only N in the denominator when using a sample to represent its
population will result in underestimating the population variance, especially Ior small
sample sizes. This systematic understatement causes the sample variance to be a
biased estimator oI the population variance. By using (n - 1) instead oI "N" in the
denominator, we compensate Ior this underestimation. Thus, by using n-1, the sample
variance (s
2
) will be an unbiased estimator oI the population variance (s
2
).

The major problem with using the variance is the diIIiculty interpreting it. Why? The
variance, unlike the mean, is in terms oI units squared. How does one interpret
squared percents or squared dollars? The solution to this problem is to use the
standard deviation. The Iormula Ior the standard deviation is very simple: it is the
square root oI the variance. It is the most commonly used measure oI spread. The
variance indicates the adequacy oI the mean as representative oI the population by
measuring the deviation Irom expectation. Basically it and the standard deviation are
measures or the average deviation Irom the mean.

An important attribute oI the standard deviation as a measure oI spread is that iI the
mean and standard deviation oI a normal distribution are known, it is possible to
compute the percentile rank associated with any given score. In a normal distribution,
about 68 oI the scores are within one standard deviation oI the mean and about 95
oI the scores are within two standards deviations oI the mean.

The standard deviation has proven to be an extremely useIul measure oI spread in part
because it is mathematically tractable. Many Iormulas in inIerential statistics use the
standard deviation.

l. calculate the proportion of items falling within a specified number of standard
deviations of the mean, using Chebyshev's inequality.

CFACENTER.COM 19
Chebyshev's inequality
Let c be any number greater than 1. For any sample or population oI data, the
proportion oI observations that lie FEWER than c standard deviations Irom the mean
is at least 1 -1/c
2
.
It applies to both populations and samples, and Ior discrete and continuous data,
regardless oI the shape oI the distribution.
It gives a conservative estimate oI the proportion oI observations in an interval
about the mean.
It highlights the importance oI s and places lower and upper limits.
Empirical rule: 68 within 1s, 95 within 2s, and 99 within 3s.

Chebyshev's inequality is useIul in that iI we know the standard deviation, we can use
it to measure the minimum amount oI dispersion.

Example: What approximate percent oI a distribution will lie within /- two standard
deviations oI the mean?
From Chebyshev's Inequality: 1-(1/k
2
) 1 - (1/2
2
) 0.75 or 75.

m. define, calculate, and interpret the coefficient of variation.

A direct comparison oI two or more measures oI dispersion may be diIIicult. For
example, the diIIerence between the dispersion Ior monthly returns on T-bills and
dispersion Ior a portIolio oI small stocks is not meaningIul because the means oI the
distributions are Iar apart. In order to make a meaningIul comparison, we need a
relative measure.

It is oIten useIul to compare the relative variation in data sets that have diIIerent
means and standard deviations, or that are measured in diIIerent units. Relative
dispersion is the amount oI variability present in comparison to a reIerence point or
benchmark. Coefficient of variation is used to standardize the measure oI absolute
dispersion. It is deIined as: CV s / X-bar.

It gives a measure oI risk per unit oI return, and an idea oI the magnitude oI variation
in percentage terms. It allows us Ior direct comparison oI dispersion across data sets.
The lower the CV the better because the investment would oIIer less risk per unit oI
return. It is also called relative standard deviation.

The CV is not an ideal measure oI dispersion. What iI the expected return is zero!?
Generally, the standard deviation is the measure oI choice Ior overall risk, and beta Ior
individual assets.
CFACENTER.COM 20

Example: The mean monthly return on T-bills is 0.25 with a standard deviation oI
0.36. For the S&P 500, the mean is 1.09 with a standard deviation oI 7.30.
Calculate the coeIIicient oI variation Ior T-bills and the S&P 500 and interpret your
results.

T-bills: CV 0.36/0.25 1.44
S&P 500: CV 7.30/1.09 6.70
Interpretation: There is less dispersion relative to the mean in the distribution oI
monthly T-bill returns when compared to the distribution oI monthly returns Ior the
S&P 500 (1.44 6.70).

n. define, calculate, and interpret the Sharpe measure of risk-adjusted performance.

The Sharpe measure is a more precise return-risk measure than standard deviation. It
recognizes the existence oI a risk-Iree return, a return Ior virtually zero standard
deviation. It measures the reward to total volatility trade-oII.

It is deIined as:
(r
p
- r
I
) / s
p

r
p
is the mean return to a portIolio.
r
I
is the mean return to a risk-Iree asset.
(r
p
- r
I
) measures the extra reward that investors receive Ior the added risk
taken, and it is called the excess return on portIolio p.
s
p
is the standard deviation oI the portIolio returns.

Note that the numerator oI the Sharpe measure recognizes the existence oI a risk-Iree
return. PortIolios with large Sharpe ratios are preIerred to those with smaller ratios
because we assume that investors preIer return and dislike risk. The Sharpe ratio is
also called the reward-to-variability-ratio.

Example: The mean monthly return on T-bills (the risk-Iree rate) is 0.25. The mean
monthly return on the S&P 500 is 1.30 with a standard deviation oI 7.30.
Calculate the Sharpe measure Ior the S&P 500 and interpret the results.
Sharpe measure (1.30 - 0.25)/7.30 0.144
Interpretation: The S&P 500 earned 0.144 oI excess return per unit oI risk, where
risk is measured by standard deviation.

CFACENTER.COM 21
o. describe the relative locations of the mean, median, and mode for a
nonsymmetrical distribution.

For the positively skewed distribution, the mode is less than the median, which is less
than the mean.

Recall that the mean is aIIected by outliers. In a positively skewed distribution, there
are large, positive outliers which will tend to 'pull the mean upward. An example oI
a positively skewed distribution is that oI housing prices. Suppose that you live in a
neighborhood with 100 homes. Ninety-nine oI those homes sell Ior $100,000 and
there is one house that sells Ior $1,000,000. The median and the mode will be
$100,000, but the mean will be $109,000. Hence, you can see that the mean has been
'pulled upward by the existence oI one home in the neighborhood.

For the negatively skewed distribution, the mean is less than the median, which is less
than the mode. In this case, there are large, negative outliers which tend to "pull" the
mean downward.

Tips on how to remember the relative locations:
The mean is always in the direction oI the skew. For example, a positively
(negatively) skewed distribution skews to the right (leIt), so its mean is on the
right (leIt). This is because the mean is unduly inIluenced by extreme values.
The median is always in the middle.

p. define and interpret skewness and explain why a distribution might be positively
or negatively skewed.

A distribution is skewed iI one oI its tails is longer than the other. Skewness allows us
to see iI large positive or negative deviations dominate.

A positively skewly distribution means that it has a long tail in the positive direction.
It is sometimes called "skewed to the right". It is characterized by many small losses
and a Iew extreme gains.
CFACENTER.COM 22

A negatively skewed distribution has a long tail in the negative direction. It is
sometimes called skewed to the leIt." It is characterized by many small gains and a
Iew extreme losses.

Distributions with positive skew are more common than distributions with negative
skews. One example is the distribution oI income. Most people make under $40,000 a
year, but some make quite a bit more with a small number making many millions oI
dollars per year. The positive tail thereIore extends out quite a long way whereas the
negative tail stops at zero.

For a more psychological example, a distribution with a positive skew typically
results iI the time it takes to make a response is measured. The longest response times
are usually much longer than typical response times whereas the shortest response
times are seldom much less than the typical response time.

