1. An analyst has estimated the probabilities of two unrelated events.

Which probability rule is most appropriate for calculating the joint probability
of these two events?

A. Addition

 B. Multiplication

C. Total probability

Explanation

Basic probability rules

Probability that either events A or B occur

Addition rule P(A or B) = P(A) + P(B) − P(AB) Remember to subtract the joint probability that both events
occur

Probability that both events A and B occur

Multiplication rule P(A and B) = P(A) × P(B) When A and B are independent events, formula simplifies to
P(A) × P(B)

Unconditional probability that A occurs whether a different event

Total probability P(A) = P(A|B occurs) × P(B occurs) + P(A|B not
B occurs or does not occur
rule occur) × P(B not occur)
More easily understood with a tree diagram

To calculate the joint probability of two events, P(A and B), use the multiplication rule for probability: P(AB) = P(A|B)P(B).

If events A and B are independent (ie, unrelated), as in this instance, then P(A) = P(A|B) (ie, probability of A is the same as probability of A given
B) since the probability of A occurring is the same whether or not B occurs. The multiplication rule then simplifies to P(AB) = P(A)P(B).

(Choice A) The addition rule can be used to determine the probability of an event (A) or another event (B). For any two events, the addition rule
for probabilities describes how to calculate the probability that A or B will occur, or P(A or B).

(Choice C) The total probability rule is used to calculate the unconditional probability that an event occurs, regardless of the occurrence of other
events (example).

Things to remember:
To calculate the joint probability of two events, use the multiplication rule for probability: P(AB) = P(A|B)P(B). If the events are independent, the
rule simplifies to P(AB) = P(A)P(B).

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2. Two research analysts asked a mutual fund manager the following questions:

Analyst A: "What is the probability that the fund will have a zero percent return this year?"

Analyst B: "What is the probability that the fund will have a negative return this year?"

The two events described by the analysts are most likely:

A. mutually exclusive and exhaustive.

 B. mutually exclusive and not exhaustive.

C. neither mutually exclusive nor exhaustive.

Explanation

An event is a set of possible outcomes. In this situation, the two events are

Event A: the fund earns a return of 0%

Event B: the fund earns a return of less than 0% (ie, a negative return)

These two events are mutually exclusive, meaning that they cannot both occur at the same time. If Event A happens, then Event B cannot
happen at the same time.

Exhaustive events cover all possible outcomes. Event A and Event B are not exhaustive since they do not cover outcomes in which returns are
greater than 0%.

Things to remember:
Mutually exclusive events cannot occur at the same time. Exhaustive events cover all possible outcomes.

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3. An investment advisor uses several criteria to screen a list of 200 mutual funds for a client.

Criterion Fraction of the 200

Description
number funds meeting criterion

1 Environmentally sustainable 0.80

2 Large-cap value 0.50

3 Multisector 0.40

4 Low turnover 0.25

5 Contains bonds 0.25

A mutual fund must meet the first four criteria in order to pass the screening. If the criteria are independent, the number of funds that pass the
screen is closest to:

A. 2

B. 4

 C. 8

Explanation

Events are independent if the occurrence of one event is not linked to the occurrence of other events. To answer this question, derive the joint
probability of mutual funds meeting the first four criteria. The multiplication rule for independent events states that the joint probability of all the
events is equal to the product of the probabilities of each individual event.

Since 200 funds are screened, there are 8 funds (0.04 × 200 funds) that meet the first four criteria.

(Choice A) This results from incorrectly multiplying all five criteria together.

(Choice B) This results from incorrectly multiplying the probability of a fund meeting the first four criteria (0.04) by 100 instead of 200.

Things to remember:
The multiplication rule for independent events states that the joint probability of all the events is equal to the product of the probabilities of each
individual event.

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4. A and B are two events with the following probabilities:

The joint probability of A and B is closest to:

A. 0.0868

 B. 0.2520

C. 0.2790

Explanation

When asked to calculate the joint probability of two events, use the multiplication rule for probability: P(AB) = P(A|B)P(B). If the events A
and B are independent, then P(A) = P(A|B) (ie, probability of A is the same as probability of A given B) since the probability of A occurring is the
same whether or not B occurs. If this is the case, the multiplication rule simplifies to P(AB) = P(A)P(B).

In this scenario, P(A) is not equal to P(A|B): 0.31 ≠ 0.28. Therefore, events A and B are not independent. Substitute into the multiplication rule:

(Choice A) 0.0868 is equal to P(A|B)P(A). This is an incorrect statement of the multiplication rule since the second event in the conditional
probability should be the same as the event in the second part of the product: P(AB) = P(A|B)P(B) = P(B|A)P(A).

(Choice C) 0.2790 is the result of incorrectly treating events A and B as if they were independent [ie, P(AB) = P(A)P(B)]. Since the events are not
independent, P(AB) = P(A|B)P(B) must be used instead.

Things to remember:
When asked to calculate the joint probability of two events, one should use the multiplication rule for probability: P(AB) = P(A|B)P(B). If the events
are independent, the rule simplifies to P(AB) = P(A)P(B).

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5. A regulator devised a test to determine if distressed banks will go bankrupt and has estimated the following related probabilities:

The probability that a bank goes bankrupt is closest to:

A. 0.06

B. 0.49

 C. 0.54

Explanation

When a question requires a candidate to calculate the probability that an event occurs based on whether a different event occurs or does not
occur, this signals the candidate to use the total probability rule.

The question asks for the probability of a bank going bankrupt, an event the occurrence of which is related to whether it passes a test. The
probability of not passing the test is 0.62, so the probability of passing the test is 1 − 0.62 = 0.38. The joint probability that a bank goes bankrupt
and it passes the test is 0.05; the conditional probability that a bank goes bankrupt given that it does not pass the test is 0.7903.

The total probability rule can be illustrated as a tree diagram. The first node shows the two unconditional probabilities of whether a bank passes
the test or does not pass. The next nodes show the conditional probabilities of bankruptcy and no bankruptcy, based on whether the bank passes
the test or not. The two conditional probabilities containing no bankruptcy are irrelevant since the question asks for the probability that a bank
goes bankrupt.

The joint probability of bankruptcy and passing the test is given in the question as 0.05. The joint probability that a bank goes bankrupt and does
not pass the test is calculated as:

The total probability that a bank goes bankrupt is the sum of the two joint probabilities involving the bank going bankrupt: 0.05 + 0.4899 = 0.5399 ≈
0.54.

