FE2707 Expe

ted value/mathemati al expe tation 1

FE2707 Expe ted value/mathemati al expe tation

The expe ted value plays a large role in ones ability to determine the reasonable out ome
of a gamble, whi h in turn should determine how mu h one would be willing to pay for
said gamble. Two examples will serve to illustrate. Suppose that one is to determine
the pri e of a sto k tomorrow by throwing a fair six sided die, the pri e being the
value thrown. How mu h should one be willing to pay for this sto k today? Suppose
that an individual will live for t more years with probability p(t) and wishes to buy
a life insuran e poli y worth one million dollars. What monthly premium should the
insuran e ompany harge?
One approa h to answering these questions is through the expe ted value of the
gamble, whi h we illustrate with the sto k example. The sto k takes on values (in
dollars) in the set f1; 2; 3; 4; 5; 6g, ea h with probability 61 . If the gamble is taken many
times, or if one bets on many su h sto ks, say 600, then about 100 will be pri ed at 1,
100 at 2, et . The total value will be 100  (1 + 2 + 3 + 4 + 5 + 6) = $2100, an \average"
of about $3:50 per sto k. Thus, a risk neutral player should be willing to pay $3:50
for this sto k, less if risk averse, and more if risk seeking. As will be seen below, the
mathemati al expe tation of this gamble is exa tly $3:50. This onne tion between the
expe tation and the intuitive notion of \average" is what motivates the formal denition,
and in ertain ases, one an show that the average and the expe tation approa h ea h
other with arbitrary pre ision as the number of times one takes the gamble be omes
large. In short, the expe tation is a powerful tool that serves to represent the out ome
of a (perhaps ompli ated) gamble by a single value.
Denition of Expe tation. The formal version of a gamble is a random variable X
that an take on values ! in some set,
. The two ases onsidered here are when

is dis rete/ ountable (as with the sto k example), or when

is some subset of the
real line (as with the life insuran e example). In the dis rete ase, a probability mass
fun tion p(!i) denes the probability that X = !i. In the ontinuous ase, a probability
density fun tion p(!)d! denes the probability that X 2 [!; ! + d!). Let f (X ) be any
fun tion of the random variable X , sometimes alled the payo fun tion. Then, the
mathemati al expe tation of f , E [f (X )℄, is dened by
E [f (X )℄ =
P p(!i)f (!i) E [f (X )℄ = R d! p(!)f (!)
! 2

! 2

i
i
(1)
(Dis rete) (Continuous)
whenever the summation or integral satises ertain onvergen e properties (see for
example DeGroot and S hervish, 2002, h.4), otherwise it does not exist. In words,
multiply ea h possible payo by the probability of obtaining that payo and then take
the sum. When f (X ) is a return on an investment, one usually refers to the expe ted
return.
Examples.
 FE2707 Expe ted value/mathemati al expe tation 2

(i) Sto k example.

= f1; 2; 3; 4; 5; 6g, with p(!i) = 16 . f (X ) = X is the pri e of the
sto k. The expe ted sto k pri e is given E [f (X )℄ = 61 (1 + 2 + 3 + 4 + 5 + 6) = 3:5.
(ii) Life insuran e example.
= [0; 1). Let p(t) be the probability density that
! = t, i.e. that the insuree dies at time t. Suppose that the net prot (fa toring
in the present value of the premiums minus R 1
the pay-out) is given by f (t). Then,
the expe ted prot is given by E [f (t)℄ = 0 dt p(t)f (t), whi h will be a fun tion
of the premium. By in reasing the premium, the insuran e ompany makes more
expe ted prot per poli y sold, but the quantity of su h poli ies sold will be lower.
The insuran e ompany will thus try to maximize total prot taking into a ount
this trade o.
(iii) St. Petersberg paradox. The following gamble was invented by Daniel Bernoulli,
1700{1782. Person A tosses a oin until the rst head appears. If the rst head
appears at toss n, A pays B 2n dollars. How mu h should B be willing to pay
to play this gamble? Let X , the random variable be the toss on whi h the
rst head appears. then
= f1; 2; 3; : : :g, with probabilities f 21 ; 14 ; 81 ; : : :g. The
Ppayo f (X ) is given by f2; 4; 8; : : :g, and so the expe ted value of the payo is
f (!i)p(!i ) = 1 + 1 + 1 + : : : = 1. This is an example where the expe tation
does not exist, and so it is not lear how mu h this gamble is worth based on the
expe tation.
Some useful properties of the expe tation.
(i) Linearity.If the payo is the linear sum of two payos that may ea h depend on
dierent random variables, then the expe ted payo is the linear sum of the two
expe ted payos.
(ii) Produ t. If the payo is the produ t of two payos that ea h depend on dierent
independent random variables, then the expe ted payo is the produ t of the

expe ted payos.

(iii) Central Limit Theorem. If the same gamble is played independently many times,
then the average of the payos will approa h the mathemati al expe tation,
provided ertain mathemati al onditions are met.
While the expe tation gives a reasonable hara terization for the out ome of a gamble,
it an be used to hara terize its risk as well. Many measures of risk based on the
expe tation an be devised, the most often used being the varian e. If the payo fun tion
is f (X ) then the varian e is dened by V ar(X ) = E [f (X )2℄ E [f (X )℄2. More details
regarding the expe tation an be found in DeGroot and S hervish (2002, h.4) and Feller
(1968, h.9) and more te hni al dis ussions regarding probability and expe tations an
be found in Billingsley (1986, h.4). The expe tations of ertain well know distributions
an also be found in these referen es, as well as te hniques for omputing expe tations.
The denitions an be generalized to onditional expe tations, and expe tations of
fun tions of more than one random variable, whi h an be found in the further reading.
Malik Magdon-Ismail
 FE2707 Expe ted value/mathemati al expe tation 3

Further Reading
Billingsley, P. (1986). Probability and Measure. Wiley Series in Probability and
Mathemati al Statisti s. Wiley.
DeGroot, M. H. and S hervish, M. J. (2002). Probability and Statisti s. Addison{Wesley,
Reading, Massa husetts.
Devore, J. L. (1999). Probability and Statisti s for Engineering and the S ien es.
Duxbury Press.
Feller, W. (1968). An Introdu tion to Probability Theory and its Appli ations, volume 1.
John Wiley & Sons, New York.
Larsen, R. and Marx, M. (1986). An Introdu tion to Mathemati al Statisti s. Prenti e-
Hall, New Jersey.
Ross, S. M. (2001). A First Course in Probability. Prenti e Hall, New Jersey.
See also: Averages ( omputations), Bayes theorem and risk analysis, Central limit
theorem, De ision tree analysis, Martingales, Probability (fundamentals), Risk-return
tradeo.