Negatively skewed distributions do occur, however.

q. define and interpret kurtosis and explain why a distribution might have positive
excess kurtosis.
Kurtosis is based on the size oI a distribution's tails. It is the statistical measure that
tells us when a distribution is more or less peaked than a normal distribution.

Distributions with relatively large tails (that is, more peaked than normal) are called
"leptokurtic"; those with small tails ((that is, less peaked than normal) are called
"platykurtic." A distribution with the same kurtosis as the normal distribution is
called "mesokurtic." II a return distribution has more returns clustered closely around
the mean, it is leptokurtic. II it has more returns with large deviations Irom the mean
(and thus has Iatter tails), it is platykurtic.

Kurtosis is critical in a risk management setting. Most research oI the distribution oI
securities returns has shown that returns are not normal. Actual securities returns tend
to exhibit both skewness and kurtosis (sounds like Iungus!). The reason that skewness
and kurtosis are critical Ior risk management is that iI securities returns are modeled
aIter a normal distribution, then predictions Irom those models will take into
CFACENTER.COM 23
consideration the potential Ior extremely large, negative outcomes. In Iact, most risk
managers put very little emphasis on the mean and standard deviation oI a distribution
and Iocus more on the distribution oI returns in the tails oI the distribution -- that is
where the risk is.

r. describe and interpret measures of and kurtosis.
To calculate skewness:

where u is the mean and is the standard deviation.

The normal distribution has a skew oI 0 since it is a symmetric distribution.
II a skewness is positive, the average magnitude oI positive deviations is larger than
the average magnitide oI negative deviations.

To calculate excess kurtosis:

where is the standard deviation.
The kurtosis calculated here is actually excess kurtosis, and the kurtosis equals excess
kurtosis 3.

For all normal distributions, kurtosis is equal to 3, and excess kurtosis is equal to 0.

A leptokurtic distribution has an excess kurtosis greater than 0, and a platykurtic
distribution has an excess kurtosis less than 0.
CFACENTER.COM 24
C. Probability Concepts

a. define a random variable, an outcome, an event, mutually exclusive events, and
exhaustive events.

An experiment is the act oI making an observation or taking some measurement. For
example, tossing a die and observing the number on the up Iace is an experiment.

A particular result oI an experiment is called an outcome. It is a value taken by a
random variable. For example, there are six possible outcomes to the experiment oI
tossing a die.

A random variable is a quantity whose Iuture outcomes are uncertain. For example,
when you toss a die, the number that will Iace up is a random variable -- you are
unsure which number will come up.

Any outcome or speciIied set oI outcomes oI a random variable is called an event. For
example, one event in the die-tossing experiment is to observe an odd number (three
possible outcomes: 1, 3, 5).

Mutually exclusive events: Events such that only one occur at a time. In the above
example, event A (observe an odd number) and event B (observe an even number) are
mutually exclusive because they cannot occur simultaneously -- a number iI either
odd or even, but cannot be both.

Exhaustive events: Events that cover all the distinct possible outcomes. For example,
in the above example event A and B are exhaustive because they cover all 6 possible
outcomes oI the die-tossing experiment.

b. explain the two defining properties of probability.

In general, probability is the likelihood that an event will happen. P(E) stands Ior "the
probability oI event E".

The two deIining properties oI a probability are:
0 P(E) 1, the probability oI any event E is a number between 0 and 1.
The probability oI 0 means that the event can never happen, and the
probability oI 1 means that the event is certain to happen.

CFACENTER.COM 25
The sum oI the probabilities oI any list oI mutually exclusive and exhaustive
events equals 1. For example, the sum oI the possibilities oI two events
(observing an odd number event, and observing an even number event in the
die-tossing example) is 1 as they are mutually exclusive and exhaustive.

c. distinguish among empirical, subjective, and a priori probabilities.

Empirical probability
A probability based on relative Irequency oI occurrence. It is estimated Irom historical
data. For example, based on historical data over a 10-year period, the probability oI
deIault Ior real estate mortgage loans is 7. We cannot estimate the empirical
probability Ior an event without historical data. For empirical probabilities to be
accurate, relationships must be stable over time.

Priori probability
A probability based on logical analysis rather than observation or personal judgment.
For example, when you toss a Iair die, the probability oI rolling an even number iI
50.

Empirical and priori probabilities generally do not vary Irom person to person, and
they are oIten grouped as objective probabilities.

Subjective probability
A probability based on personal or subjective judgment. For example, based on his
own judgment, Bill believes that the probability that IBM's revenue will increase in
2005 is 60.

d. describe the investment consequences of probabilities that are inconsistent.

According to the Dutch Book Theorem, one oI the most important probability results
Ior investments, inconsistent probabilities create proIit opportunities. Investors, by
their buy and sell decisions to exploit the inconsistent probabilities, should eliminate
the proIit opportunity and inconsistency.

Suppose that:

CFACENTER.COM 26
II event E occurs, the values oI two assets, A and B, will both rise.
The price oI asset A reIlects a higher probability oI event E than the price oI
asset B and thus inconsistent probabilities exist.

All else equal, asset A is overvalued compared with asset B.
II event E does occur, the price oI asset A will not rise as much as the price oI
asset B. This is because the occurrence oI event E is mostly incorporated in
the price oI asset A.
II event E does not occur, the prices oI both assets will Iall, but the price oI
asset A will decline more than the price oI asset B. This is because compared
with asset B, the price oI asset A understates the probability that event E may
not occur.

ThereIore, investors can proIit by buying undervalued asset (i.e. B) and selling
overvalued asset (i.e. A). Conservative investors will buy asset B and reduce or Iully
liquidate their position in asset A. Aggressive investors will buy asset B and short
asset A. This strategy is known as the pairs arbitrage trade, which involves using
the proceeds Irom the short sale oI one stock to purchase another.

Note that the above discussion is based on the assumption that the occurrence oI event
E will increase the values oI two assets, A and B. II the occurrence oI event E will
reduce the value oI assets A and B, asset B is overvalued iI compared with asset A. To
proIit Irom inconsistent probabilities, investors should buy asset A and sell asset B.

Example:

Suppose that iI a hike in oil price occurs, the stock prices oI American Airlines (AA)
and British Airways (BA) will decline. The stock price oI AA reIlects a 0.7 probability
oI a hike in oil price, whereas the stock price oI BA reIlects only a 0.40 probability. In
this situation, the stock oI AA is undervalued iI compared with the stock oI BA. A
conservative investor can proIit by buying the stock oI AA and reducing or
eliminating his holdings in the stock oI BA. An aggressive investor can proIit by
buying the stock oI AA and shorting the stock oI BA.

e. distinguish between unconditional and conditional probabilities.

The complement oI event A is the event that A does not occur. It is expressed as Ac.
The probabilities oI an event and its complement must sum to 1: P(A) P(A
c
) 1.
Note that event A and its complement A
c
are mutually exclusive (there is no
overlapping oI their possible outcomes) and exhaustive (these two events include all
CFACENTER.COM 27
possible outcomes). For example, event A reIers to an increase in interest rates. The
probability oI event A is 0.7. A
c
is the event that interest rates will not increase. P(A
c
)
1 - 0.7 0.3.

Probabilities are either unconditional or conditional.