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6. A money management firm surveyed individuals about their attitudes toward investing. A partial summary of the data is shown below:

Event Probability

Investor is an active investor 0.45

Portfolio holds equities, given that the investor

0.75
is an active investor

Portfolio does not hold equities, given that the

0.80
investor is not an active investor

If a randomly selected individual's portfolio holds equities, the probability that the investor is not an active investor is closest to:

A. 11.0%

 B. 24.6%

C. 44.8%

Explanation

Estimates concerning probabilities are often updated based on new information. In the diagram above, there is a 0.20 conditional probability that
a portfolio holds equities if its investor is not an active investor. Bayes' formula can be used to find the reverse conditional probability that answers
the question, "What is the probability that an investor is not an active investor, given that the investor's portfolio holds equities?"

The probabilities that a portfolio holds equities are:

0.3375 for an active investor and

0.1100 for a nonactive investor.

Therefore, the total probability that any investment portfolio contains equities, regardless of the type of investor, is 0.3375 + 0.11 = 0.4475 (Choice
C). Bayes' formula can be used to calculate an updated probability. However, it is often easier to invert the tree diagram using the previously
calculated probabilities. Note that the middle column in the diagram below shows the updated conditional probabilities:

In this scenario, before any portfolios were randomly selected, the estimated probability that a nonactive investor's portfolio would include equities
was 20%. Based on the survey findings, the probability that a portfolio containing equities belongs to a nonactive investor increased to
approximately 24.6%.

(Choice A) 11.0% is the total probability that a nonactive investor's portfolio holds equities.

Calculate and interpret an updated probability in an investment setting using Bayes’ formula
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7. Two events, A and B, are not independent: B's probability depends on whether A occurs. If the unconditional probability of A is known, which of
the following probability rules is least appropriate to estimate the unconditional probability of B?

 A. Addition rule

B. Multiplication rule

C. Total probability rule

Explanation

The outcome of an event is often affected by different scenarios that impact the probability of the event. In this question, the probability of B is
impacted by whether A occurs. The probability of B refers to its unconditional probability: the total probability that B occurs if A occurs AND if A
does not occur.

B's outcome is affected by A's outcome, so the probability that B occurs given that A occurs, the conditional probability P(B|A), may not be the
same as the probability that B occurs given that A does not occur: P(B|A) ≠ P(B|AC).

Since A either occurs or does not occur, A and AC are mutually exclusive and exhaustive. This means that the joint probabilities P(B AND A) and
P(B AND AC) cover all possible outcomes of B. The sum of these joint probabilities is the total probability (ie, unconditional probability) of B. Since
the total probability rule requires the use of the multiplication rule to calculate the joint probabilities (which are then summed to calculate the total
probability), the total probability and multiplication rules are appropriate to use for this calculation (Choices B and C).

The addition rule, which calculates the probability that either A or B occurs, is not appropriate here. The question asks for the probability of B
irrespective of A's occurrence.

Things to remember:
When different scenarios affect the likelihood of an event occurring, the total probability rule is used to calculate the unconditional (ie, total)
probability of the event. Unconditional probability is the sum of joint probabilities, which require the use of the multiplication rule.

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8. An analyst's estimates concerning a company's change in EPS are:

P(Positive change in EPS) = 0.50

P(No change in EPS) = 0.20
P(Negative change in EPS) = 0.30

The analyst has heard rumors that the company may increase its dividend payout this year and estimates the following conditional probabilities of
a dividend increase given the change in EPS:

Probability (Increased dividend | Positive change in EPS) = 0.60

Probability (Increased dividend | No change in EPS) = 0.30
Probability (Increased dividend | Negative change in EPS) = 0.10

If the company announces a dividend increase, the revised probability that there was a negative change to its EPS is closest to:

A. 0.030

 B. 0.077

C. 0.390

Explanation

Probability estimates are often revised based on updated information. In this question, an analyst has estimated the independent probabilities of
the change in a company's EPS. The analyst has also estimated the conditional probabilities that the company will increase its dividend.

As shown, the probability of a dividend increase for each possible EPS outcome is:

0.5 × 0.6 = 0.30 if EPS increases from the previous year

0.2 × 0.3 = 0.06 if EPS remains the same as the previous year
0.3 × 0.1 = 0.03 if EPS decreases from the previous year

The total probability of a dividend increase is the sum of the three joint probabilities of a dividend increase, or 0.3 + 0.06 + 0.03 = 0.390 (Choice
C).

Bayes' formula can be used to reverse the conditional probability to answer the question, "What is the probability that the change in EPS was
negative given that there was a dividend increase?" It is often easier to invert a tree diagram using previously calculated probabilities than to
memorize and apply Bayes' formula:
Before knowing that the company increased the dividend, the analyst estimated a 0.10 probability that EPS experienced a negative change from
last year to this year. With the updated information concerning the dividend increase, Bayes' formula demonstrates that the probability of a
negative change in EPS is reduced to approximately 0.077.

(Choice A) 0.030 is the joint probability that the company raises its dividend and has a negative change in this year's EPS from the previous year.

Things to remember:
Bayes' formula is used to update estimates of conditional probabilities based on new information.

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9. The probability that the price of natural gas will decline below $4.00 per MMBtu (million British thermal units) this year is 30%. The probability of
a producer suspending production given that the natural gas price drops below $4.00 per MMBtu is 60%. The probability of both the natural gas
price dropping below $4.00 per MMBtu and the producer suspending production is closest to:

 A. 0.18

B. 0.72

C. 0.90

Explanation

P(B): the (unconditional) probability that natural gas price drops below $4.00 per MMBtu

P(A|B): the (conditional) probability that the producer suspends production given that natural gas price drops below $4.00 per MMBtu

Unconditional probability measures the likelihood that an event will occur, regardless of another event's occurrence. The unconditional
probability of natural gas price dropping below $4.00 per MMBtu is 30%. Conditional probability measures the likelihood that an event will occur
based on the occurrence of another event. The conditional probability of the producer suspending production given that natural gas price drops
below $4.00 per MMBtu is 60%.

The joint probability of two events P(AB) refers to the probability that both events will occur. It is the product of P(A|B) and P(B). To answer this
question, find the probability of both the natural gas price dropping below $4.00 per MMBtu and the producer suspending production.

(Choice B) 0.72 results from subtracting the product of P(A|B) and P(B) from the sum of P(A|B) and P(B).

(Choice C) 0.90 results from incorrectly adding together the P(A|B) and P(B).

Things to remember:
Unconditional probability measures the likelihood that an event will occur regardless of another event's occurrence P(B). Conditional probability
measures the likelihood that an event will occur based on the occurrence of another event P(A|B). The joint probability of two events refers to the
probability that both events will occur, P(AB) = P(A|B) × P(B).

