Statistical Analysis in Finance

Sessions 1 & 2:
Probability and Probability
Distributions

Dr. Nemanja Radić

www.cranfield.ac.uk/som

Statistical Analysis in Finance

Content :
SESSIONS 1 & 2: PROBABILITY AND PROBABILITY
DISTRIBUTIONS
Session 3: Sampling and Estimations
Session 4: Hypothesis Testing
Session 5: Problem Solving
Sessions 6 & 7: Regression Analysis
Session 8: Regression Models with Dummy Variables
Sessions 9 &10: Problem Solving and Exam Revision
2
 Statistical Analysis in Finance

Reading:
Statistical Techniques in Business and Economics
(17/E) by Douglas A. Lind, William G. Marchal and
Samuel A. Wathen 2017. McGraw-Hill. Chapters 5, 6
and 7.

Statistical Analysis in Finance

Course Assessment
The course will be assessed through closed book
examination.

Your knowledge and understanding of the subject will

be assessed through a closed book examination.
[100% of the marks]

4
 Intended Learning Outcomes

• Understand basic concepts of probability.

• Calculate probabilities using the rules of addition

and multiplication, and using a contingency table

• Discuss the characteristics and properties of a

probability distribution

• Describe and compute probabilities using some

common distributions
5

Definition of Probability

• A probability is a numerical value that measures

the likelihood that an uncertain event occurs.

• The value of a probability is between zero (0) and

one (1).

• A probability of zero indicates impossible events.

• A probability of one indicates definite events.

6
 Examples to clarify the definitions of the
terms experiment, outcome, and event

Fundamental Probability Concepts

• An experiment is a trial that results in one of

several uncertain outcomes.

• Example 1: Trying to assess the probability of an

athlete winning a medal in the men’s 1500m event
while competing in the next Olympic Games.

8
 Fundamental Probability Concepts (cont’d)

• A sample space, denoted S, of an experiment includes

all possible outcomes of the experiment.
• For example, a sample space containing letter grades
is:
S = {A, B,C, D, F}

• An event is a subset
of the sample space. A, B,C, D F
The event The simple event
“passing grades” “failing grades”
is a subset of S. is a subset of S.
9

Fundamental Probability Concepts (cont’d)

• Events are considered to be:

• Mutually exclusive If they do not share any
common outcome of a random experiment (i.e., only one
event can occur at a time). For example, the events
“earning a medal” and “failing to earn a medal” in a
single Olympic event are mutually exclusive.

• Exhaustive If all possible outcomes of a random

experiment are included in the events. For example, the
events “earning a medal” and “failing to earn a medal” in
a single Olympic event are exhaustive since these are
the only outcomes.
10
 Ways of Assigning Probability

1. SUBJECTIVE CONCEPT OF PROBABILITY

The likelihood (probability) of a particular event happening that is assigned
by an individual based on whatever information is available. It is calculated
by drawing on personal and subjective judgment.

• If there is little or no past experience or information on which to base a

probability, it may be arrived at subjectively.

• Illustrations of subjective probability are:

1. Asking Manchester City manager about the chance of Man City
winning the premiership before the session starts.

2. Estimating the likelihood the Euro currency will cease to exist in the
next 5 years.

3. Estimating the likelihood the UK budget deficit will be reduced by

half in the next 5 years.
11

Ways of Assigning Probability

2. EMPIRICAL PROBABILITY
The probability of an event happening is the fraction of the time
similar events happened in the past. It is calculated from data as a
relative frequency of occurrence.

• In Finance we often estimate the probability of an event as a

relative frequency of occurrence based on historical data.

• For example, Zidane (2012) report that of their sample of 16189

dividend changes for US firms during the years 1962 to 2010,
14911 were increases and 1278 were decreases. What is the
probability that a dividend change is a dividend decrease for US
firms?

12
 Ways of Assigning Probability

3. CLASSICAL PROBABILITY (A PRIORI PROBABILITY)

Based on the assumption that the outcomes of an experiment are
equally likely. It is based on logical analysis rather than observation or
personal judgment.
Consider an experiment of rolling a six-sided die. What is the
probability of the event “an even number of spots appear face up”?
The possible outcomes are:

There are three “favorable” outcomes (a two, a four, and a six) in the
collection of six equally likely possible outcomes.