Unconditional probability, also called marginal probability, is simply the
probability oI an event occurring. It reIers to the probability oI an event that is not
conditioned on the occurrence oI another event. For example, what is the probability
that the stock earns a return above the risk-Iree rate? An unconditional probability can
be considered as a stand-alone probability. It is expressed as P(A).

A conditional probability is the probability oI an event given that another event has
occurred. It is denoted as P(A , B) (read: "the probability oI A given B").

For example, what is the probability that the total oI two dice will be greater than 8
given that the Iirst die is a 6? This can be computed by considering only outcomes Ior
which the Iirst die is a 6. Then, determine the proportion oI these outcomes that total
more than 8. There are 6 outcomes Ior which the Iirst die is a 6, and oI these, there are
Iour that total more than 8 (6,3; 6,4; 6,5; 6,6). The probability oI a total greater than 8
given that the Iirst die is 6 is thereIore 4/6 2/3 . More Iormally, this probability can
be written as: P(total~8 , Die 1 6) 2/3 . In this equation, the expression to the leIt
oI the vertical bar represents the event and the expression to the right oI the vertical
bar represents the condition. Thus it would be read as "The probability that the total is
greater than 8 given that Die 1 is 6 is 2/3." In more abstract Iorm, p(A,B) is the
probability oI event A given that event B occurred.

f. define a joint probability.

A joint probability is the probability oI both events A and B happening. It is denoted
as P(AB) (read: "the probability oI A and B"). For example, Kevin is assessing the
probability that both the airIare and the oil price increase. Such a probability is a joint
probability. In contrast, a conditional probability is the probability oI an event given
the occurrence oI another event.

A joint probability function oI two random variables X and Y gives the probability
oI joint occurrences oI values oI X and Y.

CFACENTER.COM 28

g. calculate, using the multiplication rule, the joint probability of two events.

II we know the conditional probability P(A,B) and we want to know the joint
probability P(AB), we can use the Iollowing multiplication rule for probabilities:

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

Example 1:
II someone draws a card at random Irom a deck and then, without replacing the Iirst
card, draws a second card, what is the probability that both cards will be aces? Event
A is that the Iirst card is an ace. Since 4 oI the 52 cards are aces, p(A) 4/52 1/13.
Given that the Iirst card is an ace, what is the probability that the second card will be
an ace as well? OI the 51 remaining cards, 3 are aces. ThereIore, p(B,A) 3/51 1/17
and the probability oI A and B is: 1/13 x 1/17 1/221.

Example 2:
The probability oI an increase in the oil price, P(B) is 0.4. The probability oI an
increase in airIare given an increase in oil price, P(A,B) is 0.3. The joint probability oI
an increase in both oil price and airIare, P(AB), is 0.3 x 0.4 0.12.

h. calculate, using the addition rule, the probability that at least one of two events
will occur.

II we have two events, A and B, that we are interested in, we oIten want to know the
probability that either A or B occurs. Such probabilities are calculated using the
addition rule for probabilities.
P(A or B) P(A) + P(B) - P(AB)

The logic behind this Iormula is that when P(A) and P(B) are added, the occasions on
which A and B both occur are counted twice. To adjust Ior this, P(AB) is subtracted.

II events A and B are mutually exclusive, the joint probability oI A and B is 0.
Consequently, the probability oI either A or B occurs is simply the sum oI the
unconditional probabilities oI A and B: P (A or B) P(A) P(B).

What is the probability that a card selected Irom a deck will be either an ace or a
spade? The relevant probabilities are: P(ace) 4/52; P(spade) 13/52

CFACENTER.COM 29
The only way in which an ace and a spade can both be drawn is to draw the ace oI
spades. There is only one ace oI spades, so:
P(ace and spade) 1/52.

The probability oI an ace or a spade can be computed as:
P(ace) P(spade) - P(ace and spade) 4/52 13/52 - 1/52 16/52 4/13.

Consider the probability oI rolling a die twice and getting a 6 on at least one oI the
rolls. The events are deIined in the Iollowing way:
Event A: 6 on the Iirst roll: p(A) 1/6
Event B: 6 on the second roll: p(B) 1/6
P(A and B) 1/6 x 1/6
P(A or B) 1/6 1/6 - 1/6 x 1/6 11/36

The same answer can be computed using the Iollowing admittedly convoluted
approach: Getting a 6 on either roll is the same thing as not getting a number Irom 1
to 5 on both rolls. This is equal to: 1 - P(1 to 5 on both rolls).

The probability oI getting a number Irom 1 to 5 on the Iirst roll is 5/6. Likewise, the
probability oI getting a number Irom 1 to 5 on the second roll is 5/6 . ThereIore, the
probability oI getting a number Irom 1 to 5 on both rolls is: 5/6 x 5/6 25/36. This
means that the probability oI not getting a 1 to 5 on both rolls (getting a 6 on at least
one roll) is: 1-25/36 11/36.

Despite the convoluted nature oI this method, it has the advantage oI being easy to
generalize to three or more events. For example, the probability oI rolling a die three
times and getting a six on at least one oI the three rolls is:
1 - 5/6 x 5/6 x 5/6 .421

i. distinguish between dependent and independent events.

Two events A and B are independent iI and only iI P(A,B) P(A), or equivalently,
P(B,A) P(B). That is, the occurrence oI one event has no inIluence on the
probability oI the occurrence oI the other event.

For example, suppose you Ilip a coin twice. The event oI getting a "head" on the Iirst
Ilip does no aIIect the probability oI getting a "head" on the second Ilip. ThereIore,
the event oI getting a "head" on the second Ilip is independent oI the event oI getting
a "head" on the Iirst Ilip.

CFACENTER.COM 30
When two events are not independent, they must be dependent: the occurrence oI one
is related to the probability oI occurrence oI the other.

II we are trying to Iorecast one event, inIormation about a dependent event must be
useIul, but inIormation about an independent event will not be useIul.

j. calculate a joint probability of any number of independent events.

A and B are two events. II A and B are independent, then the probability that events A
and B both occur is:
P(A and B) P(A) x P(B)

In other words, the probability oI A and B both occurring is the product oI the
probability oI A and the probability oI B. This relationship is known as the
multiplication rule for independent events.

What is the probability that a Iair coin will come up with heads twice in a row? Two
events must occur: a head on the Iirst toss and a head on the second toss. Since the
probability oI each event is 1/2, the probability oI both events is: 1/2 x 1/2 1/4.

Now consider a similar problem: Someone draws a card at random out oI a deck,
replaces it, and then draws another card at random. What is the probability that the
Iirst card is the ace oI clubs and the second card is a club (any club). Since there is
only one ace oI clubs in the deck, the probability oI the Iirst event is 1/52. Since 13/52
1/4 oI the deck is composed oI clubs, the probability oI the second event is 1/4.
ThereIore, the probability oI both events is: 1/52 x 1/4 1/208.

Similarly, Ior any number oI independent events E
1
, E
2.
....E
n
, the probability that all oI
them occur is:
P(E
1
and E
2
..... and E
n
) P(E
1
) x P(E
2
) x ..... x P(E
n
)

k. calculate, using the total probability rule, an unconditional probability.

