CFA Level One Quantitative Methods:

Session 2 Basic Statistics and Probability

Frequency Distributions:
Appropriate Number of Classes 2
k
N (N = total number of observations)
Sample Mean
N
x
x

Weighted Mean

) (
) (
w
wx
x
w
Median: midpoint in the data (half of datapoints above and half below) important if mean is affected by
outliers
Mode: most frequently occurring value
Positive Skewness: Mode < Median < Mean
Negative Skewness: Mean < Median < Mode
Arithmetic Mean (using classes)
N
fx
x

(where f = frequency of observations in a class)

Median (locate the class in which the median lies and interpolate with:
i
f
CF
n
L Median .
2
1
1
]
1

+
(where L = lower limit of class containing the median; CF = cumulative frequency preceding the median
class; f = frequency of observations in the median class; I = class interval of median class)
Variance and Standard Deviation:
Sample Sandard Deviation
( )
1 1
) (
2
2
2

n
n
x
x
n
x x
s
For population Std Dev, use

instead of x and use N instead of n-1

(Variance is the square of Std Dev)
For a frequency distribution:
( )
1
2
2

n
n
fx
fx
s
(f is frequency by class; x the class midpoint)
68% of observations are within 1 S.D. of the mean
95% of observations are within 2 S.D. of the mean
99.7% of observations are within 3 S.D. of the mean
Coefficient of Variance enables comparison of two or more S.D.s where the units differ:
100 .
1
]
1

x
StdDev
CV
Skewness can be quantified using:
[ ]
StdDev
Median Mean
S
k

. 3
Basic Probability
For mutually exclusive events: P(A or B) = P(A) + P(B)
For non-mutually exclusive events: P(A or B) = P(A) + P(B) P(A and B)
For independent events: P(A and B) = P(A) x P(B)
For conditional events: P(A and B) = P(A) x P(B given that A occurs) = P(A) x P(B|A)
Bayes theory calculates the posterior probability which is a revision of probability based on a new event, i.e.
the probability that A occurs once we know B has occured:
P(A1|B) = P(A 1) x P(B|A1)
P(A1) x P(B|A1) + P(A2) x P(B|A2)
Mean of a Probability Distribution
[ ]

) (x xP
(where x is the value of a discrete random variable and P(x) the probability of that value occurring)
Standard Deviation of a Probability Distribution ( ) ( ) x P x

2
(Variance =
2
)
Binomial Probability
2 mutually exclusive outcomes for each trial
The random variable is the result of counting the successes of the total number of trials
The probability of success is constant from one trial to another
Trials are independent of one another
Binomial Probability of success: ( )
x n x
x
p p
x n x
n
P

) 1 (
)! ( !
!
Good for small values of n
For each value of n binomal tables can be used, plotted for a given value of n as:
- p (probability of success)
- x (number of observed successes)
Probabilities can be summed to give a cumulative probability
For a binomial distribution . . . .
Mean:
np
Std. Dev: ) 1 ( p np
Poisson Probability Distribution
Used when p < 0.05 and n > 100 (it is the limiting form of the binomial distribution function):
( )
!
) )( (
x
e
P
x
x

For a poisson distribution mean = variance np

2
so std dev. np
Poisson distribution tables are available and give the probability of x (number of successes) for a given
(mean number of successes)
Normal Probability Distribution
Standard Normal Distribution
Mean = median = mode
Mean = 0
= 1
Used as a comparison for other normal distributions
Z values
Used to standardize observations from normal distributions. The Z value describes how far an observation is
from the population mean in terms of standard deviations:
Z = Observation - Mean = x -
Std Dev
The area under the curve in a normal distribution between two values is the probability of an observation
falling between the two values.
A table of Z values is used to find the area under the normal curve between the mean and a particular figure;
these are given as a decimal so (x100) to get the percentage probability. These tables are used for:
Finding the probability that an observation will fall between the mean and a given value
A one-tailed test of Z
Finding the probability that an observation will fall in a range around the mean (a confidence interval)
A two-tailed test of Z
Confidence intervals are two tailed tests of Z at integer standard deviations and describe the probability of an
observation falling between the mean and n standard deviations from the mean
34% of observations fall between the mean and 1 so 68% t 1
45% of observations fall between the mean and 1.65 so 90% t 1.65
47.5% of observations fall between the mean and 1.96 so 95% t 1.96
49.5% of observations fall between the mean and 2.58 so 99% t 2.58
Standard Errors
Sampling error =
x
(also for Variance and Std. Dev. Is the diff between the sample statistic
and the population statistic)
A distribution of sample means from a large sample size has approximately normal distribution, a mean of
and a variance of
2
Point estimates are a single sample value used to estimate population parameters (e.g. sample mean x )
Interval estimates area calculated from the point estimates and describe the range around the point estimate in
which the population parameter is likely to fall for a given level of confidence as from Z values:
95% of the time population mean is within t 1.96 of the sample mean x
99% of the time population mean is within t 2.58 of the sample mean x
The standard error of sample means (std. Dev. of sample means distribution) proves this:
n
x