13

To sum up…

14
 Combining Events

• Given a sample space consisting of simple events, we can define

events and then combine events to form new events.
• A Venn Diagram represents the sample space for the event(s).
• For example, this Venn Diagram illustrates the sample space
for events A and B.

A B

• The union of two events (A ∪ B) is the event consisting of all

simple events in A or B. 15

Combining Events (cont’d)

• The intersection of two • The complement of

events (A ∩ B) consists
of all simple events in
both A and B.
A∩B
event A (i.e., Ac) is the
event consisting of all
simple events in the
sample space S that are
not in A.

A B A Ac

A∪B 16
 Combining Events: Example 1

• Recall the Olympic medal’s sample space defined as

S = {gold, silver, bronze, no medal}. Given the
following, find A ∪ B, A ∩ B, A ∩ C, and Bc.
• A = {gold, silver, bronze}.
• B = {silver, bronze, no medal}.
• C = {no medal}.

• Solution:
• A ∪ B = {gold, silver, bronze, no medal}. Note that there is no
double counting.
• A ∩ B = {silver, bronze}. A ∩ C = Æ (null or empty set).
• Bc = {gold}.
17

Rules of Computing Probabilities: Addition

(cont’d)

• The Complement Rule

• The probability of the complement of an event,
P(Ac), is equal to one minus the probability of the
event.
Sample Space S

( )
P Ac = 1- P ( A) A Ac

19
 Rules of Computing Probabilities: Addition
(cont’d)

• Not mutually exclusive

• The probability that event A or B occurs, or that at least
one of these events occurs, is:
Events A and B
A∩B
both occur.

A B

A∪B A occurs or B occurs

or both occur.

P ( A ! B ) = P ( A) + P (B ) - P ( A " B ) 20

The concept of unconditional probability

• Unconditional (Marginal) Probability

• The probability of an event without any

restriction.

• For example, P(A) = probability of finding a

job, and P(B) = probability of prior work
experience.

21
 The concept of conditional probability

• The probability of an event given that another

event has already occurred.
• In the conditional probability statement, the
symbol “ | ” means “given.”
• Whatever follows “ | ” has already occurred.

• For example, P(A | B) = probability of finding a

job given prior work experience.

22

Conditional Probability (cont’d)

• Conditional Probabilities with the Venn Diagram,

P(A | B)

A B

• Since P(A | B) represents the probability of A

conditional on B (B has occurred), the relevant
portion of the sample space reduces to B.

• P(A | B) is based on the portion of A that is

included in B. 23
 Calculating a Conditional Probability

• Given two events A and B, each with a positive probability

of occurring, the probability that A occurs given that B has
occurred (A conditioned on B) is equal to:

P ( A ! B)
P ( A | B) =
P (B )

• Similarly, the probability that B occurs given that A has

occurred (B conditioned on A) is equal to:

P ( A ! B)
P (B | A) =
P ( A)
24

Calculating a Conditional Probability:

Example 2

• An economist predicts a 60% chance that country

A will perform poorly economically and a 25%
chance that country B will perform poorly
economically. There is also a 16% chance that both
countries will perform poorly. What is the probability
that country A performs poorly given that country B
performs poorly?

25
 The concept of independent events

• Independent and Dependent Events

• Two events are independent if the occurrence of one
event does not affect the probability of the occurrence of
the other event.
• Events are considered dependent if the occurrence of
one is related to the probability of the occurrence of the
other.

• Two events are independent if and only if

P ( A | B ) = P ( A) or P (B | A) = P (B )

• In Example 3: since P(A|B) = 0.64 ≠ P(A) = 0.60, events

A and B are not independent. 26

Rules of Computing Probabilities:

Multiplication

• Joint probability: A probability that measures

the likelihood two or more events will happen
concurrently.

• General rule of multiplication

• Special rule of multiplication

27
 Computing Probabilities:
General Multiplication Rule

• When two events are not independent we use

the general multiplication rule to compute the
joint probability, P(A∩B), is equal to

P( A ! B)
P( A / B) = Þ P( A ! B) = P( A / B) P( B)
P( B)

28

Computing Probabilities: Special

Multiplication Rule

• The Multiplication Rule for Independent

Events

• The joint probability of A and B equals the

product of the individual probabilities of A and B.

