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edupristine Joint Probability

Consider the following information to calculate the joint probability P(RI) of a recession & an incre >>The probability of the monetary authority increasing interest rates (I) is 40% >>The probability of a recession ( R ) given an increase in interest rates is 70%.

P(I) P(R/I) P(RI)

0.40 0.70 0.28

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P(RI) of a recession & an increase in interest rates. reasing interest rates (I) is 40%. ncrease in interest rates is 70%.

The joint probability of two events is the probability that they will both occur. P(AB) = P(A/B)*P(B) The joint probability of A & B, P(AB), is equal to the conditional probability of A given B, P(A/B), times the unconditional probability of B, P(B).

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Probability that at Least One of Two Events will Occur

Using the information in the previous example and the fa determine the probability that either inte

Given that P(I) P(R) P(RI) P(I or R)

0.40 0.34 0.28 0.46

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previous example and the fact that the unconditional probability of a recission, P(R), is 34%, the probability that either interest rates will increase or a recession will occur.

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Suppose you are modelling long-term interest rates, and you believe that supply of corporate debt is a major contributing fa corporate debt stays constant, you believe that there is a 35% chance of increasing interest rates; if the supply of corpora increasing is 50%; of staying the same is 40%; of dropping is 10%

Solution P(A|S1) P(A|S2) P(A|S3) P(S1) P(S2) P(S3) Unconditional probability 0.60 0.35 0.05 0.50 0.40 0.10 44.5%

We use the total probability rule:

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ebt is a major contributing factor. Suppose you believe that the probability that rates will rise if supply of corporate debt rises is 60%; if the s ates; if the supply of corporate debt falls, you believe that there is a 5% chance of rates increasing. You think that the likelihood of corporate e is 40%; of dropping is 10%. What is the unconditional probability of interest rates rising?

se the total probability rule: P(A), the unconditional probability, = P(A|S1)*P(S1) + P(A|S2) *P(S2) + P(A|S3) *P(S3), where the Si represent mutually exclusive and exhaustive events.

orporate debt rises is 60%; if the supply of hink that the likelihood of corporate debt

), where

www.edup The probability distribution of EPS for Jain's stores is given in the figure below. Calculate the variance & standard deviation of EPS . Probability 20% 10% 30% 40% 100% Solution: E(EPS) $1.26 0.023 0.029 0.001 0.027 0.080 0.28 EPS ($) 1.6 1.8 1.2 1.0

Variance SD

Note: The units of standard deviation are the same as that of EPS. so we would say that the SD of EPS is $0.28

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hat the SD of EPS is $0.28

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Calculating Expected EPS using a Tree Diagram From the given outcome and its relative probabilities, calculate the expected EPS for Jain's stores. Outcomes Probability A good economy 65% A poor economy 35% A good economy & relatively good results at the co. 35% A good economy & relatively poor results at the co. 65% A poor economy & relatively good results at the co. 55% A poor economy & relatively poor results at the co. 45% Solution:

35%
y om n o ec 65% ood g A

1.74

65%

E(EPS) 1.54
Ap oor 35 eco % nom y

55%

1.17
45%

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35%

EPS Prob. EPS Prob.

2 18% 2 42%

65%

55% EPS

Prob. EPS Prob.

1 24% 1 16%

45%

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Assume that the european economy can be in three posssible states next year: boom, normal or slow economic growth. An expert source has calculated that P(boom) = 30%. P(normal) = 50% and P(slow) = 20%. The returns for two different stock under each of the economic states are provided in the table below. Calculate the covariance of the returns for the two stock Return under each economic states Events Stock A Stock B Boom 20% 30% Normal 12% 10% Slow 5% 0% Solution: P(boom) P(normal) P(slow) E(RA) E(RB) Covariance Computation Boom Normal Slow Cov(RA,RB)

30% 50% 20% 13% 14%

0.0034 0.0002 0.0022 0.0058

This example illustrate the use of a joint probability function. A joint probab random variables gives the probability of the joint occurance of specified o

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al or slow economic = 20%. The returns for late the covariance of the

probability function. A joint probability function for two the joint occurance of specified outcomes.

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Use the previous example to compute the correlation of the returns for the stocks A & B, given that variance of return for stock A = 0.0028 and stock B = 0.0124.

Solution: Var(RA) Var(RB) SD(RA) SD(RB)

Cov(RA,RB)

0.00280 0.01240 5% 11% 0.0058 0.9843

Since this value is close to +1 indica

Corr(RA,RB)

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close to +1 indicates that the linear relationship is not only positive but strong.

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A mortgage holding company has found that 3% of its mortgage holders default on their mortgage and lose the property. Fu the life of their mortgage as compared to 45% of those who do not default. What is the probability that a mortgagee with tw property?

Solution: P(D) P(D') P(L/D) P(L'/D) P(L/D') P(L'/D') 3% 97% 90% 10% 45% 55%

P(D/ L)
P(D/L)

PL / D* P(D) P(L / D) * P(D) P(L / D' ) * P(D' )

5.83%

Solving using a probability model

3%

97%

Sum the probability of late payment in both the states (Default & N

Now given the late payment, the probability that the mortgage w

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ortgage and lose the property. Furthermore, 90% of those who default are late on at least two monthly payments over obability that a mortgagee with two or more late monthly payments will default on the mortgage and lose the

90%
10%

2.70% (Default + Late)

0.30% (Default + Not-Late)

45%

43.65% (Not-Default + Late)

55%

53.35% (Not-Default + Not-Late)

ent in both the states (Default & Not-Dufault) =

46.35% 5.83%

e probability that the mortgage will default =

payments over