Name______SOLUTION_________

Business Statistics
Midterm Exam
Fall 2013
Russell




Do not turn over this page until you are told to do so. You will have 2 hours to complete
the exam. There are a total of 100 points divided into three parts. The true and false
questions are worth 10 points, the multiple choice are 3 points each for a total of 30
points and the long answer questions are worth 60 points. You can use one side of an
8.5x11 sheet of notes during the exam. No other notes are permitted. You may use a
calculator. Please write clearly and provide answers in the space provided. If you need
additional space use the back of the exam pages and clearly organize your work.



Students in my class are required to adhere to the standards of conduct in the Booth
Honor Code and the Booth Standards of Scholarship. The Booth Honor Code also
requires students to sign the following Booth Honor pledge,

"I pledge my honor that I have not violated the Honor Code during this examination. I
also understand that discussing the contents of this exam before all students have
completed the exam would be a violation of the Honor Code".

Please sign here to acknowledge _______________________________

2

I. True or False
Clearly indicate the best answer by circling T or F indicating that the statement is
true or false respectively. If neither T nor F is clearly indicated the problem will
be marked as incorrect. Each problem is worth 1 point.


T F For a given set of returns data, converting the data from returns, to returns
measured in percent will result in a sample mean and sample standard deviation
that is 100 times larger.

T F If a histogram has a long right tail and short left tail, the median will be above the
mean.

T F If the sample covariance is near 1 then there must be a very strong positive
relationship between the two variables.

T F For any continuous random variable X, ( ) Pr .68 X o o < < + = .

T F If two random variables X and Y are independent then the correlation must be
zero.

T F If you play 100 slot machines and whether or not you win is an iid Bernoulli with
probability .01, the probability that you dont get any winners is .366.

T F Standardized values from a data set obtained by subtracting the mean and dividing
by the standard deviation that are larger than three are always very rare events.

T F If X and Y are identically distributed random variables, they have the same mean
and variance.

T F Daily temperatures in Chicago could be modeled well as an IID process.

T F For a sample average ( x ) constructed from 50 iid draws from the random
variable X, ( ) E X x = .




3
II. Multiple choice: Clearly circle the answer that is best. Each problem is worth 3
points for a total of 30. No partial credit will be given in this section. If no
answer is clearly circled the problem will be marked as incorrect.

For problems 1 and 2 consider the data set 1 3 2 3 5.

1. What is the sample average?

a. 3
b. 2
c. 2.5
d. 2.8
e. None of the above.

2. What is the sample variance?

a. 2.1
b. 2.2
c. 2.3
d. 4
e. None of the above.

Refer to the following table for questions 3 and 4. Let X denote the number of service
visits required to fix a problem with a product purchased from a company.


x 1 2 3 4
P(x) .6 .2 .15 .05


3. The probability that it will take more than 2 visits?

a. .8
b. .2
c. .55
d. 1.0
e. None of the above.

4. Given that it takes more than one visit, what is the probability that it will take 4
visits?

a. .5625
b. .3352
c. .3751
d. .125
e. None of the above.
4

Suppose annual returns for a mutual fund are N(.1792, .12
2
). Use the following table to
answer questions 5-8.

Nor mal wi t h mean = 0. 179200 and st andar d devi at i on = 0. 120000

x P( X <= x)
- 0. 1000 0. 0100
0. 0000 0. 0677
0. 1000 0. 2546
0. 2000 0. 5688
0. 3000 0. 8430
0. 4000 0. 9671

5. What is the probability that the return on the fund is negative?

a. 23.34%
b. 6.77%
c. 1%
d. 93.33%
e. None of the above.


6. What is the probability that the return on the fund is between 0 and .2?

a. 49.11%
b. 35.43%
c. 56.88%
d. 50.11%
e. None of the above.

7. What is the probability that the return will be larger than .2?
a. 0.7652
b. 0.2134
c. 0.5375
d. 0.4312

8. Find the value such that there is a 1% chance that the return is less than that value.

a. 0
b. .1
c. .3
d. -.1
f. None of the above.




5
Use the following histogram for problems 9 and 10.


x
F
r
e
q
u
e
n
c
y
8 6 4 2 0 -2 -4
12
10
8
6
4
2
0
Histogram of x





9. The distribution looks roughly normal with mean and standard deviation given by:

a. =2 and o=4
b. =3 and o=4
c. =2 and o=3
d. =3 and o=3
e. None of the above.