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10. An analyst determines that the probabilities of two events are as follows:

Event Description Probability

A Price of oil increases 0.33

B S&P 500 Index increases 0.49

Assuming the events are independent but not mutually exclusive, the probability that at least one of the two events will occur is closest to:

A. 0.16

 B. 0.66

C. 0.82

Explanation

The probability that at least one of the two events (A or B) will occur is the same as the probability that:

Only A (one event) will occur, or

Only B (one event) will occur, or
Both A and B (two events) will occur.

The addition rule for probability states that for events that are not mutually exclusive:

P(A or B) = P(A) + P(B) − P(AB)

Note that the probability that both events occur, which is possible since the events are not mutually exclusive, must be subtracted to avoid double
counting that probability.

In this scenario, P(A) and P(B) are given, but the probability of both A and B [P(AB)] is not given. However, for independent events, P(AB) can be
calculated according to the multiplication rule for probability as P(A)P(B). Substituting P(A)P(B) for P(AB) into the addition rule above:

P(A or B) = P(A) + P(B) − P(A)P(B)

= 0.33 + 0.49 − (0.33 × 0.49)

= 0.6583 ≈ 0.66, or 66%

(Choice A) 0.1617 is the result of multiplying P(A) and P(B). This is P(AB), the probability that both A and B will occur, not the probability of A or
B.

(Choice C) 0.8200 is the result of treating A and B as mutually exclusive and not subtracting the probability that both events will occur, P(AB).
This has the effect of double-counting the probability of A and B both occurring and so overestimates the probability of A or B occurring.

Things to remember:
The addition rule for probability states that for two events that are not mutually exclusive, such as A and B in this scenario, P(A or B) = P(A) + P(B)
− P(AB). For independent events, the multiplication rule for probability states that P(AB) = P(A)P(B).

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11. An analyst estimates the probability distribution for a company's upcoming quarterly EBITDA:

Probability EBITDA ($ billions)

0.5 2.05

0.2 2.20

0.3 2.40

The standard deviation of the distribution (in $ billions) is closest to:

A. 0.147

B. 0.150

 C. 0.152

Explanation

The standard deviation of a random variable measures the dispersion around the variable's expected value (ie, mean). In this scenario, the
random variable is the company's next quarterly EBITDA. To solve for standard deviation, first calculate the expected value of EBITDA by finding
the mean of the distribution: the probability-weighted average of the possible EBITDA outcomes. The distances between each outcome and the
mean can then be used to calculate the standard deviation as a probability-weighted average dispersion around the expected EBITDA value.

Probability EBITDA ($ billions)

0.5 2.05

0.2 2.20

0.3 2.40

From the given probabilities and EBITDA outcomes shown above, calculate the standard deviation as follows:

2
(Choice A) Standard deviation of 0.147 results from taking the simple average of the [Xi − E (X)] terms in the second step, instead of using
the probability-weighted average.

(Choice B) Standard deviation of 0.150 results from using a simple average, instead of a weighted average, to calculate the expected EBITDA
value.

Things to remember:
The standard deviation of a random variable measures the dispersion around the variable's expected value (ie, mean). To calculate standard
deviation, first calculate the mean, then use its distance from each outcome to solve for the standard deviation as a probability-weighted average
dispersion.

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12. The following are probabilities associated with two events: a recession and a central bank lowering interest rates:

The probability of a recession is closest to:

A. 0.40

B. 0.54

 C. 0.67

Explanation

When a question requires a candidate to calculate the probability that an event occurs based on whether a different event occurs or does not
occur, the candidate should use the total probability rule.

The question asks for the probability of a recession, which depends on whether the central bank lowers interest rates. The probability that the
bank lowers rates is 0.77, so the probability that it does not lower rates is 1 – 0.77 = 0.23. The conditional probability of a recession given a rate
cut is 0.70 whereas the conditional probability given no rate cut is 0.5625.

The total probability rule can be visualized as a four-outcome tree diagram. The first node shows the two unconditional probabilities of whether a
rate cut occurs. The next nodes show the conditional probabilities of a recession or no recession based on whether the bank lowers interest
rates. (The two conditional probabilities of no recession are irrelevant since the question asks for the probability of a recession occurring.)

The total probability of a recession is the sum of the two joint probabilities of a recession, P(recession AND lower rates) + P(recession AND does
not lower rates) = 0.54 + 0.13 = 0.67.

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13. An analyst designates the following events as possible return outcomes for a portfolio's value at the end of one year, estimating their
probabilities as follows:

Event Return Range (%) Probability

V −16 ≤ X < −12 0.17

W −12 ≤ X < −5 0.21

X −5 ≤ X < 0 0.34

Y 0≤X<5 0.14

Z 5 ≤ X < 12 0.12

It is least appropriate to conclude that the events are:

A. dependent.

 B. exhaustive.

C. mutually exclusive.

Explanation

Properties of probability

The probability of any event's occurrence is between 0 and 1.

In any set of mutually exclusive and exhaustive events, the sum of probabilities for all events equals 1.

Events that are mutually exclusive cannot happen at the same time. Events that are exhaustive account for 100% of the possible outcomes in a
sample space. For any set of mutually exclusive and exhaustive events, the sum of their probabilities is equal to 1. Events may be:

The events in this scenario are mutually exclusive since their return ranges do not overlap. The sum of the events' probabilities is:

P(V) + P(W) + P(X) + P(Y) + P(Z)

= 0.17 + 0.21 + 0.34 + 0.14 + 0.12

= 0.98

Since the sum of the event's probabilities is not equal to 1, it is not appropriate to conclude that the events are exhaustive.

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14. The probability that a company will win a government contract bid is 0.2. If it wins the bid, there is a 0.6 probability that the company will beat
earnings this year. The unconditional probability that the company will beat earnings is 0.36. If the company did beat earnings at year-end, then
the probability that the company won the bid is closest to:

A. 0.20

 B. 0.33

C. 0.40

Explanation

In this scenario, the probability of the company beating earnings is dependent on whether it wins the government bid. When events are
dependent, Bayes' formula can be used to find the probability of the preceding event (in this case, the probability that the company won the bid)
using the known outcome of the dependent event (ie, the company beat earnings).

The unconditional probability of the company beating earnings is given as 0.36. Since new information confirms that the company subsequently
beat earnings, the updated (posterior) probability that the company won the bid is 0.12 / 0.36 = 0.33. This is revised from its original (prior)
probability of winning the bid of 0.2.

(Choice A) 0.20 is the unconditional probability of winning the bid. It is also the prior probability.

(Choice C) 0.40 is the probability that the company does not beat earnings given that the company wins the bid: 1 − P(Beat earnings | Win bid).