P ( A ! B ) = P ( A) P (B )

29
 Contingency Tables and Probabilities

• A contingency table generally shows frequencies for two

qualitative or categorical variables, x and y.
• Each cell represents a mutually exclusive combination
of the pair of x and y values.
• Here, x is “Age Group” with two outcomes
while y is “Brand Name” with three outcomes.

30

Contingency Tables and Probabilities

(cont’d)

• Note that each cell in the contingency table represents

a frequency.

• In the above table, 174 customers under the age of 35

purchased an Under Armour product.
• 54 customers at least 35 years old purchased an Under
Armour product.
31
 Contingency Tables and Probabilities
(cont’d)

• The contingency table may be used to calculate probabilities

using relative frequency.
• Note: Abbreviated labels have been used in place of the
class names in the table.

• First obtain the row and column totals.

• Sample size is equal to the total of the row totals or
column totals. In this case, n = 600.
32

Contingency Tables and Probabilities

(cont’d)

• Joint Probability Table

• The joint probability is determined by dividing each cell
frequency by the grand total.
Joint
Probabilities

Marginal
(unconditional)
Probabilities
• For example, the probability that a randomly selected
person is under 35 years of age and makes an Under
Armour purchase is
174
P ( A ! B1 ) = = 0.29
600 33
 Contingency Tables and Probabilities:
Example 3

A study on firm riskiness over a certain period found the following results:

Firm Failure

Firm riskiness
Failed (F1) Non-Failed (F2)

Risky (R1) 62 7,263

Less risky (R2) 170 19,748

a. What is the probability of randomly selecting a risky firm?

b. Compute the unconditional probabilities of less risky firm, failed firm, and non-
failed firm.
c. What is the probability of randomly selecting a risky firm and a failed firm?
d. What is the probability of randomly selecting either a risky firm or a failed firm?
e. What is the probability of randomly selecting a non-failed firm, given that it is
risky?
34

Contingency Tables and Probabilities:

Example 3 (cont’d)

A study on firm riskiness over a certain period found the following results:

Firm Failure

Firm riskiness Total

Failed (F1) Non-Failed (F2)

Risky (R1) 62 7,263 7,325

Less risky (R2) 170 19,748 19,918

Total 232 27,011 27,243

35
 The Total Probability Rule

• Consider event B and its

complement Bc. These
two events are mutually B A Bc
exclusive and exhaustive.
• The circle, representing
event A, consists entirely of
its intersections with B and Bc. P ( A ! B ) P ( A ! B )
c

• P(A) is the sum of its intersections with some mutually

exclusive and exhaustive events corresponding to an
experiment.
36

The Total Probability Rule (cont’d)

• The total probability rule conditional on two

events, B and Bc, is

(
P ( A ) = P ( A ! B ) + P A ! Bc )
• or equivalently,

( ) ( )
P ( A ) = P ( A | B ) P ( B ) + P A | Bc P B c

37
 Bayes’ Theorem

• Baye’s theorem uses TPR to update a probability of an

uncertain outcome that has been affected by a new piece
of evidence.

• When we make investment decisions, we often start with a

view point based on our previous experience and
knowledge (prior probability).

• These viewpoint may be changed or confirmed by new

knowledge or observations (posterior probability).

38

Bayes’ Theorem (cont’d)

• A procedure for updating probabilities based on

new information.

• Prior probability is the original (unconditional)

probability (e.g., P(B) ).
• Posterior probability is the updated (conditional)
probability (e.g., P(B | A) ).

P( A ! B)
P( B / A) =
P( A) 39
 Bayes’ Theorem (cont’d)

• Given a set of prior probabilities for an event

and some new information, the rule for
updating the probability of the event is called
Bayes’ theorem.

P ( A ! B)
P (B | A) =
(
P ( A ! B ) + P A ! Bc )
or

P ( A | B ) P (B )
P (B | A) =
( ) ( )
P ( A | B ) P (B ) + P A | Bc P Bc
40

Bayes’ Theorem: Example 4

• The ARSENAL football team, a Premier League team in

the London, plays 80% of their games at night and 20%
during the day. The team wins 50% of their night games
and 80% of their day games. According to today’s
newspaper, they won yesterday.

• What is the probability the game was played at night?

41
 Counting Rules

• In several areas of statistics the calculation of probabilities involves

defining and counting outcomes. Here we discuss short cuts for counting.