If is not known use sample standard deviation s
Calculation of the confidence intervals uses the Z values:
e.g. 95% confidence interval
,
_

t
n
s
x 96 . 1
For other intervals replace 1.96 with the Z value from the Z value table for a given confidence level
Hypothesis Testing
Step Action Steps
1 Write the Null
Hypothesis and the
Alternative
Hypothesis
H0 Will always contain an equality
H1 Never contains an equality
For a one tailed test H0 is greater than or equal to (or less than or equal to) a
given test value; H1 is subsequently less than (or greater than) the test value
For a two tailed test H0 is equal to a test value and H1 does not equal that
value
2 Select level of
significance
The significance level is the probability of rejecting the Null Hypothesis when
it is true (related to confidence intervals):
5% significance level: 95% confidence level . . . . t 1.96 (for 2 tailed test)
1% significance level: 99% confidence level . . . . t 2.58 (for 2 tailed test)
Risk of rejecting a correct H0 is risk; Risk of accepting a wrong H0 is risk
H0 Accept Reject
Is True correct error
Is False error correct
Step Action Comments
3 Calculate the test
statistic
Use:
n
x
Z

*
Where:
Z = Test statistic
x = Sample Mean

= Population Mean (H0)

= Standard error of sample means (if unavailable use sample std. dev.**)
* for single observations use just Z value
Z = x-

**
n
s
s
x

4 Establish the
decision rule
The decision rule states when to reject the null hypothesis:
How many Standard Deviations (Z) the sample mean x must be from
H0 in order to be rejected
Driven by the significance level
Critical Z value
Significance Level One tailed Two tailed
10% 1.29 1.65
5% 1.645 1.96
1% 2.33 2.58
If the sample mean is less than the critical Z value from H0 then the null
hypothesis is accepted
5 Make the decision Based on the data
Addtionally, P-values are considered; this is the probability of observing another sample as extreme as the
current one assuming that the null hypothesis is true.
If the P-value is less than the significance level then H0 is rejected. For a two-tailed test:
Pvalue = 2 x (0.5 - The area under the curve from the centre of the distribution to Z *)
* taken from the standard Z tables
Correlation Coefficient:
[ ][ ]

2 2 2 2
) ( ) ( ) ( ) (
) )( ( ) (
y y n x x n
y x xy n
r

Coefficient of determination = R
2
= r
2
= % of Ys variability explained by variability in X
Ys total variability
e.g. R
2
= 0.80 between a stock and the index means that 80% of the stocks movement is explained by
movement in the index (systematic risk) and 20% is specific to the stock (unsystematic risk)
Total risk = Systematic Risk + Unsystematic Risk
t-statistics and hypothesis testing
t-Statistics are used in place of Z-statistics for small (n < 30) samples; they are used in hypothesis testing just
as the Z-statistic
2
1
2
r
n r
t

(r = correlation coefficient; r
2
= coefficient of determination ; n-2 = degrees of freedom)
Us t-Statistics to determine if the correlation of x and y is significantly different from zero; i.e. the null
hypothesis is that x and y are uncorrelated:
H0: r = 0
H0: r 0
Once the t-value is computed look up on a table of critical t-values for a given number of degrees of freedom
and significance level; if the computed t-value is greater than the critical t-value then reject the null
hypothesis.
Linear Regression Analysis
Relationship between x and y can be shown on a regression line the best fit straight line through a set of
data points. The regression line is found by the least squares principle and is based on the equation for a
straight line:
bx a y +
where:

2 2
) ( ) (
) )( ( ) (
x x n
y x xy n
b and
n
x
b
n
y
a


Non Linear series (e.g. a curvilinear series) can be plotted by taking logs (NB a curvilinear series is an
example of compounding and is exponential)
log (Y) = log (a) + log (bX)
Once the linear relationship has been established then the Standard Error can be calculated using the sum of
squared errors (SSE) method:
( )
2
'
2
,

n
y y
S
i
y x
Where y' is the value of y for each value of x from the regression line and yi is the actual value of y for each x
Could also use:
2
) ( ) (
2
,

n
xy b y a y
S
y x
In order to determine how good the regression is (i.e. how closely correlated variation is y is with variation in
x) we use the coefficient of determination R
2

( ) [ ] ( ) [ ]
( )

2
2 2
2
'
y y
y y y y
R
i
where ( )

2
' y y
i
= SSE; ( )

2
y y = ys sum of
squares
As SSE tends to 0; R
2
tends to 1; telling us that the observations of y for a given x are falling closer and closer
onto the regression line.
Also since
r R
2
; when R
2
= 1; r = 1; so as r tends to 0; the standards error of estimates tends to y (the
standard deviation of y)
The following assumptions underpin linear regression:
Normality: for each observation of x the distribution of dependent y variables is normal
Linearity: the mean of each dependent observation y lies on the regression line
Homoskedasticity: the variability of y doesnt change with x
Statistical Independence: the dependent observations of y are unrelated to one another
Confidence intervals are used in regression analysis to determine the range in which a dependent variable y
lies for a given value of the independent variable x and to determine the probability that it applies to the whole
group:
Confidence Interval:
( )
( )
1
1
1
1
]
1