Things to remember:
When events are dependent, Bayes' theorem revises the probability of a preceding event given that the subsequent event has occurred.

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15. An investor holds two funds: Fund A and Fund B. The investor wants to forecast the probability that Fund A will outperform Fund B each year
for the next two years. If each year's performance is independent, which probability rule should the analyst use?

A. Addition rule

 B. Multiplication rule

C. Total probability rule

Explanation

Events are independent if the occurrence of one event is not influenced by the occurrence of another event. The probability that Fund A
outperforms Fund B in the first year has no bearing on which fund performs better in the second year.

The investor wants to determine the probability of Fund A outperforming Fund B in both years (ie, the joint probability). The multiplication rule for
independent events states that the joint probability of all the events is equal to the product of the probabilities of each individual event.

(Choice A) The addition rule is used to determine the probability of at least one event occurring. If the investor wants to know the probability of
Fund A outperforming Fund B in at least one of the two years, then the investor should apply the addition rule.

(Choice C) The total probability rule states that the probability of an event is the probability-weighted average of the conditional probabilities of the
event. This rule is not applicable to the scenario in the question since the events are independent.

Things to remember:
The multiplication rule for independent events states that the joint probability of multiple events is equal to the product of the probabilities of each
individual event.

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16. A and B are two events with the following probabilities:

The probability of A occurring is closest to:

A. 0.23

B. 0.29

 C. 0.40

Explanation

When a question involves the probability of one event or another event occurring, use the addition rule for probabilities. If the two events are
mutually exclusive, both A and B cannot occur at the same time [P(AB) = 0], so the formula can be simplified to P(A or B) = P(A) + P(B). However,
if the events are not mutually exclusive, use P(A or B) = P(A) + P(B) − P(AB):

In this scenario, A and B are not mutually exclusive since P(AB) = 0.17 ≠ 0, and P(A or B), P(AB), and P(B) are given. Rearrange the addition rule
to solve for P(A):

This is different than the multiplication rule, which is used to calculate the joint probability that A and B both occur [P(AB)], not the probability that A
or B occurs.

(Choice A) 0.23 is the result of incorrectly treating events A and B as mutually exclusive. If events are mutually exclusive, the addition rule
simplifies to P(A or B) = P(A) + P(B). This is not applicable here; since P(AB) ≠ 0, the events are not mutually exclusive.

(Choice B) 0.29 is the result of incorrectly subtracting P(AB) from P(A or B).

Things to remember:
The probability of A or B is the probability of A plus the probability of B minus the joint probability of A and B. Events are mutually exclusive only if
the joint probability of A and B occurring is equal to zero. If events are mutually exclusive, the probability of A or B is the probability of A plus the
probability of B.

Formulate an investment problem as a probability tree and explain the use of conditional expectations in investment application
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17. A and B are two events with the following probabilities:

The probability of A or B is closest to:

A. 0.12

 B. 0.67

C. 0.73

Explanation

The addition rule can be used to determine the probability of an event OR another event. For any two events (A and B), the addition rule for
probabilities describes how to calculate the probability that A or B will occur, or P(A or B). The formula can be simplified from P(A or B) to
P(A) + P(B) if the events are mutually exclusive, which is true if their joint probability is equal to zero [P(AB) = 0]. This makes sense: if events are
mutually exclusive, there is zero chance of them both occurring.

As described in the diagram above, if events are not mutually exclusive, adding P(A) and P(B) will double count P(AB), the joint probability of A
and B, which would overestimate the probability of A or B occurring. Thus, after P(A) and P(B) are added together, P(AB) is subtracted to avoid
double counting.

In this scenario, P(AB) is not equal to zero [P(AB) = 0.06], so events A and B are not mutually exclusive. The probability of A or B is calculated as:

(Choice A) 0.12 is the result of incorrectly using the multiplication rule for the probabilities of two independent events, instead of using the
addition rule for probabilities. The multiplication rule describes how to calculate the joint probability that both A and B occur.

(Choice C) 0.73 is the result of failing to subtract the joint probability [P(AB)] of A and B. If the events are not mutually exclusive, failing to
subtract the joint probability has the effect of double counting P(AB).

Things to remember:
The addition rule for probabilities states that the probability of A or B is equal to the probability of A plus the probability of B, minus the probability
of A and B. If the events are mutually exclusive, this can be simplified to the probability of A or B equals to the probability of A plus the probability
of B.

Formulate an investment problem as a probability tree and explain the use of conditional expectations in investment application LOS
18. An analyst studies 10 years of historical data on stock splits for companies listed on the Toronto Stock Exchange (TSE) to determine the
probability that a firm listed on the TSE will have a stock split this year. The probability derived from this method is best described as:

A. a priori.

 B. empirical.

C. subjective.

Explanation

Approaches to estimating probabilities

Probability Source of estimate Example

Using historical stock split data to estimate the

Empirical Historical data
probability of a future stock split

Referencing another exchange's stock split data to

A priori Logical reasoning
logically derive the probability of a future stock split

Subjective Other related variables Using current price and volume or "gut" feeling to
(varies) or personal judgment estimate the probability of a future stock split

A probability can be sorted into one of three broad categories. In this question, the analyst uses historical information for stock splits to derive
the probability of a future stock split on the Toronto Stock Exchange (TSE). Since the probability was derived from the historical data method, it is
classified as an empirical probability.

(Choice A) An a priori probability is derived from logical reasoning, not historical observations. For example, an analyst can use the percentage
of split-adjusted stocks listed on another exchange to logically derive the probability of a stock split for a firm listed on the TSE.

(Choice C) A subjective probability uses other variables (eg, price, volume) or a personal judgment (eg, "gut feeling"), rather than historical data,
to make an estimate.

Things to remember:
A probability can be placed into one of three broad categories (ie, empirical, a priori, subjective) based on the way it is derived. A probability
derived from analyzing historical data is considered an empirical probability.

Calculate and interpret an updated probability in an investment setting using Bayes’ formula
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19. Fifty mutual funds are each subjected to two tests. The first tests a fund's 5-year average return, and the second tests its 5-year average
expense ratio. The results are:

16 funds pass both tests,

31 funds pass the first test, and
20 funds pass the second test.