• The Factorial Formula

• The number of ways to assign (order) every member of a group of
size n to n slots is calculated using the factorial formula:

n ! = n ´ ( n - 1) ´ ( n - 2) ´ ( n - 3 ) ´ !´ 1
• By definition, 0! = 1.
• For example, in how many ways can a football coach assign 10
players to each of the 10 team positions?
• Solution: 10 = 10 x 9 x 8 x 7 x……..x1 = 3,628,800

42

Counting Rules (cont’d)

• The Combination Formula

• The number of ways to choose x objects from a total of

n objects, where the order in which the x objects are
listed does not matter, is referred to as a combination
and is calculated as:

n!
n
( )
n Cx = x =
( n - x )! x !

43
 Counting Rules

• The Permutation Formula (combination with order)

• The number of ways to choose x objects from a total of n

objects, where the order in which the x objects is listed
does matter, is referred to as a permutation and is
calculated as:

n!
n Px =
( n - x )!

44

Combination and Permutation Examples

Example 5
• A representative of the Environmental Protection
Agency (EPA) wants to select samples from 10
landfills. The director has 15 landfills from which she
can collect samples.

• How many different samples are possible?

45
 Random Variables

• A sample space is set of all outcomes of an experiment.

• A random variable summarizes outcomes of an experiment with
numerical values. For instance, if you roll a die, each outcome has a
value from 1 through 6.

• Random variable
• A rule that assigns numerical values to the outcomes of an
experiment.
• Denoted by uppercase letters (e.g., X ).

• Values of the random variable are denoted by corresponding lowercase

letters.
• Corresponding values of the random variable:
x1, x2, x3, . . .

46

Random Variables (cont’d)

EXAMPLES

1. Experiment: Select a mutual fund; X = the number of companies in the

fund portfolio.
The values of X are 2, 3, 4, ...

2. Experiment: Select a football player; X = the number of goals the

player has scored during the season.
The values of X are 0, 1, 2, 3, ...

3. Experiment: Survey a group of 10 football players; X = the average

number of goals scored by the players during the season.
The values of X are 0, 0.1, 0.2, 0.3, ...., 1.0, 1.1, .

47
 Types of Random Variables

• DISCRETE RANDOM VARIABLE • CONTINUOUS RANDOM

A random variable that can
assume only certain clearly
separated values. It is usually the
result of counting something.
• The number of students in a
class.
• The number of children in a
family.
• The number of cars entering a
carwash in a hour.
• Number of home mortgages
approved by a Bank last week.
VARIABLE
Can assume an infinite number of
values within a given range. It is
usually the result of some type of
measurement.
• Rate of return.
• The weight of each student in
this class.

48

Probability Distributions

• A probability distribution: A listing of all the outcomes of a random

variable and the probability associated with each outcome

Experiment: Toss a coin

three times.

X = Observe the number of

heads.

What is the probability

distribution of X (the
number of heads)?

The possible values are:

Zero heads,
One head,
Two heads, and
Three heads.
49
 Probability Distributions (cont’d)

• Note: A probability distribution may be viewed as a

table, graphically, or algebraically.
50

A probability distribution may be expressed

algebraically.

• A probability distribution may be expressed algebraically.

• For example, for the six-sided die experiment, the
probability distribution of the random variable X is:

ì1 6 if x = 1,2,3,4,5,6
P ( X = x) = í
î0 otherwise

• Using this formula we can find

P ( X = 5) = 1 6 P ( X = 7) = 0

51
 Probability Distribution Function

• A probability mass function is used to describe

discrete random variables.

• A probability density function is used to describe

continuous random variables.

• A cumulative distribution function may be used

to describe both discrete and continuous random
variables.

52

Random Variables and Discrete Probability

Distributions

• The probability mass function of a discrete random

variable X is a list of the values of X with the associated
probabilities, that is, the list of all possible pairs

( x,P ( X = x ))
• The cumulative distribution function of X is defined as

P ( X £ x)

53
 Characteristics of a Probability Distribution

1.The probability of a particular outcome is between

0 and 1 inclusive.
0 £ P ( X = x) £ 1
2. The outcomes are mutually exclusive events.

3. The list is exhaustive. So the sum of the probabilities

of the various events is equal to 1.