II we have an event or scenario S, the event not-S, called the complement oI S, is
written S
C
. Note that P(S) P(S
C
) 1, as either S or not-S must occur.
CFACENTER.COM 31

Total probability rule explains the unconditional probability oI the event in terms oI
probabilities conditional on the scenarios.
P(A) P(A,S)P(S) P(A,S
C
)P(S
C
)
P(A) P(A,S
1
)P(S
1
) P(A,S
2
)P(S
2
) ... P(A,S
n
)P(S
n
)

The Iirst equation is the just a special case oI the second equation.

The second equation states the Iollowing: the probability oI any event |P(A)| can be
expressed as a weighted average oI the probabilities oI the event, given scenarios
|terms such P(A,S
1
)|; the weights applied to these conditional probabilities are the
respective probabilities oI the scenarios|terms such as P(A
1
multiplying P(A,S
1
)), and
the scenarios must be mutually exclusive and exhaustive.

Suppose there are two events:
Event A: IBM's revenue will increase.
Event B: the economy is going into an expansion. P(B) 0.6, and thereIore
P(B
c
) 0.4.
The probability oI an increase in IBM's revenue given an economic expansion
is P(A,B) 0.8.
The probability oI an increase in IBM's revenue given no economic expansion
is P(A, B
c
) 0.7.

Using the total probability rule, we can compute the probability oI an increase in
IBM's revenue: P(A) P(A,B) x P(B) P(A, B
c
) x P(B
c
) 0.8 x 0.6 0.7 x 0.4
0.76.

l. define, calculate, and interpret expected value, variance, and standard deviation.

The expected value oI a random variable is the probability-weighted average oI the
possible outcomes oI the random variable. For a random variable X, the expected
value oI X is denoted E(X).

E(X) P(x
1
) x
1
P(x
2
) x
2
... P(x
n
) x
n

In investment analysis, Iorecasts are Irequently made using expected value. For
example, the expected value oI earnings per share, dividend per share, rate oI return,
etc. It represents the central value oI all possible outcomes.

The variance oI a random variable is the expected value (the probability-weighted
CFACENTER.COM 32
average) oI squared deviations Irom the random variable's expected value.
s
2
(X) E|X - E(X)|
2
}

Variance is a number greater than or equal to 0.
II it is 0, there is no dispersion or risk. The outcome is certain.
Variance greater than 0 indicates dispersion oI outcomes.
Increasing variance indicates increasing dispersion, all else equal.
Variance oI X is a quantity in the squared units oI X, thereIore it's diIIicult to
interpret the variance.

The standard deviation is the positive square root oI variance.

Variance and standard deviation measure the dispersion oI possible outcomes around
the expected value oI the random variable. All else equal, increasing variance or
standard deviation indicates increasing dispersion oI the possible outcomes.

m. explain the use of conditional expectation in investment applications.

In investments, we make use oI any relevant inIormation available in making our
Iorecast. When we reIine our expectations or Iorecasts, we are typically making
adjustments based on new inIormation or events; in these cases we are using
conditional expected values. The expected value oI a random variable X given an
event or scenario S is denoted E(X,S).

n. calculate an expected value using the total probability rule.

Parallel to the total probability rule Ior stating unconditional probabilities in terms oI
conditional probabilities, total probability rule for expected value states
(unconditional) expected values in terms oI conditional expected values.
E(X) E(X,S)P(S) E(X,S
C
)P(S
C
)
E(X) E(X,S
1
)P(S
1
) E(X,S
2
)P(S
2
) ... E(X,S
n
)P(S
n
)
where S
1
, S
2
, ..., S
n
are mutually exclusive and exhaustive scenarios or events.

The general case, equation 2, states that the expected value oI X equals the expected
value oI X given Scenario 1, E(X,S
1
), times the probability oI Scenario 1, P(S
1
), plus
the expected value oI X given Scenario 2, E(X,S
2
), times the probability oI Scenario 2,
CFACENTER.COM 33
P(S
2
), and so on.

o. define, calculate, and interpret covariance and correlation.

Variance and standard deviation measure the dispersion oI a single random variable.
OIten times, we want to know the relationship between two variables. For example,
what is the relationship between the perIormance oI the S&P 500 and that oI the US
long-term corporate bonds? For this purpose, we can use covariance and correlation to
measure the degree to which two random variables are related to each other.

Given two random variables R
i
and R
j
, the covariance between the two variables is:
Cov(R
i
, R
j
) E|(R
i
- ER
i
)(R
j
- ER
j
)|

Facts about covariance:
Covariance oI returns is negative iI, when the return on one asset is above its
expected value, the return on the other asset is below its expected value (an
average inverse relationship between returns).
Covariance oI returns is 0 iI return on the assets are unrelated.
Covariance oI returns is positive iI, when the return on one asset is above its
expected value, the return on the other asset is above its expected value (an
average positive relationship between returns).
The covariance oI a random variable with itselI (own covariance) is its own
variance.

The correlation between two random variables, R
i
and R
j,
is deIined as p(R
i
, R
j
)
Cov(R
i
, R
j
)/s(R
i
)S(R
j
). Alternative notations are Corr(R
i
, R
j
) and p
ij
.
Properties oI correlation:
Correlation is a number between -1 and 1.
A correlation oI 0 indicates an absence oI any linear (straight-line) relationship
between the variables.
Increasingly positive correlation indicates an increasingly strong positive linear
relationship (up to 1, which indicates a perIect linear relationship).
Increasingly negative correlation indicates an increasingly strong negative linear
relationship (down to -1, which indicates a perIect inverse linear relationship).

The correlation between two variables represents the degree to which variables are
related. It is important to keep in mind that correlation does not necessarily mean
causation. For example, there is a high positive relationship between the number oI
Iire Iighters sent to a Iire and the amount oI damage done. Does this mean that the Iire
Iighters cause the damage? Or is it more likely that the bigger the Iire, the more Iire
CFACENTER.COM 34
Iighters are sent and the more damage that is done. In this example, the variable "size
oI the Iire" is the causal variable, correlating with both the number oI Iire Iighters sent
and the amount oI damage done.

p. explain the relationship among covariance, standard deviation, and correlation.

p(R
i
, R
j
) Cov(R
i
, R
j
)/(s(Ri)s(R
j
))

q. calculate the expected return and the variance for return on a portfolio.

The expected return on a portIolio oI assets is the market-weighted average oI the
expected returns on the individual assets in the portIolio. The variance oI a portIolio's
return consists oI two components: the weighted average oI the variance Ior
individual assets, and the weighted covariance between pairs oI individual assets.

You have a portIolio oI two mutual Iunds, A and B, 75 invested in A.
E(R
A
) 20; E(R
B
) 12.
Covariance Matrix:
Fund A B
A 625 120
B 120 196

The expected return on the portIolio is:
E(R
p
) w
A
E(R
A
) (1 - w
A
E(R
B
)) 0.75 x 20 0.25 x 12 18.

The correlation matrix:
s(R
A
) (625)2 25 percent, s(R
B
) (196)2 14 percent.
p(R
A
, T
B
) Cov(R
A
, R
B
)/s(R
A
)s(R
B
) 120 / (25 x 14) 0.342857, or 0.34.

The variance oI the portIolio is:
s
2
(R
P
)
w
A
2
s
2
(R
A
) w
B
2
s
2
(R
B
) 2w
A
w
B
Cov(R
A
, R
B
)
(0.75)
2
(625) (0.25)
2
(196) 2(0.75)(0.25)(120)
408.8125

The standard deviation is:
CFACENTER.COM 35
s(R
P
) (408.8125)
1/2
20.22 percent.

r. calculate covariance given a joint probability function.