Given that a fund passed the first test, the probability that it also passed the second test is closest to:

A. 0.248

 B. 0.516

C. 0.700

Explanation

This question demonstrates the concept of conditional probability, which is the estimated likelihood of an event occurring given that another
event occurs. The formula for conditional probability is:

In this scenario, P(AB) is the joint probability that a fund passes both tests. This is given as 16/50, or 0.32. If P(A) is the probability of passing
Test 2 and P(B) is the probability of passing Test 1, then the probability that a fund passes Test 2 given that it passes Test 1 equals P(A and B) ÷
P(B). The steps for calculating the conditional probability are shown below:

Formulate an investment problem as a probability tree and explain the use of conditional expectations in investment application
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20. An analyst studies events that may happen to companies in their first year of operation:

a major cyberattack on a small (S1), medium (S2), or large (S3) company, and
bankruptcy (T).

The analyst estimates the following probabilities:

Joint probability of T and S1 P(TS1) 0.340

Joint probability of T and S2 P(TS2) 0.390

Probability of T P(T) 0.908

Probability of T given S3 P(T|S3) 0.890

If there is no probability of a bankruptcy without a cyberattack, then the probability that a large company experiences a cyberattack in its first year
of operation is closest to:

A. 0.176

 B. 0.200

C. 0.377

Explanation

The unconditional probability of an event (A) occurring can be expressed in terms of the probabilities of the scenarios (Si) that affect the likelihood
of the event, assuming those scenarios are mutually exclusive and exhaustive. The total probability rule states that the probability of any
event can be expressed as:

the sum of the joint probabilities P(ASi) of the event and the scenarios, or alternatively as
a weighted average of the conditional probabilities P(A|Si) of the event, where the weight of each conditional probability is the probability
of each respective scenario, P(Si).

Thus, P(ASi) = P(A|Si) × P(Si).

In this question, the total probability rule states that the probability of bankruptcy P(T) is equal to the sum of the joint probabilities P(TS1), P(TS2),
and P(TS3). Since P(TS3) = P(T|S3)P(S3), the only unknown is the probability of a cyberattack on a large business, which can be solved as
follows:

P(T) = P(TS1) + P(TS2) + P(T|S3)P(S3)

0.908 = 0.340 + 0.390 + [0.890 × P(S3)]

P(S3) = 0.200

(Choice A) 0.176 is the result of incorrectly formulating the total probability rule as the total probability of T being equal to the sum of the
conditional probabilities of each scenario. This is incorrect since the total probability of T is the sum of the joint probabilities of each scenario: P(T)
= P(TS1) + P(TS2) + P(TS3).

(Choice C) 0.377 is the result of dividing P(TS1) by P(T|S3).

Things to remember:
The total probability rule for N events states that the probability of any event can be calculated as a weighted average of the conditional
probabilities of the event. The weight of each conditional probability is the probability of each respective scenario, where the scenarios are
mutually exclusive and exhaustive.

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21. There is a 0.6 probability that a portfolio manager will add a new asset to an existing portfolio.

If the manager adds the asset, then there is a 0.9 probability that the overall portfolio will beat its benchmark.
If the manager does not add the asset, then there is a 0.7 probability that the portfolio will beat its benchmark.

If the portfolio beats its benchmark at the end of the year, the probability that the manager bought the new asset is closest to:

A. 0.60

 B. 0.66

C. 0.82

Explanation

The probability of an event is often impacted by the occurrence of a related preceding event. In this question, the probability of the portfolio
beating its benchmark is related to whether the manager includes the new asset.

Bayes' theorem calculates a type of "inverse" probability that revises the probability of a preceding event given that the subsequent event
has occurred. Bayes' theorem uses the occurrence of a subsequent event to infer the probability of a preceding event.

New information at year-end confirms that the portfolio did beat its benchmark. Work backward to deduce the probability of this being attributed to
the manager including the new asset.

Originally, there was a 0.82 (or 0.54 + 0.28) probability of the portfolio beating its benchmark.
Since the portfolio beat its benchmark, the updated (posterior) probability that the asset was added is 0.66 [or 0.54 ÷ (0.54 + 0.28)]. This
is revised from its original (prior) probability of 0.6.

Another option is to use the Bayes' formula solution method to answer this question; however, the formula is complex and requires detailed
memorization. For the exam, the decision tree approach is highly recommended.

(Choice A) 0.60 is the original (prior) probability of the manager adding the new asset.

(Choice C) 0.82 is the original total probability of the portfolio beating its benchmark.

Things to remember:
Bayes' theorem calculates a type of "inverse" probability that revises the probability of a preceding event given that the subsequent event has
occurred.

Calculate and interpret an updated probability in an investment setting using Bayes’ formula
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22. The expected value of a random variable is most likely a(n):

A. equally weighted average of possible outcomes.

 B. probability-weighted average of possible outcomes.

C. equally weighted average of historical observations.

Explanation

The expected value of a random variable is the probability-weighted average of the variable's possible outcomes. The expected value is used
with a random variable that has a particular probability distribution. The probability distribution weights the average based on the likelihood of
each potential outcome's occurrence.

Suppose an analyst makes several estimates of a company's earnings per share (EPS) and assigns a probability to each estimated value,
creating the following discrete frequency distribution:

The simple arithmetic mean of the four EPS estimates is 352.50. However, the simple average fails to account for the probabilities assigned by
the analyst to each outcome. The expected value of the EPS, which accounts for each outcome's probability, is:

(Choice A) This is a description of a simple arithmetic average.

(Choice C) This is a description of a historical sample or arithmetic mean, which should not be confused with the expected value or weighted
mean. A sample mean is an equally weighted average based on a particular set of observations whose values have already been determined (ie,
not random variables).

Things to remember:
The expected value of a random variable is the probability-weighted average of the variable's possible outcomes. A sample mean, the arithmetic
average of a sample, is used to find the mean of a specific set of non-random variables (eg, historical values).

Calculate expected values, variances, and standard deviations and demonstrate their application to investment problems
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23. Within a certain stock index, 70% of the securities are technology stocks, 50% of the securities are growth stocks, and 40% of the securities
are both technology stocks and growth stocks. The categories are not mutually exclusive. If one security is selected randomly, the probability that
it is either a technology stock or growth stock is closest to:

A. 0.50

 B. 0.80

C. 0.85

Explanation

For events that are not mutually exclusive, the probability that at least one event will occur equals the sum of the individual events' probabilities
minus their joint probability. The joint probability that the stock is both a technology stock and a growth stock is captured in the overlapping area in
the diagram below. Since the overlapping area shares outcomes with Event A and Event B, P(AB) should be subtracted from the sum of their
individual probabilities to avoid double counting.

(Choice A) 0.50 is the probability that the security is a growth stock.

(Choice C) 0.85 results from subtracting the product of P(A) and P(B) from the sum of P(A) and P(B). Joint probability of two events [P(A and B)]
cannot be calculated from multiplying the probabilities of two events in a nonmutually exclusive scenario.