åP ( X £ x ) = 1
i

54

Mean, Variance, and Standard Deviation of

a Probability Distribution

• Summary measures for a probability distribution

include the

• Mean (Expected Value)

• Variance

• Standard Deviation

55
 Expected Value, Variance, and Standard
Deviation a Probability Distribution

• Population Mean Expected Value

m E(X)
• m is the long-run average value of the random
variable over infinitely many independent
repetitions of an experiment.

• For a discrete random variable X with values

x1, x2, x3, . . . that occur with probabilities
P(X = xi), the expected value of X is

E ( X ) = µ = å xi P ( X = xi )
56

Mean, Variance, and Standard Deviation a

Probability Distribution (cont’d)

• Variance and Standard Deviation

• For a discrete random variable X with values
x1, x2, x3, . . . that occur with probabilities
P(X = xi),

Var ( X ) = s 2 = å ( xi - µ ) P ( X = xi )
2

= å xi2P ( X = xi ) - µ 2

• The standard deviation is the square root of the

variance.

SD ( X ) = s = s 2
57
 Binomial Probability Experiment

• Use the number of trials, n, and the probability of a

success, p, to compute binomial probability

BINOMIAL PROBABILITY EXPERIMENT

1. An outcome on each trial of an experiment is classified into one of two
mutually exclusive categories — a success or a failure.
2. The random variable is the number of successes in a fixed number of
trials.
3. The probability of success is the same for each trial.
4. The trials are independent, meaning that the outcome of one trial does
not affect the outcome of any other trial.

• Note: Do not confuse the symbol p, with the mathematical

constant 3.1416

58

How is a Binomial Probability Computed?

P(X) = nCx Px (1- p)n-x

where
• C denotes a combination.
• n is the number of trials.
• x is the random variable defined as the number of successes.
• p is the probability of a success on each trial.

The Moments of Binomial Probability Distribution:

The mean expected value (E(X)) is: µ = n p
The variance (Var(X)) is: σ2 = np 1 − p
The standard deviation (SD(X)) is: SD(X) = σ = np 1 − p
59
 Example 6: Binomial Probability Distribution

• Approximately 20% of UK workers are afraid that

they will never be able to retire. Suppose 10
workers are randomly selected.
• What is the probability that none of the workers
is afraid that they will never be able to retire?

60

Example 7

It is asserted that 80% of the cars approaching an individual

toll booth in New Jersey are equipped with an E-ZPass
transponder. Find the probability that in a sample of six cars:
a) All six will have the transponder.
b) At least three will have the transponder.
c) None will have a transponder.

61
 The Poisson Probability Distribution

• A binomial random variable counts the number of

successes in a fixed number of trials.

• In contrast, a Poisson random variable counts the

number of successes over a given interval of time or
space (area or region), provided that we know what the
average is.

• For example, if we know that the average number of ships

arriving to the port is 15 per day, then Poisson distribution
can answer questions such as ‘what is the probability of
having 20 ships arriving in an hour’?
62

The Poisson Probability Distribution

Other Examples of a Poisson random variable include:

• With respect to time — the number of cars that cross

the London Bridge between 9:00 am and 10:00 am on
a Monday morning; Number of bankruptcies that are
filed every year.

• With respect to space — the number of defects in a

50-yard roll of fabric; Number of leaks in a specified
stretch of a pipeline.

63
 The Poisson Probability Distribution (cont’d)

• For a Poisson random variable X, the probability of x

successes over a given interval of time or space is

e- µ µ x
P ( X = x) = for x = 0,1,2!,
x!
n where: μ (mu) is the mean number of occurrences
(successes) in a particular interval; e is the constant
2.71828 (base of the Napierian logarithmic system); x is
the number of occurrences (successes); P(x) is the
probability for a specified value of x.
64

The Poisson Probability Distribution (cont’d)

Ø The mean number of successes μ can be

determined in Poisson situations by np, where
n is the number of trials and p the probability of
a success.
μ = np
Ø The variance of the Poisson distribution is also
equal to np (its mean).

65
 Example 8: Poisson Probability Distribution

Cars arrive at the Stirling roundabout of the A1(M) London

motorway at the rate of two per minute. The distribution of
arrivals approximates a Poisson distribution.
Ø What is the probability that no cars arrive in a particular
minute?
Ø What is the probability that at least one car arrives
during a particular minute?