We can calculate covariance using the joint probability Iunction oI the random
variables iI that can be estimated. The joint probability Iunction oI two random
variables X and Y, denoted P(X, Y), gives the probability oI joint occurrences oI
values X and Y. For example, P(3, 2) is the probability that X equals 3 and Y equals 2.

s. calculate an updated probability, using Bayes' formula.

Given a set oI prior probabilities Ior an event oI interest, iI you receive new
inIormation, the rule Ior updating your probability oI the event is:

Updated probability oI event given the new inIormation (Probability oI the new
inIormation given event / Unconditional probability oI the new inIormation) x Prior
probability oI event.


t. calculate the number of ways a specified number of tasks can be performed using
the multiplication rule of counting.

In some cases, it's relatively easy to list and count all oI the possible outcomes. For
example, iI you Ilip a dime in the air, there are only two possible outcomes -- it will
come up with either heads or tails. In other cases, there are a large number oI possible
outcomes. For example, imagine iI you want to choose two stocks Irom the thousands
oI issues that trade on the NYSE.

II one thing can be done in n
1
ways, and a second thing, given the Iirst, can be done in
n
2
ways, and so on Ior k things, then the number oI ways the k things can be done is
n
1
x n
2
x n
3
... x n
k
.

For example, suppose a portIolio manager is making two decisions:
CFACENTER.COM 36

Which type oI instrument to invest in: stocks or bonds.
Which country to invest in: US, Canada or Germany.
The number oI possible ways the manager can make these two decisions is 2 x 3 6.

Note that the multiplication rule is applicable iI there are two or more groupings. In
the preceding example, there are two groups: one Ior investment instruments and the
other Ior countries. In addition, only one item can be selected Irom each group.

u. solve counting problems using the factorial, combination, and permutation
notations.

Suppose that there are n numbers in a group and n slots available. Only one member
can be assigned to each slot. The number oI ways to assign every number to the n
slots is n factorial: n! n x (n - 1) x (n - 2) x (n - 3) ... x 1. Note that by convention 0!
1.

For example, Iive equity analysts are assigned to cover Iive industries. The number oI
ways to assign them is 5! 5 x 4 x 3 x 2 x 1 120.

Unlike the multiplication rule, Iactorial involves only a single group. It involves
arranging items within a group, and the order oI the arrangement does matter.
Arrangement oI ABCDE is diIIerent Irom the arrangement oI ACBDE.

A combination is a listing in which order oI listing does not matter. The number oI
ways that we can choose r objects Irom a total oI n objects, where the order in which
the r objects is listed does not matter (The combination formula, or the binomial
formula):

n
C
r
n! / |(n - r)! x r!|

For example, iI you will select two oI the ten stocks you are analyzing, how many
ways can you select the stocks? 10! / |(10 - 2)! x 2!| 45.

An ordered listing is known as a permutation, and the Iormula that counts the
number oI permutations is known as the permutation Iormula.
The number oI ways that we can choose r objects Irom a total oI n objects, where the
order in which the r objects is listed does not matter, is:

n
P
r
n! / (n - r)!

For example, iI you will select two oI the ten stocks you are analyzing, and invest
CFACENTER.COM 37
$10,000 in one stock, $20,000 in another stock, how many ways can you select the
stocks? Note that the order oI your selection is important in this case. 10P2 10!/(10 -
2)! 90.

v. distinguish among problems for which different counting methods are
appropriate.

see LOS u please.

w. calculate the number of ways to choose r objects from a total of n objects, when
the order in which the r objects is listed does or does not matter.

see LOS u please.
CFACENTER.COM 38
D. ~Common Probability Distributions

a. explain a probability distribution.

A probability distribution speciIies the probabilities oI the possible outcomes oI a
random variable.

Discrete Probability Distribution: A table, graph or rule that associates a probability
P(Xxi) with each possible value xi that the discrete random variable X can assume.
It is a theoretical model Ior the relative Irequency distribution oI a population.

b. distinguish between and give examples of discrete and continuous random
variables.

A random variable is a quantity whose Iuture outcomes are uncertain. Depending on
the characteristics oI the random variable, a probability distribution may be either
discrete or continuous.

A discrete variable is one that cannot take on all values within the limits oI the
variable. For example, responses to a Iive-point rating scale can only take on the
values 1, 2, 3, 4, and 5. The variable cannot have the value 1.7. The variable "Number
oI correct answers on a 100 point multiple-choice test" is also a discrete variable since
it is not possible to get 54.12 problems correct. The number oI movies you will see
this year, the number oI trades a broker will perIorm next month, and the number oI
securities in a portIolio are all examples oI discrete variables.

A continuous variable is one Ior which, within the limits the variable ranges, any
value is possible. For example, the variable "Time to solve an anagram problem" is
continuous since it could take 2 minutes, 2.13 minutes etc. to Iinish a problem. A
variable such as a person's height can take on any value too. The rate oI return on an
asset is also a continuous random variable since the exact value oI the rate oI return
depends on desired number oI decimal spaces.

Statistics computed Irom discrete variables are continuous. The mean on a Iive-point
scale could be 3.117 even though 3.117 is not possible Ior an individual score.

CFACENTER.COM 39

c. describe the range of possible outcomes of a specified random variable.

Sometimes the possible values of a random variable have both lower and upper
bounds. For example, there are three possible values oI the number oI heads showing
Iace up on two tosses oI a coin: 0, 1, and 2. ThereIore, the lower bound is 0, and the
upper bound is 2.

Sometimes the lower bound exists, but the upper bound does not. For example, the
lower bound oI the price oI a stock is 0, since it cannot Iall below 0. However, there is
no upper bound on the price (at least theoretically).

Sometimes the upper bound exists, but the lower bound does not. Consider the
proIit/loss oI the seller oI a call option. Suppose the buyer pays the seller $2 to buy a
call option, which gives the buyer the right to buy a stock at $10 by the end oI 2006.
The maximum proIit the seller can make is $2, but the maximum loss the seller may
incur is unlimited since there is no upper bound on the possible values oI stock prices.

In other cases, neither bound is obvious. Consider the proIit/loss oI a big company. In
a good year, its proIit could be as high as dozens oI billions, and so could be its loss in
a very bad year.

d. define a probability function and determine whether a given function satisfies the
conditions for a probability function.

Every random variable is associated with a probability distribution that describes the
variable completely. A probability Iunction is one way to view a probability
distribution. It speciIies the probability that the random variable takes on a speciIic
value: P(X x) is the probability that a random variable X takes on the value x.

For a discrete random variable, the shorthand notation Ior the probability Iunction is
p(x) P(X x). For continuous random variables, the probability Iunction is denoted
I(x) and called the probability density function, or just the density.

e. state the two key properties of a probability function.

CFACENTER.COM 40
A probability Iunction has two key properties:
0 p 1, because probability is a number between 0 and 1.
The sum oI the probabilities p(x) over all values oI X equals 1. II we have an
exhaustive list oI the distinct possible outcomes oI a random variable and add up
the probabilities oI each, the probabilities must sum to 1.

f. define a cumulative distribution function and calculate probabilities for a random
variable, given a cumulative distribution function.