Things to remember:
For events that are not mutually exclusive, the probability that at least one event will occur equals the sum of the individual events' probabilities
minus their joint probability.

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24. Three companies make a specialty component used in the automobile industry. The relevant information for each company is shown below:

Market Share (%) Defective Components (%)

Company A 58 3

Company B 31 2

Company C 11 4

If a component is randomly selected and found to be defective, the probability that it was manufactured by Company C is closest to:

A. 0.004

B. 0.028

 C. 0.157

Explanation

In this question, the conditional probability that a component is defective given that Company C manufactured it is 0.04. It is often useful to revise
initial probability estimates when updated information is provided. If it is later learned that a component was defective (ie, the updated
information), Bayes' formula essentially reverses the conditions. It calculates the probability that Company C manufactured the component
given that it was defective:

The unconditional probability that a component is defective is the sum of each total probability that any of the three companies manufactures a
defective component: 0.0174 + 0.0062 + 0.0044 = 0.0280. The probability that Company C manufactured a component given that it is defective is:

Before knowing whether a component was defective, there was a 0.11 probability that it was manufactured by Company C. After learning that the
component was defective, the new probability that Company C manufactured it increased to 15.7%. Although Company C has the smallest
market share, it also has the highest percentage of defective components.

(Choice A) 0.4% is the joint probability that Company C both manufactured a component and that it was defective.

(Choice B) 2.8% is the sum of the total probability that all three companies manufactured a defective component, that is, the unconditional
probability that a component is defective.

Things to remember:
Bayes' formula is one way to update probabilities based on new information. It essentially "inverts" a conditional probability by using the
occurrence of an event to update the probability of the event that preceded it.

Calculate and interpret an updated probability in an investment setting using Bayes’ formula
LOS
25. An analyst has four independent criteria for selecting stocks and assumes the probabilities of meeting each criterion apply to every stock as
follows:

Under the analyst's assumptions, the probability of a stock meeting the first three criteria is closest to:

A. 0.014

 B. 0.025

C. 0.931

Explanation

The multiplication rule for independent events describes how to calculate the joint probability, P(ABC. . .N), of any number of independent
events. The joint probability is equal to the product of the probabilities of each event.

In this scenario, the analyst assumes that any stock chosen will have a 45.1% chance to meet Criterion A, a 28.7% chance to meet Criterion B,
and a 19.3% chance to meet Criterion C. Each criterion is an independent event. Substitute values into the formula to determine the joint
probability that all three events occur (ie, that the stock meets the first three criteria):

Two events, A and B, are independent if and only if the probability of B is equal to the probability of B given A and vice versa: P(B) = P(B|A) and
P(A) = P(A|B). This is reasonable since if the events are independent, the probability of B occurring is the same whether A occurs or not and vice
versa.

(Choice A) 0.014 is the chance that a stock will meet all four criteria: P(ABCD) = P(A) × P(B) × P(C) × P(D) = 0.01384. The question asks about
the joint probability of the first three events only.

(Choice C) 0.931 is the result of incorrectly applying the addition rule for mutually exclusive events, instead of the multiplication rule, to the first
three probabilities.

Things to remember:
The joint probability of any number of independent events is the product of their probabilities. This is true only if the events are independent.

Formulate an investment problem as a probability tree and explain the use of conditional expectations in investment application
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26. A distressed company may default on existing debt of £10 million depending on whether it declares bankruptcy. The company has a 0.8
probability of going bankrupt.

If the company goes bankrupt, then its lender has

a 0.6 probability of recovering £3 million and
a 0.4 probability of recovering nothing.
If the company does not go bankrupt, then its lender has
a 0.7 probability of recovering the full loan and
a 0.3 probability of recovering £9 million.

The lender's expected recovery amount on the loan is closest to:

A. £1.44 million.

 B. £3.38 million.

C. £5.58 million.

Explanation

A random variable's expected value is derived from its potential outcomes under different scenarios. In this question, the expected recovery
amount equals the probability-weighted average of the recovery amounts under Scenario 1 (bankruptcy) and Scenario 2 (no bankruptcy). Since
there are four different outcome values for the recovery amount, the overall expected recovery amount is calculated as follows:

(Choice A) This answer, £1.44 million, is the sum of only the probability-weighted recovery amounts under Scenario 1, where the company goes
bankrupt; this answer neglects to factor in the probability-weighted recovery amounts under Scenario 2.

(Choice C) This choice, £5.58 million, is the simple average of the four recovery amount values, not the probability-weighted outcomes of
Scenarios 1 and 2.

Things to remember:
The expected value of a random variable equals the sum of the probability-weighted averages of its possible outcomes.

Formulate an investment problem as a probability tree and explain the use of conditional expectations in investment application
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27. Which of the following statements concerning properties of probability is least likely to be accurate?

A. An event can have an infinite number of outcomes.

 B. The sum of probabilities for two mutually exclusive events equals 1.

C. If P(A | B) is greater than 0, then A and B cannot be mutually exclusive.

Explanation

Properties of probability

The probability of any event's occurrence is between 0 and 1.

In any set of mutually exclusive and exhaustive events, the sum of probabilities for all events equals 1.

Events are mutually exclusive if only one event can occur at a time. A set of events is exhaustive if it covers all possible outcomes. Only when
events are mutually exclusive and exhaustive does the sum of their probabilities equal 1.

For example, the possible outcomes for a company's earnings per share (EPS) may have different events:

Event A: EPS is less than EUR 0.

Event B: EPS is between EUR 0 and EUR 0.05 per share.

Events A and B are mutually exclusive since neither can occur simultaneously (ie, EPS cannot be both negative and non-negative). However,
unless Events A and B cover all possible outcomes (ie, they are exhaustive), the sum of their individual probabilities can be less than 1. Since it is
possible to describe an Event C, in which EPS could be more than EUR 0.05, Events A and B are not exhaustive and their probabilities do not
equal 1.

(Choice A) An event is not limited to one possible outcome. To continue the EPS example above, Event A is that EPS is less than EUR 0, but
any negative EPS result would mean that the event occurred.

(Choice C) The formula for conditional probability, P(A | B) = P(AB) / P(B), means that for the conditional probability to be greater than 0, the joint
probability that Events A and B both occur [P(AB)] must also be greater than 0. Mutually exclusive events cannot occur simultaneously, so the
joint probability of mutually exclusive events is 0.

Things to remember:
A property of probability is that the sum of all probabilities in a set of mutually exclusive and exhaustive events must equal 1.