10. By viewing the histogram above, what can you say about the data:

a. iid
b. Independent but not identically distributed
c. Identically distributed but not independent
d. Dependent
e. Not enough information to tell.
6
III. Long answer questions. Try to do work in the space provided under each
question and be show all work in order to facilitate partial credit. Be sure to clearly
indicate your final answer and complete all computations. This section is worth 60
points.

Problem 1. (12 points)

Here are the summary statistics for the returns on two assets

Descriptive Statistics: usa, france

Var i abl e N N* Mean St Dev
usa 107 0 0. 01346 0. 03328
f r ance 107 0 0. 01383 0. 05494

Covariances: france, usa

f r ance usa
f r ance 0. 00301820
usa 0. 00091587 0. 00110774

Consider a portfolio that invests 20% into a risk free asset that will obtain a .05 return
over the next year, 50% in the USA asset and 30% in the French asset. Hence,
.2(.05) .5 .3
USA France
P R R = + + .

a. Find the mean of P


E(P) =0.2*0.05 +0.5*E(R
USA
) +0.3* E(R
France
)
=0.2*0.05 +0.5*0.01346 +0.3*0.01383
=0.0209






b. Find the variance of P.

Riskfree rate is a constant no variance or covariance with the risky assets.

Var(P) =(0.5
2
)*Var(R
USA
) +(0.3
2
)* Var(R
France
) +2*0.5*0.3*Covar(R
USA
, R
France
)
=(0.5
2
)*(0.03328
2
) +(0.3
2
)*(0.05494
2
) +2*0.5*0.3*0.00091587
=0.000823




7






Suppose instead that you borrow at the risk free rate and use the money to invest in the
USA and France assets. Suppose that your weights are .2(.05) .75 .45
USA France
P R R = + + .

c. What is the mean of P now?

E(P) =-0.2*0.05 +0.75*E(R
USA
) +0.45* E(R
France
)
=(-0.2)*0.05 +0.75*0.01346 +0.45*0.01383
=0.00632













d. What is the variance of P now?

Var(P) =(0.75
2
)*Var(R
USA
) +(0.45
2
)* Var(R
France
) +2*0.75*0.45*Covar(R
USA
, R
France
)
=(0.75
2
)*(0.03328
2
) +(0.45
2
)*(0.05494
2
) +2*0.75*0.45*0.00091587
=0.00185
8
Problem 2. (26 points)

Consider the following joint probability distribution for an indicator variable for whether
the economy is in an expansion or a contraction in quarter i and quarter i+1. X
i
=1
denotes a expansion and X
i
=0 denotes a contraction in quarter i. The series is a first
order Markov model so that ( ) ( )
1 1 0 1
Pr | , ,... Pr |
i i i i i
X X X X X X
+ +
= . Consider the
following joint model for X
i
and X
i+1
:

X
i

0 1
X
i+1
0 .35 .15
1 .15 .35

a. Are consecutive expansion/contraction indicators dependent or independent?
Explain.

Pr(X
i
=0) =0.35 +0.15 =0.5; Pr(X
i+1
=0) =0.35 +0.15 =0.5
Pr(X
i
=0, X
i+1
=0) =0.35 is not equal to the product of the marginals, hence dependent



b. Explain why X
i
and X
i+1
are identically distributed and state the distribution.

Pr(X
i
=0) =Pr(X
i+1
=0) =0.5
Pr(X
i
=1) =Pr(X
i+1
=1) =0.5
They have the same (unconditional) model


c. What is the probability of an expansion?

Pr(X
i
=1) =0.5

d. What is the mean of X
i
?

E(X
i
) =Pr(X
i
=0)*0 +Pr(X
i
=1)*1 =0.5*0 +0.5*1 =0.5



e. What is the variance of X
i
?

Var(X
i
) =Pr(X
i
=0)*(0 E(X
i
))
2
+Pr(X
i
=1)* (1 E(X
i
))
2

=0.5*0.5
2
+0.5*0.5
2

=0.25
9

f. Without doing any calculations, what is the sign of the correlation between X
i

and X
i+1
? State you logic.

Positive, since 70% (sum of diagonals) of the time they are the same value. There is a
good chance they are the same value.


g. What is the conditional distribution of X
i+1
given quarter i is a expansion
quarter?

Pr(X
i+1
=0|X
i
=1) =0.15/0.5 =0.3
Pr(X
i+1
=1|X
i
=1) =0.35/0.5 =0.7


h. What is the conditional distribution of X
i+1
given that quarter i is a
contraction?