We are oIten interested in Iinding the probability oI a range oI outcomes rather than a
speciIic outcome. A cumulative distribution function (cdI) gives the probability that
a random variable X is less than or equal to a particular value x, P(Xx). In contrast,
a probability Iunction is used to Iind the probability oI a speciIic outcome. To derive a
cumulative distribution Iunction F(x), we simply sum up the values oI the probability
Iunction Ior all outcomes less than or equal to x.

The two characteristics are:
The cumulative distribution Iunction lies between 0 and 1 Ior any x: 0 F(x)
1
As we increase x, the cdI either increases or remains constant.

Given the cumulative distribution Iunction, we can also calculate the probabilities Ior
the random variable. In general:
P(X x
n
) F(X
n
) - F(X
n
- 1)

A cumulative frequency distribution is a plot oI the number oI observations Ialling
in or below an interval. It can show either the actual Irequencies at or below each
interval (as shown here) or the percentage oI the scores at or below each interval. The
plot can be a histogram as or a polygon.

g. define a probability density function.

see LOS d please.

CFACENTER.COM 41

h. define a discrete uniform random variable and calculate probabilities, given a
discrete uniform probability distribution.

A uniform distribution is one Ior which the probability oI occurrence is the same Ior
all values oI X. It is sometimes called a rectangular distribution. For example, iI a Iair
die is thrown, the probability oI obtaining any one oI the six possible outcomes is 1/6.
Since all outcomes are equally probable, the distribution is uniIorm. II a uniIorm
distribution is divided into equally spaced intervals, there will be an equal number oI
members oI the population in each interval.

The discrete uniform distribution is the simplest oI all probability distributions. The
distribution has a Iinite number oI speciIied outcomes, and each outcome is equally
likely. Mathematically, suppose that a discrete uniIorm random variable, X, has n
possible outcomes: x
1
, x
2
, ..., x
n-1
, and x
n
.
p(x
1
) p(x
2
) p(x
3
) ... p(x
n-1
) p(x
n
) p(x). That is, the probabilities Ior
all possible outcomes are equal.
F(x
k
) kp(x
k
). That is, the cumulative distribution Iunction Ior the k
th
outcome
is k times oI the probability oI the k
th
outcome.
II there are k possible outcomes in a particular range, the probability Ior that
range oI outcomes is kp(x).

For example, the possible outcomes are the integers 1 to 8 (inclusive), and the
probability that the random variable takes on any oI these possible values is the same
Ior all outcomes (that is, it is uniIorm).

i. define a binomial random variable and calculate probabilities, given a binomial
probability distribution.

When a coin is Ilipped, the outcome is either a head or a tail; when a magician
guesses the card selected Irom a deck, the magician can either be correct or incorrect;
when a baby is born, the baby is either born in the month oI March or is not. In each
oI these examples, an event has two mutually exclusive possible outcomes. For
convenience, one oI the outcomes can be labeled "success" and the other outcome
"Iailure." II an event occurs N times (Ior example, a coin is Ilipped N times), then the
binomial distribution can be used to determine the probability oI obtaining exactly r
successes in the N outcomes.

CFACENTER.COM 42
A Bernoulli trial is an experiment with two outcomes, which can represent success or
Iailure, up move or down move, or another binary outcome.

A binomial random variable X is deIined as the number oI successes in n Bernoulli
trials. The assumptions are:
the probability, p, oI success is constant Ior all trials.
the trials are independent.

The binomial probability Ior obtaining r successes in n trials is:
p(r)
r
C
n
p
r
(1 - p)
n-r
n!/|(n - r)! x r!|}p
r
(1 - p)
n-r

where p(r) is the probability oI exactly r successes, n is the number oI events, and p is
the probability oI success on any one trial. This Iormula assumes that the events:
are dichotomous (Iall into only two categories)
are mutually exclusive
are independent and
are randomly selected

To remember the Iormula, note that there are three components:
n!/|(n-r)! x r!|: it is the number oI ways we can get r successes and n - r
Iailures in n trials, where the order oI success/Iailure does not matter. This is
the combination Iormula.
p
r
: it is the probability oI getting x consecutive success.
(1 - p)
n-r
: it is the probability oI getting n - r consecutive Iailures.

Consider this simple application oI the binomial distribution: What is the probability
oI obtaining exactly 3 heads iI a Iair coin is Ilipped 6 times? For this problem, n 6, r
3, and p .5.
p(3) 6!/|(6 - 3)! x 3!|}0.5
3
(1 - 0.5)
6-3

0.3125.

OIten the cumulative Iorm oI the binomial distribution is used. To determine the
probability oI obtaining 3 or more successes with n 6 and p .3, you compute P(3)
P(4) P(5) P(6).

j. calculate the expected value and variance of a binomial random variable.

For a single Bernoulli random variable Y which takes on the value 1 with probability
p and the value 0 with probability 1 - p, its mean is p and its variance is p(1 - p).

CFACENTER.COM 43
A general binomial random variable, B(n, p), is the sum oI n bernoulli random
variables, and so the mean oI a B(n, p) random variable is np. Given that a B(1, p)
variable has variance p(1 - p), the variance oI a B(n, p) random variable is n times that
value, or np(1 - p), using the independent assumption.

For example, Ior a B(n 5, p 0.10) random variable, the expected number oI
successes is 5 x 0.1 0.5 with a standard deviation oI (5 x 0.1 x 0.9)1/2 0.67.

k. describe the continuous uniform distribution and calculate probabilities, given a
continuous uniform probability distribution.

II a continuous random variable is equally likely to Iall on any point between its
maximum and minimum values, it is a continuous uniform random variable, and its
probability distribution is a continuous probability distribution.

The continuous uniIorm distribution is the simplest continuous probability
distribution.
The probability density Iunction is: I(x) 1 / (b - a) Ior a x b; or 0
otherwise.
The cumulative density Iunction is: F(x) 0 Ior x a; (x - a)/(b - a) Ior a
x b; 1 Ior x ~ b.

The probability density Iunction is a horizontal line with a height oI 1/(b-a)
over a range oI values Irom a to b.
The cumulative density Iunction is a sloped line with a height oI 0 to 1 over a
range oI values Irom a to b, and is a horizontal line with a height oI 1 when the
value oI the variable equals or exceeds b.

For example, with a 0 and b 8, I(x) 0.125. II we graph this density it will plot as
a horizontal line with a value oI 0.125.

II we want to Iind the probability F(3) P(X 3), we Iind the area under the curve
graphing the probability density Iunction, between 0 to 3 on the x-axis. The middle
line oI the expression Ior the cumulative probability Iunction is:
F(x) 0 Ior x a; (x - a)/(b - a) Ior a x b; 1 Ior x ~ b.
CFACENTER.COM 44

For a continuous uniIorm random variable, the mean is given by u (a b)/2, and the
variance is given by
2
(b - a)
2
/12.

l. explain the key properties of the normal distribution.

Normal distributions are a Iamily oI distributions that have the same general shape.
They are symmetric with scores more concentrated in the middle than in the
tails.
Normal distributions are sometimes described as bell shaped with a single
peak at the exact center oI the distribution.
The tails oI the normal curve extends indeIinitely in both directions. That is,
possible outcomes oI a normal distribution lie between - inIinite to inIinite.
They may diIIer in how spread out they are.