Calculate and interpret an updated probability in an investment setting using Bayes’ formula
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28. An analyst considers the impact of a company's earnings-per-share on its CEO's compensation and estimates the following probabilities:

Based on the information given, a calculated probability of 0.38 most likely represents the:

 A. total probability of an increase in compensation.

B. joint probability of an increase in compensation and in EPS.

C. conditional probability that compensation increased given that EPS does not increase.

Explanation

This question uses the total probability rule to estimate the probability of a compensation increase. The compensation increase is impacted by
whether the company's EPS increases. One scenario is that EPS does not increase, which has a probability of 0.6. Since the probability of EPS
increasing is mutually exclusive and conditional, the probability of an EPS increase is (1 − 0.6) = 0.4.

After the independent probabilities of an EPS increase are determined, the next step is to identify and calculate the conditional probabilities of
compensation increasing, given that EPS increases and also given that it does not. The sum of those conditional probabilities is the total
probability that compensation increases.

The likelihood that compensation increases given that EPS increases is 0.8, so the joint probability that both EPS and compensation increase is
0.8 × 0.4 = 0.32 (Choice B). This is not the total probability of a compensation increase since it does not address the scenario of compensation
increasing given that EPS does not increase.

Conditional probabilities can also be mutually exclusive and exhaustive. The probability of no compensation increase given no EPS increase
is 0.9, so the conditional probability that compensation increases given that EPS does not increase is 1 − 0.9 = 0.1. The joint probability of no EPS
increase and a compensation increase is 0.6 × 0.1 = 0.06 (Choice C). The result is the total probability of a compensation increase of 0.32 + 0.06
= 0.38.

Things to remember:
The total probability rule estimates the unconditional probability of an event where there are multiple scenarios that affect the event's occurrence.
The total probability is the sum of each joint probability of the event and the scenario.

Formulate an investment problem as a probability tree and explain the use of conditional expectations in investment application
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29. An analyst wants to estimate the unconditional probability that a company will default on its bonds, which depends on whether its revenue
growth is positive. If the analyst can estimate the probability that revenue growth will be positive, then the most appropriate probability rule to
estimate the unconditional probability of default is the:

A. addition rule.

B. multiplication rule.

 C. total probability rule.

Explanation

Basic probability rules

Probability that either events A or B occur

Addition rule P(A or B) = P(A) + P(B) − P(AB) Remember to subtract the joint probability that both events
occur

Probability that both events A and B occur

Multiplication rule P(A and B) = P(A) × P(B) When A and B are independent events, formula simplifies to
P(A) × P(B)

Unconditional probability that A occurs whether a different event

Total probability P(A) = P(A|B occurs) × P(B occurs) + P(A|B not
B occurs or does not occur
rule occur) × P(B not occur)
More easily understood with a tree diagram

The total probability rule estimates the expected unconditional probability of an event that is conditioned on mutually exclusive and exhaustive
events. Mutually exclusive events cannot occur at the same time. Events are exhaustive when they cover all possible outcomes. The sum of
probabilities for mutually exclusive and exhaustive events is 1, so the total probability rule covers all possible scenarios.

The tree diagram below demonstrates the total probability that the company in this scenario will default given the probability that its revenue will or
will not grow. Revenue growth is a mutually exclusive event (ie, revenue cannot simultaneously grow and not grow). It is also exhaustive since
the probabilities that revenue will grow, stay flat, or decline sum to 1. The analyst can estimate the probability of positive growth, so the probability
of flat or negative growth is 1 − P(Positive growth).

The probability of default given positive revenue growth is a conditional probability, as is the probability of default given flat or negative growth.
The total probability rule estimates the unconditional probability of default by summing the probabilities of all possible conditional probabilities.

(Choice A) The addition rule does not require that the events be mutually exclusive or exhaustive.

(Choice B) The multiplication rule calculates the joint probability that two events will both occur, but those events cannot be mutually exclusive.
Mutually exclusive events cannot occur simultaneously, so their joint probability equals 0.

Things to remember:
The total probability rule is used for events that are conditioned on scenarios that themselves are both mutually exclusive and exhaustive. This
rule calculates the probability of an event under all possible scenarios.

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30. A trader owns a share of stock and estimates that there is a:

0.6 probability of the stock closing at a higher price today,

0.9 probability that the trader will sell the stock given that the stock closes higher, and
0.2 probability that the trader will sell the stock given that the stock does not close higher.

The expected probability that the trader will sell the stock is closest to:

A. 0.54

B. 0.60

 C. 0.62

Explanation

Unconditional probability is the likelihood that an event will occur, regardless of another event's occurrence. The unconditional probability of
selling the stock can be calculated from the conditional probabilities of selling the stock.

The conditional probability of selling the stock, given that its price closes higher, is 0.9. Since the probability of the stock closing higher is
0.6, the probability of both the stock closing higher and the trader selling the stock is 0.6 × 0.9, or 0.54.
The conditional probability of selling the stock, given that the price does not close higher, is 0.2. Since the probability of the stock not
closing higher is 0.4 or (1 − 0.6 probability of the stock closing higher), the probability that the stock won't close higher and the trader will sell
the stock equals 0.4 × 0.2, or 0.08.

Since the unconditional probability of selling the stock is the likelihood of the trader selling the stock regardless of whether the stock closes higher,
the answer is the sum of the probabilities of the selling the stock under both scenarios above, or 0.62 (ie, 0.54 + 0.08).

(Choice A) 0.54 is the joint probability of selling the stock and the stock closing higher.

(Choice B) 0.60 is the probability of the stock closing higher.

Things to remember:
The unconditional probability of selling the stock is the weighted average of its conditional probabilities; the weights are the probabilities of the
preceding scenarios.

Formulate an investment problem as a probability tree and explain the use of conditional expectations in investment application
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31. For two events, A and B, which of the following best describes a property of conditional probability?

A. A and B are mutually exclusive events.

 B. Conditional probability can be higher than unconditional probability.

C. The probability of A given B cannot equal the probability of B given A.

Explanation

Conditional probability is the probability that one event will occur given that another event occurs. For example, an analyst may believe there
is a 0.30 probability that a company will report earnings per share (EPS) of at least USD 0.20 (Event B). If Event B occurs, the analyst estimates a
0.60 probability that the company will increase its dividend (Event A). This describes a conditional probability since an of EPS of more than USD
0.20 impacts the probability of the dividend increase.

Conditional probability can be higher, lower, or the same as unconditional probability. For example, the analyst may believe there is a 0.15
unconditional probability that the company will raise its dividend regardless of EPS. The conditional probability of a dividend increase given a
threshold level of EPS (0.60) is higher than the unconditional probability of a dividend increase (0.15).

