Section 1: Introduction and Probability Concepts
Section 1: Introduction and Probability Concepts
Section 1: Introduction and Probability Concepts
Carlos M. Carvalho
The University of Texas at Austin
McCombs School of Business
http://faculty.mccombs.utexas.edu/carlos.carvalho/teaching/
1
Getting Started
I Syllabus
I General Expectations
1. Read the notes
2. Work on homework assignments
3. Be on schedule
2
Course Overview
3
Let’s start with a question...
4
Introduction
5
Random Variables
6
Probability
Probability is a language designed to help us talk and think about
aggregate properties of random variables. The key idea is that to
each event we will assign a number between 0 and 1 which reflects
how likely that event is to occur. For such an immensely useful
language, it has only a few basic rules.
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Conditional, Joint and Marginal Distributions
10
Conditional, Joint and Marginal Distributions
S pr (S|E = 1) S pr (S|E = 0)
1 0.05 1 0.20
2 0.20 2 0.30
3 0.50 3 0.30
4 0.25 4 0.20
11
Conditional, Joint and Marginal Distributions
S pr (S|E = 1) S pr (S|E = 0)
1 0.05 1 0.20
2 0.20 2 0.30
3 0.50 3 0.30
4 0.25 4 0.20
12
Conditional, Joint and Marginal Distributions
pr (S = 4 and E = 1) = pr (E = 1) × pr (S = 4|E = 1)
= 0.70 × 0.25 = 0.175
In english, 70% of the times the economy grows and 1/4 of those
times sales equals 4... 25% of 70% is 17.5%
13
Conditional, Joint and Marginal Distributions
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15
Conditional, Joint and Marginal Distributions
)=7*5
Example... Given E = 1 what is the probability of S = 4?
A
5%">"37 J"""""""W""""""" """""""X
("'1"(95 !
K"""!K`""""!Kb""""!Kb !K`
2 A)*51IXM
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="(95"a$'%(
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pr (S = 7PA
4, E = 1)+> 0.175
!Q !!"#
pr (S = 4|E = 1) =
7PA U > !prQ (E = 1) = 0.7 = 0.25 !$#
7P> !Q !" 16
Conditional, Joint and Marginal Distributions
Example... Given S = 4 what is the probability of E = 1?
A
*51IX+
95 J"""""""W""""""" """""""X
(8 !
"37M K"""!K`""""!Kb""""!Kb !K`
>
J"""!K V""!JX""""! V""""!JRV !R
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pr (S = 4, E = 1) 0.175
pr (E = 1|S = 4) = = = 0.745
pr (S = 4) 0.235
7PA +> !Q !!"#
7P> ! U A Q !" # 17
Independence
pr (Y = y |X = x) = pr (Y = y )
In other words,
18
Trump’s victory
19
>?)=7*5
Disease Testing Example
0'15)15"(51('%/!
H5("0"IJ"'%&'<)(5"8$3"9);5"(95"&'15)15!
Let D =H5("NIJ"'%&'<)(5"(9)("8$3"(51("7$1'(';5"B$."'(!
1 indicate you have a disease
Let T = 1 indicate that you test positive for it
-$1("&$<($.1"(9'%:"'%"(5.=1"$B"7P&Q")%&"7P(U&Q!
/73 NIJ 0
0IJ
/42 /43 K""""""""""""""""""""""""J
NIK " K"""!bRKWI!b^Z!bb"""""!KKJ
/4+ NIJ
N
/7G 0IK J"""!KKb^""""""""""""""""""!KJb
/77
NIK
If you take the test and the result is positive, you are really
interested in the question: Given that you tested positive, what is
the chance you have the disease?
20
+,"-.#/&!0/$.1$/2!1"$"-.3/45($61/$5./75(#7./&!
Disease5(-./$5./8"1.(1.9+
Testing Example
0
K""""""""""""""""""""""""J
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J"""!KKb^""""""""""""""""""!KJb
]P0IJUNIJQ"I"!KJb¥P!KJb_!KKb^Q"I"K!``
0.019
pr (D = 1|T = 1) = = 0.66
(0.019 + 0.0098)
21
Disease Testing Example
23
Probability and Decisions
Revenue P(Revenue)
$250,000 0.7
$0 0.138
$25,000,000 0.162
24
Probability and Decisions
Revenue P(Revenue)
$3,721,428 0.7
$0 0.138
$10,000,000 0.162
25
Mean and Variance of a Random Variable
n
X
E (X ) = Pr (xi ) × xi
i=1
26
Mean and Variance of a Random Variable
n
X
Var (X ) = Pr (xi ) × [xi − E (X )]2
i=1
27
The Standard Deviation
28
Continuous Random Variables
29
The Normal Distribution
I A random variable is a number we are NOT sure about but
we might have some idea of how to describe its potential
outcomes. The Normal distribution is the most used
probability distribution to describe a random variable
I The probability the number ends up in an interval is given by
the area under the curve (pdf) 0.4
0.3
standard normal pdf
0.2
0.1
0.0
−4 −2 0 2 4
30
The Normal Distribution
I The standard Normal distribution has mean 0 and has
variance 1.
I Notation: If Z ∼ N(0, 1) (Z is the random variable)
0.4
standard normal pdf
0.3
0.2
0.2
0.1
0.1
0.0
0.0
−4 −2 0 2 4 −4 −2 0 2 4
31
z z
The Normal Distribution
Note:
Questions:
32
The Normal Distribution
33
The Normal Distribution
I We write X ∼ N(µ, σ 2 ). “Normal distribution with mean µ
and variance σ 2 .
I The parameter µ determines where the curve is. The center of
the curve is µ.
I The parameter σ determines how spread out the curve is. The
area under the curve in the interval (µ − 2σ, µ + 2σ) is 95%.
Pr (µ − 2 σ < X < µ + 2 σ) ≈ 0.95
σ µ−σ
µ − 2σ µ µ + σ µ + 2σ
σ 34
Mean and Variance of a Random Variable
35
The Normal Distribution
I Example: Below are the pdfs of X1 ∼ N(0, 1), X2 ∼ N(3, 1),
and X3 ∼ N(0, 16).
I Which pdf goes with which X ?
−8 −6 −4 −2 0 2 4 6 8 36
The Normal Distribution – Example
37
The Normal Distribution – Example
0.020
0.010
0.010
0.000
0.000
−40 −20 0 20 40 60 −40 −20 0 20 40 60
sp500 sp500
I (i) Pr (SP500 < 0) = 0.35 and (ii) Pr (SP500 < −25) = 0.02
I In Excel: NORMDIST and NORMINV (homework!)
38
The Normal Distribution
1. Note: In
X ∼ N(µ, σ 2 )
X −µ
Z= ∼ N(0, 1)
σ
3. Summary:
X ∼ N(µ, σ 2 ):
µ: where the curve is
σ: how spread out the curve is
95% chance X ∈ µ ± 2σ.
39
The Normal Distribution – Another Example
Prior to the 1987 crash, monthly S&P500 returns (r ) followed
(approximately) a normal with mean 0.012 and standard deviation
equal to 0.043. How extreme was the crash of -0.2176? The
standardization helps us interpret these numbers...
r ∼ N(0.012, 0.0432 )
r − 0.012
z= ∼ N(0, 1)
0.043
For the crash,
−0.2176 − 0.012
z= = −5.27
0.043
Make sure to read the article on this topic available in the class
website...
41