The key properties are:
The normal distribution is completely described by two parameters: the mean
(m) and the standard deviation (s).
The normal distribution is symmetric: it has a skewness oI 0, a kurtosis (it
measures the peakedness oI a distribution) oI 3, an excess kurtosis oI (which
equals kurtosis less 3) 0. As a consequence, the mean, median and the mode are
all equal Ior a normal random variable.
A linear combination oI two or more normal random variables is also normally
distributed.

One reason the normal distribution is important is that many psychological,
educational and Iinancial variables are distributed approximately normally. Measures
oI reading ability, introversion, job satisIaction and memory are among the many
psychological variables approximately normally distributed. Although the
distributions are only approximately normal, they are usually quite close.

A second reason the normal distribution is so important is that it is easy Ior
mathematical statisticians to work with. This means that many kinds oI statistical tests
can be derived Ior normal distributions. Almost all statistical tests discussed in the
textbook assume normal distributions. Fortunately, these tests work very well even iI
the distribution is only approximately normally distributed. Some tests work well
even with very wide deviations Irom normality.

Finally, iI the mean and standard deviation oI a normal distribution are known, it is
easy to convert back and Iorth Irom raw scores to percentiles.

CFACENTER.COM 45
For example, normal distribution is an approximate model Ior asset returns. The price
oI any asset can only drop to 0. ThereIore, the lowest return on an asset is -100 (that
is, you lose all your investment in the asset). Since the normal distribution extends to
minus inIinite without limit, it is not an accurate model Ior asset returns. However, Ior
the normal distribution, the probability oI outcomes below -100 is very small.
ThereIore, the normal distribution can be considered an approximate model Ior
returns. However, the normal distribution tends to underestimate the probability oI
extreme returns.

m. construct and interpret confidence intervals for a normally distributed random
variable.

We can use the sample mean to estimate the population mean, and the sample
standard deviation to estimate the population standard deviation. The sample mean
and sample standard deviation are point estimates.

Probability statements about a random variable are oIten Iramed using confidence
intervals built around point estimates. In investment work, conIidence intervals Ior a
normal random variable in relation to its estimated mean are oIten used.

ConIidence intervals use point estimates to make probability statements about the
dispersion oI the outcomes oI a normal distribution. A conIidence interval speciIies
the percentage oI all observations that Iall in a particular interval.

The exact conIidence intervals Ior a normal random variable X:
90 conIidence interval Ior X is: x-bar - 1.645s to x-bar 1.645s: this means
that 10 oI the observations Iall outside the 90 conIidence interval, with 5
on each side.
that 5 oI the observations Iall outside the 95 conIidence interval, with
2.5 on each side.
that 1 oI the observations Iall outside the 99 conIidence interval, with
0.5 on each side.

You need to memorize these numbers (1.645, 1.96 and 2.58) to quickly solve relevant
problems. For details about conIidence interval, reIer to study session 3.

CFACENTER.COM 46

n. define the standard normal distribution, explain how to standardize a random
variable, and calculate probabilities using the standard normal probability
distribution.

The standard normal distribution is a normal distribution with a mean oI 0 and a
standard deviation oI 1. It is denoted N(0,1). Below are some conIidence intervals Ior
the standard normal distribution:

There is unlimited number oI normal distributions, each with a diIIerent mean or
standard deviation. ThereIore, it's impractical to provide a table oI probabilities Ior
each combination oI mean and standard deviation. However, we can standardize the
actual distribution Ior a normal random variable to a standard normal distribution.
Normal distributions can be transIormed to standard normal distributions by the
Iormula:
z (X - m)/s
where X is a score Irom the original normal distribution, m is the mean oI the original
normal distribution, and s is the standard deviation oI original normal distribution.

The standard normal distribution is sometimes called the z distribution. A z score
(also called z-value, or z-statistic) is the distance between a selected value (X) and
the population mean, divided by the population standard deviation. It is in Iact a
standard normal random variable. For instance, iI a person scored a 70 on a test with
a mean oI 50 and a standard deviation oI 10, then they scored 2 standard deviations
above the mean. Converting the test scores to z scores, an X oI 70 would be: z (70 -
50) / 10 2.

So, a z score oI 2 means the original score was 2 standard deviations above the mean.
Note that the z distribution will only be a normal distribution iI the original
distribution (X) is normal.

Example:

The rates oI return on the assets in a portIolio are normally distributed, with a mean oI
CFACENTER.COM 47
20 and a standard deviation oI 12. What's the probability that the return on an
asset Ialls between -3.52 and 50.96?

Solution:
II the return on the asset is -3.52, its z-value is z (-3.52 - 20)/12
-1.96.
II the return on the asset is 50.96, its z-value is (50.96 - 20)/12 2.58.
Recall that a normal distribution is symmetrical. The 95 conIidence interval
is -1.96 to 1.96. The 99 conIidence interval is -2.58 to 2.58. The probability
oI z-value Ialling between -1.96 to 2.58 is 95/2 99/2 97.

How to Use the Z-Table

The z-table is the table oI the cumulative distribution Iunction Ior the standard normal
random variable. A portion oI the z-table is presented as below ( N(z) represents the
cumulative probability distribution Ior a standard random variable Z):

An entry in the z-table indicates the probability that a standard normal variable is less
than or equal to a given value. For example, suppose that you want to Iind the
probability that a standard normal variable is less than or equal to 1.01. In the z-table,
go down the column headed by the letter z to 1.00. Move to the right and read the
entry under the column headed 0.01. It's 0.8438. That is, P(Z 1.01) 0.8438 or
84.38, and P(Z ~ 1.01) 15.62.

A standard normal distribution is symmetrical with a mean oI 0. ThereIore, P(Z 0)
CFACENTER.COM 48
50 ~ P(0 Z 1.01) 0.8438 - 0.5 34.38.

o. distinguish between a univariate and a multivariate distribution.

A univariate distribution describes a single random variable. For example, suppose
that we would like to model the distribution oI the return on an asset. Such a
distribution is a univariate distribution. All oI the distributions that we have discussed
thus Iar are univariate distributions.

A multivariate distribution speciIies the probabilities Ior a group oI related random
variables. It is used to describe the probabilities oI a group oI continuous random
variables iI all oI the individual variables Iollow a normal distribution.

When we have a group oI assets, we can model the distribution oI returns on each
asset individually, or the distribution oI returns on the assets as a group. A multivariate
normal distribution Ior the returns on n stocks is completely deIined by three lists oI
parameters:
the list oI the mean returns on the individual securities (n means in total).
the list oI the securities' variances oI return (n variances in total).
the list oI all the distinct pair wise return correlations ( n(n-1)/2 distinct
correlations in total).

The need to speciIy correlations is a distinguishing Ieature oI the multivariate normal
distribution in contrast to the univariate normal distribution. Consider a portIolio
consisting oI 2 assets (n 2). The multivariate normal distribution can be deIined
with 2 means, 2 variances, and 2 x (2-1)/2 1 correlation. II we have a portIolio oI
100 securities, The multivariate normal distribution can be deIined with 100 means,
100 variances, and 100 x (100 - 1)/2 4950 correlations. PortIolio return is a
weighted average oI the returns on the 100 securities. A weighted average is a linear
combination. Thus, portIolio return is normally distributed iI the individual security
returns are (joint) normally distributed. In order to speciIy the normal distribution Ior
portIolio return, we need means, variances and the distinct pair wise correlations oI
the component securities.

p. explain the role of correlation in the multivariate normal distribution.
CFACENTER.COM 49

see LOS o please.

q. define shortfall risk.