Pr(X
i+1
=0|X
i
=0) =0.35/0.5 =0.7
Pr(X
i+1
=1|X
i
=0) =0.15/0.5 =0.3



i. What is the expected value for X
i+1
given that quarter i is a contraction?

E(X
i+1
|X
i
=0) =Pr(X
i+1
=0|X
i
=0)*0 +Pr(X
i+1
=1|X
i
=0)*1
=0.7*0 +0.3*1
=0.3




j. What is the probability of getting the sequence 0, 0, 0, 1, 1, 1, 1?

Markov, so only depend on the immediately past observation.

Pr(X
1
=0)*Pr(X
2
=0|X
1
=0)*Pr(X
3
=0|X
2
=0)*Pr(X
4
=1|X
3
=0)*Pr(X
5
=1|X
4
=
1)*Pr(X
6
=1|X
5
=1)*Pr(X
7
=1|X
6
=1)
=(0.5)*(0.7)*(0.7)*(0.3)*(0.7)*(0.7)*(0.7)
=0.0252




10

Problem 3. (10 points)

Whether or not any customer decides to purchase a phone after entering the store is iid
Bernoulli with probability .2. Suppose on Friday 76 potential customers enter the store
and on Saturday 122 customers enter the store.

a. Let
Fri
Y denote the total phone purchases on Friday. What is the model for
Fri
Y ?

Binomial(76, 0.2)








b. Let
Sat
Y denote the total phone purchases on Friday. What is the model for
Sat
Y ?

Binomial(122, 0.2)







c. Let T denote the total sales on Friday and Saturday. What is the model for T?

Binomial(198, 0.2)







d. What are the mean and variance of T?

E(T) =np =198*0.2 =39.6
Var(T) =np(1 p) =31.68


11
Problem 4. (12 points)

Lets consider an extension of the random walk model
1 t t t
y y x

= + that is a little
more realistic. Lets allow for the variance of the change in the asset price to vary
over time. Typically we find that declining prices tend to be associated with more
volatile stock returns. We capture this by saying that x
t
has a distribution that
depends on the past values of x
t
in the following way:


x
t
Pr(x
t
|x
t-1
<0)

1 .4
0 .2
-1 .4
And
x
t

( )
1
| 0
t t
P x x

>

1 .3
0 .40
-1 .3

a. What are the mean and variance of the change x
t
following declining prices?

E(x
t
|x
t-1
<0) =0.4*1 +0.2*0 +0.4*(-1) =0

Var(x
t
|x
t-1
<0) =0.4*(1 0)
2
+0.2*(0 0)
2
=0.4*(-1 0)
2
=0.8







b. What are the mean and variance of the change in x
t
following rising (or no
change in) prices?

E(x
t
|x
t-1
>=0) =0.3*1 +0.4*0 +0.3*(-1) =0

Var(x
t
|x
t-1
>=0) =0.3*(1 0)
2
+0.4*(0 0)
2
=0.3*(-1 0)
2
=0.6





12

c. Now, given that y
t-1
=100 and y
t-2
=99 find the conditional model for y
t
.

Since y
t-1
=y
t-2
+x
t-1
, this means x
t-1
is 1 and is greater than zero.
We need to use Pr(x
t
|x
t-1
>=0). y
t
=y
t-1
+x
t
=100 +x
t

y_t Pr(y_t|y_t1,y_t2)
101 0.3
100 0.4
99 0.3


d. Again, given that y
t-1
=100 and y
t-2
=99 find the conditional model for y
t+1
.

Using part c, we have to try different cases for x
t
is greater than or equal to zero, versus if
x
t
is less than zero. If x
t
<0, we have to use the conditional probabilities in the first T-
chart. If x
t
>=0, we have to use the conditional probabilities in the second T-chart. We
end up with an asymmetrical conditional distribution.


y_t+1 Pr(y_t+1|y_t1,y_t2)
102 0.09
101 0.24
100 0.37
99 0.18
98 0.12







e. Suppose that you are holding a call option at 101 and a put option at 99 (this is
called a straddle). This position will deliver a positive payoff when the price
rises above 101 or falls below 99. What is the chance that this straddle
position delivers a positive payoff in period t+1 if y
t-1
=100 and y
t-2
=99?

This is just asking for the probability that y
t+1
is above 101 or below 99, i.e.

Pr(y
t+1
>101) +Pr(y
t+1
<99) =0.09 +0.12 =0.21