66

Uniform Probability Distribution

• The uniform probability distribution is perhaps the simplest distribution for a

continuous random variable.
• Describes a random variable that has an equally likely chance of assuming a
value within a specified range.
• The values a and b on the horizontal axis represent the lower and upper limits,
respectively.

• This distribution is rectangular in shape and is defined by minimum and

maximum values.
• P(x)= 1/b-a

a+b
E(X) = µ =
2

SD ( X ) = s = (b - a)
2
12
67
 Uniform Probability Distribution:
Example 9

• Based on historical data, sales for a particular

cosmetic line follow a continuous uniform
distribution with a lower limit of £2,500 and an
upper limit of £5,000.

• What are the mean and standard deviation of this

uniform distribution?

• What is the probability that sales exceed £4,000?

• What is the probability that sales is exactly £2,500?

68

Characteristics of a Normal Probability

Distribution

1. It is bell-shaped and has a single peak at the center of the distribution.

2. It is symmetrical about the mean
3. It is asymptotic: the curve gets closer and closer to the X-axis but
never actually touches it. To put it another way, the tails of the curve
extend indefinitely in both directions.
4. The location of a normal distribution is determined by the mean,µ, the
dispersion or spread of the distribution is determined by the standard
deviation,σ .
5. The arithmetic mean, median, and mode are equal
6. The total area under the curve is 1.00; half the area under the normal
curve is to the right of this center point, the mean, and the other half to
the left of it.
69
 Normal Distribution (Graphically)

• Characteristics of the Normal Distribution

• Symmetric about its mean
• Mean = Median = Mode
• Asymptotic - that is, the
tails get closer and closer to the
horizontal axis, but never touch it.
P(X < m) = 0.5 P(X > m) = 0.5

µ x
70

The Normal Distribution Formula

• For a random variable X with mean µ and variance s2

1 æ ( x - µ )2 ö
f (x) = exp ç - ÷
s 2p ç 2s 2
÷
è ø
where p = 3.14159 and exp ( x ) = e x
e » 2.718 is the base of the natural logarithm

71
 The Family of Normal Distribution

Equal Means and Different Different Means and

Standard Deviations Standard Deviations

Different Means and Equal Standard Deviations

72

The Standard Normal (Z) Distribution

• Z Distribution.
• A special case of the normal distribution:
• Mean (m) is equal to zero (E(Z) = 0).
• Standard deviation (s) is equal to one
(SD(Z) = 1).
• A z-value is the signed distance between a selected value, designated X,
and the population mean µ, divided by the population standard deviation, σ.
• The formula is:

73
 The Normal Distribution – Example 10

The weekly incomes of workers in a given

industry follow the normal probability distribution
with a mean of $1,000 and a standard deviation
of $100.

1) What is the z value for the income, let’s call it

X, of a worker who earns $1,100 per week?
2) For a worker who earns $900 per week?

75

Normal Distribution – Finding Probabilities

In the example 10
reported that the mean
weekly income of a
worker is normally
distributed with a mean
of $1,000 and a
standard deviation of
$100.

What is the likelihood of

selecting a worker
whose weekly income
is between $1,000 and
$1,100?

76
Finding areas for Z using the table

77

Cont.

78
 Finding areas for Z using Excel

The Excel function

=NORMDIST(x,Mean,Standard_dev,Cumu)
=NORMDIST(1100,1000,100,true)
generates area (probability) from
Z=1 and below

79

Normal Distribution – Finding Probabilities

(Example 11)

The distribution of weekly incomes follows the

normal probability distribution with a mean of
$1,000 and a standard deviation of $100.
What is the probability of selecting a worker whose
income is:

Between $790 and $1,000?

80
 Normal Distribution – Finding Probabilities
(Example 12)

The distribution of weekly incomes follows the

normal probability distribution with a mean of
$1,000 and a standard deviation of $100.
What is the probability of selecting a worker whose
income is:

Less than $790?

81

Normal Distribution – Finding Probabilities

(Example 13)

The distribution of weekly incomes follows the

normal probability distribution with a mean of $1,000
and a standard deviation of $100.
What is the probability of selecting a shift foreman in
the glass industry whose income is:

Between $840 and $1,200?

• = 0.9224

82