Shortfall risk is the risk that portIolio value will Iall below some minimum
acceptable level over some time horizon. The risk that assets in a deIined beneIit plan
will Iall below plan liabilities is an example oI a shortIall risk. ThereIore, shortIall
risk is a downside risk. In contrast, when a risk-averse investor makes portIolio
decisions in terms oI the mean return and the variance (or standard deviation) oI
return, both upside and downside risks are considered. For example, portIolios A and
B have the same mean return oI 20. The standard deviations oI the returns on A and
B are 5 and 8 respectively. PortIolio B has a higher risk because its standard
deviation is higher. However, though the return on portIolio B is more likely to Iall
below 20, it's also more likely to exceed 20.

SaIety-Iirst rules Iocus on shortIall risk.

r. calculate the safety-first ratio and select an optimal portfolio using Roy's
safetyfirst criterion.

Suppose an investor views any return below a level oI R
L
as unacceptable. Roy's
saIety-Iirst criterion states that the optimal portIolio minimizes the probability that
portIolio return, R
P
, Ialls below the threshold level, R
L
. In symbols, the investor's
objective is to choose a portIolio that minimizes P(R
P
R
L
). When portIolio returns
are normally distributed, we can calculate P(R
P
R
L
) using the number oI standard
deviations R
L
lies below the expected portIolio return, E(R
P
). The portIolio Ior which
E(R
P
) - R
L
is largest in terms oI units oI standard deviations minimizes P(R
P
R
L
).
Thus, iI returns are normally distributed, the saIety-Iirst optimal portIolio maximizes
the saIety-Iirst ratio (SFRatio):

SFRatio |E(R
P
) - R
L
| / s
P

The quantity E(R
P
) - R
L
is the distance Irom the mean return to the shortIall level. It
measures the excess return over the threshold return level. SFRatio gives the distance
in units oI standard deviation: it measures the excess return over the threshold level
CFACENTER.COM 50
per unit oI risk.

For example, the expected return on a portIolio is 20, and the standard deviation oI
the portIolio return is 15. Suppose the minimum acceptable return level is 10.
SFRatio (20 - 10)/15 0.67.

Note that the SFRatio is similar to the Sharpe ratio (E(R
p
) - R
I
)/standard deviation,
where R
I
is the risk-Iree rate. The SFRatio becomes the Sharpe ratio iI we substitute
the risk Iree rate Ior the threshold return RL. ThereIore, the saIety-ratio Iocuses on the
excess return over the threshold return, while the Sharpe ratio Iocuses on the excess
return over the risk-Iree rate.

Roy's saIety Iirst criterion states that the optimal portIolio should minimize the
probability that the rate oI return oI the portIolio (R
P
) will Iall below a stated
threshold level (R
L
). II returns are normally distributed, it states that the optimal
portIolio maximizes the saIety-Iirst ratio. ThereIore, assuming that returns are
normally distributed, the saIety-Iirst optimal portIolio can be selected using one oI the
Iollowing two criteria:
Lowest probability oI R
P
R
L
, or
Highest saIety-Iirst ratio.

There are three steps in choosing among portIolios using Roy's criterion (assuming
normality):
calculate the portIolio's SFRatio.
evaluate the standard normal cdI at the value calculated Ior the SFRatio; the
probability that return will be less than R
L
is N(-SFRatio).
choose the portIolio with the lowest probability.

s. explain the relationship between the lognormal and normal distributions.

A random variable Y Iollows a lognormal distribution iI its natural logarithm, lnY, is
normally distributed. You can think the term lognormal as "the log is normal". For
example, suppose X is a normal random variable, and Y e
X
. ThereIore, LnY Ln(e
X
)
X. Because X is normally distributed, Y Iollows a lognormal distribution.

Like the normal distribution, the lognormal distribution is completely
described by two parameters: mean and variance.
Unlike the normal distribution, the lognormal distribution is deIined in terms
oI the parameters oI the associated normal distribution. Note that the mean oI
Y is not equal to the mean oI X, and the variance oI Y is not equal to the
CFACENTER.COM 51
variance oI X. In contrast, the normal distribution is deIined by its own mean
and variance.
The lognormal distribution is bounded below by 0. In contrast, the normal
distribution extends to - inIinite without limit.
The lognormal distribution is skewed to the right (that is, it has a long right
tail). In contrast, the normal distribution is bell-shaped (i.e. it's symmetrical).

The reverse is also true: iI a random variable Y Iollows a lognormal distribution, then
its natural logarithm, lnY, is normally distributed.

t. distinguish between discretely and continuously compounded rates of return.

A discretely compounded rate of return measures the rate oI changes in the value oI
asset over a period under the assumption that the number oI compounding periods is
countable. Most standard deposit and loan instruments are compounded at discrete
and evenly spaced periods, such as annually or monthly. For example, suppose that
the holding period return on a stock over a year is 50. II the rate oI return is
compounded on a quarterly basis, the compounded quarterly rate oI return on the
stock is ( 1 0.5)1/4 - 1 10.67.

The continuously compounded rate of return measures the rate oI change in the
value oI an asset associated with a holding period under the assumption oI
continuously compounding. It is the natural logarithm oI 1 plus the holding period
return, or equivalently, the natural logarithm oI the ending price over the beginning
price. From t to t 1:
r
t, t1
ln(S
t 1
/S
t
) ln(1 R
t, t 1
)

S: stock price. R
t, t 1
: the rate oI return Irom t to t 1.

For example, S
0
$30, S
1
$34.50. ~ R
t, t 1
$34.50/$30 - 1 0.15, and r
0, 1

0.139762. The continuously compounded return is smaller than the associated holding
CFACENTER.COM 52
period return.

u. calculate a continuously compounded return, given a specific holding period
return.

Use Iormula in LOS t.
v. explain Monte Carlo simulation and historical simulation and describe their
major applications and limitations.
When a system is too complex to be analyzed using ordinary methods, investment
analysts Irequently use Monte Carlo simulation. An integral part is the generation oI a
large number oI random samples Irom a probability distribution or distributions.
Monte Carlo simulation in Iinance involves the use oI a computer to represent the
operation oI a complex Iinancial system.

It allows us to experiment with a proposed policy beIore actually
implementing it to assess the risks. For example, it is used to simulate the
interaction oI pension assets and liabilities oI deIined beneIit pension plans.
It is widely used to develop estimates oI Value at Risk (VAR). VAR involves
estimating the probability that portIolio losses exceed a predeIined level.
It is used to value complex securities such as European options,
mortgage-backed securities with complex embedded options.
Researchers use it to test their models and tools.

Limitations oI Monte Carlo Simulation:
It is a complement to analytical methods. It provides only statistical estimates,
not exact results.
It does not directly provide precise insights as analytical methods do. For
example, it cannot reveal cause-and-eIIect relationships.

Historic simulation samples Irom a historical record oI returns (or other underlying
variables) to simulate a process because the historical record provides the most direct
evidence on distributions (and that the past applies to the Iuture). In contrast, Monte
Carlo simulation uses a random number generator with a speciIied distribution. A
drawback is that any risk not represented in the time period selected will not be
reIlected in the simulation. For example, iI a stock market crash did not take place in
the sample period, such a risk will not be reIlected in the simulation. Besides, it does
not lend itselI to "what-iI" analysis.

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