+ t

n
x
x
x x
n
Error Std t y
n prob 2
2
2
2 ,
1
) . )( ( '
The prediction interval is very similar but applies only to a specific dependent variable and not to the entire
group:
Prediction Interval
( )
( )
1
1
1
1
]
1

+ + t

n
x
x
x x
n
Error Std t y
n prob 2
2
2
2 ,
1
1 ) . )( ( '
The prediction interval is wider than the confidence interval since we are less confident to predict a specific
value of y from x than predicting the value for a group
As SSE increases the confidence and prediction intervals widen i.e. the error factor (unsystematic risk)
increases and confidence in using the regression model to predict y falls
Steps for using the confidence and prediction intervals:
First compute the intercept and the slope for the data set (from equations for the b and a constants)
Compute the standard error estimate from:
2
) ( ) (
2
,

n
xy b y a y
S
y x
Then, clarify the confidence and prediction interval that we are trying to compute i.e. what data are
we seeking for which a confidence or prediction interval is needed
Find the critical t-Statistic for the given significance level and degrees of freedom (n 2)
Compute the confidence and prediction interval using the equations above (NB for a small sample size
adjustment is seldom required so use:
Confidence interval = prediction interval
) . )( ( '
2 ,
Error Std t y
n prob
t
Time Series
A data set which is a function of time e.g. a stock price series
Key components:
Secular trend: smooth, long term trend embedded in a time series
Cyclical trend: intermediated term variation (> 1 year) e.g. the business cycle
Seasonal variation: shorter term variation (< 1 year) patters than may repeat over time
Irregular variation episodic variation that is definable but unpredictable
The linear trend equation is the same as the basic regression equation but t replaces x:
y = a + bt
where:

n
t
t
n
t y
ty
b
2
2
) (
) (
) )( (
) (
and
n
t
b
n
y
a


Moving averages smooth out the variability of a data series by calculating and plotting a series of simple
averages. In order to apply a moving average the data series must have a Linear Trend (T) and a Rhythmic
Cycle (C) the moving average smoothes out the cyclical and irregular components of a time series.
PVs, FVs, Annuities and Holding Periods
Future Value:
n
y
i
PV FV

'

+ 1
Present Value:
n
y
i
FV
PV

'

1
Rule of 72: 72 = time taken for money to double
Percentage i
Future Value of an Ordinary Annuity:

'

1
1
]
1

,
_

y
i
y
i
PMT FV
n
1 1
Present Value of an Ordinary Annuity:

'

1
1
1
1
1
1
]
1

,
_

,
_

1
1
1
1
]
1

,
_

n
y
i
y
i
y
i
PMT PV
1
1 1
Assumes annual payments received at the end of each time period
NB for an annuity due payments fall at the start of each period so to calculate the PV either:
Set the HP12C into begin mode
or
Treat as an ordinary annuity that is one year shorter than the annuity due and simply add back on the
very first payment which will be received at its net value
Present Value of a Perpetuity:
y
i
PMT
PV
(for console bonds and pref. stock)
Non-annual compounding and amortisation:
To get Effective Annual Rate: 1
1

,
_

n
n
i
EAR (i = rate per period; n = periods per year)
To get back: ( ) [ ] 1 1 +
n
EAR n i
The limiting condition is continuous compounding:

,
_

n
y
i
e PV FV
.
.
For amortising loans:
Interest Paid = Starting balance x Interest Rate
Principle Paid = Payment Interest Paid
New Balance = Previous Starting Balance Principle Paid
Holding Period Return = HPR = Ending Value of Investment
Beginning Value of Investment
Holding Period Yield = HPY = HPR - 1
Annualised HPR
n
HPR
1

Annualised HPY
1
1

n
HPR
If the investment returns dividends this must also be included: HPR(div) = Dividend + Ending Value
Beginning Value
The simple average yield of a number of investments over time is given by the Arithmetic mean:
n
HPY
AM

Alternatively the geometric mean return can be calculated for a series of investments to incorporate any
variance:
1

n
HPR GM
Attributes of Arithmetic and Geometric Mean:
Geometric mean is the best measure of historical returns as it represents the compound annual rate of
return
AM GM; Any variance between HPRs will reduce the GM, in the absence of variance AM = GM:
GM
2
= AM
2
Variance
AM can give nonsensical results: e.g. $1 invested that doubled to $2 and then fell back to $1 over
subsequent periods would have HPYs of 100% and 50% this gives an AM(HPY) of 25%; GM returns
the true HPY of 0% - since we began with $1 and finished with $1
Average Portfolio Returns:

W HPY HPY
investment portfolio
.
) ( ) (
Expected Return: ER = (probability of a possible return) x (Value of Return)
Variance of Returns: Variance(returns) = (probability of a possible return) x (Value of Return - ER)
2
Std. Dev. Returns =
) (returns
Variance
Coefficient of Variation (of returns):
ER
CV
returns) (

CV gives a relative risk per unit return which can be used to determine which of two stocks is more risky
Historical Risk:
n
Y P H HPY

2
) (

Expected Return (Stocks and Stock Indices): ER = Expected Div. + [End Price Beginning Price]
Beginning Price