(Choice A) Mutually exclusive events are events that cannot occur at the same time: P(A and B) = 0. Since this is the numerator of the equation
for conditional probability, conditional probability for mutually exclusive events is always 0.

(Choice C) The numerator for the conditional probability of B given A is P(B and A). However, P(B and A) is the same as P(A and B). This means
that the conditional probability of A given B can equal the conditional probability of B given A if the probability of Events A and B (the denominator)
is the same, that is if P(A) = P(B).

Things to remember:
Conditional probability is the probability that one event will occur given that another event occurs. The conditional probability of an event can be
higher, lower, or the same as the unconditional probability of the same event. The conditional probability for mutually exclusive events will always
be 0.

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32. A fund has 200 bonds. The fund's previous manager added some of the bonds to the funds; the remainder were added by the current
manager. Forty of the 200 bonds are investment grade; the remainder are high-yield bonds. The current manager added 35% of the investment-
grade bonds and 80% of the high-yield bonds to the fund. The probability that a randomly selected security is either an investment-grade bond or
any bond that was not added by the current manager is closest to:

A. 20%

 B. 36%

C. 49%

Explanation

This question involves the use of the addition rule for probabilities. A is the probability of randomly selecting an investment-grade bond, which
is 40/200 = 0.20, or 20%.

B is the probability of selecting any bond that was not added to the portfolio by the current manager. The current manager did not add 65% of the
investment-grade bonds nor 20% of the high-yield bonds:

Added by current manager Not added by current manager

Investment grade 35% × 40 = 14 (1 − 35%) × 40 = 26

High yield 80% × (200 − 40) = 128 (1 − 80%) × (200 − 40) = 32

Total 142/200 = 71% 58/200 = 29%

The sum of the probabilities for A and B is 0.20 + 0.29 = 0.49, or 49%, which would be the correct answer if A and B were mutually exclusive
events (Choice C). However, they are not mutually exclusive, since it is possible that the chosen bond is an investment-grade bond that was not
added by the current manager.

The joint probability of both events, P(AB), must be subtracted from the sum of the individual event probabilities to prevent double counting. The
joint probability of selecting an investment-grade bond that was not added by the manager is 0.20 × 0.65 = 0.13, or 13%. After subtracting this
joint probability, the total probability of A or B equals 0.20 + 0.29 − 0.13 = 0.36, or 36%.

(Choice A) The probability of randomly selecting an investment-grade bond is 20%, but that does not account for the probability of selecting a
bond that the current manager did not add to the fund.

Things to remember:
The addition rule for probabilities is that the probability of A or B [P(A or B)] equals the probability of A plus the probability of B, minus the joint
probability of A and B.

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33. An analyst who is evaluating the probability that a company will fire its CEO if EPS decreases this year gathers the following relevant
estimates:

Probability that EPS decreases 0.35

Probability that company fires CEO if EPS decreases 0.85

Probability that company does not fire CEO if EPS does not decrease 0.75

The analyst later learns that the company did not fire the CEO after reporting EPS. The updated probability that the company's EPS decreased is
closest to:

A. 0.05

 B. 0.10

C. 0.15

Explanation

Probability estimates are often revised based on new information. In this scenario, the conditional probability that the CEO is not fired depends on
whether the company's earnings per share (EPS) have decreased. Two relevant conditional probabilities are as follows:

The CEO is not fired given that EPS did not decrease [P(CEO not fired | no EPS decrease)]
The CEO is not fired given that EPS decreased [P(CEO not fired | EPS decrease)]

The diagram above shows that the probabilities that the CEO is not fired are:

0.0525 if EPS decreased and

0.4875 if EPS did not decrease.

The total probability that the CEO is not fired, regardless of what happens to EPS, is 0.0525 + 0.4875 = 0.54. Bayes' formula can be used to
reverse the conditional probability and answer the question, "What is the probability that EPS decreased given that the CEO was not fired"?
However, it is often easier to invert the tree diagram using previously calculated probabilities than to memorize and apply Bayes' formula:

Before the analyst learned the outcome for the CEO, the estimated probability of an EPS decrease was 0.35. Given the updated information (ie,
CEO was not fired) and using Bayes' formula, the revised probability that EPS decreased is reduced to approximately 0.10 (ie, 0.0972).

(Choice A) 0.05 (ie, 0.0525) represents the joint probability that the CEO is not fired and that there is a decrease in EPS.

(Choice C) 0.15 is the conditional probability that the CEO is not fired given that EPS decreased.

Things to remember:
Bayes' formula is a way to update probabilities of related events based on new information.

Calculate and interpret an updated probability in an investment setting using Bayes’ formula LOS
34. A mutual fund contains 250 constituent companies.

12% of the companies are categorized as healthcare stocks.

16% of the companies are categorized as small-cap stocks.
4% of the companies are categorized as both healthcare and small-cap stocks.

If the categories are not mutually exclusive, then the probability that any constituent company is a healthcare or small-cap stock is closest to:

 A. 24.0%

B. 26.1%

C. 28.0%

Explanation

For events that are not mutually exclusive, the probability that at least one event will occur equals the sum of the individual events'
probabilities minus their joint probability (ie, P(A and B)). The joint probability that the stock is both a healthcare stock and a small-cap stock is
captured in the overlapping area in the diagram below. Since this overlapping area shares outcomes with Event A and Event B, P(A and B)
should be subtracted from the sum of their individual probabilities to avoid double counting.

(Choice B) 26.1% results from subtracting the product of P(A) and P(B) from the sum of P(A) and P(B). The joint probability of two events P(A
and B) cannot be calculated from multiplying the probabilities of two events in a non–mutually exclusive scenario.

(Choice C) 28.0% results from failing to subtract P(A and B) from the sum of P(A) and P(B).

Things to remember:
For events that are not mutually exclusive, the probability that at least one event will occur equals the sum of the individual events' probabilities
minus their joint probability.

Formulate an investment problem as a probability tree and explain the use of conditional expectations in investment application
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35. An analyst compiles the following covariance matrix for two assets:

A portfolio is created from these two assets, with 31% invested in Asset B. The portfolio's variance is closest to:

A. 4.08

 B. 14.99

C. 25.31

Explanation

Portfolio variance, an important measure of portfolio risk, depends on the assets' return variances, their covariances, and the weight of each
asset in the portfolio. To minimize portfolio risk, managers seek to minimize portfolio variance by combining assets that have low covariances with
each other. The covariance of an asset with itself is its variance: Cov(X,X) = σ2(X).

In this scenario, the weight of Asset B is 31%, so the weight of Asset A must be (1 − 0.31) = 69%. These values are substituted into the formula for
portfolio variance as follows:

(Choice A) 4.08 is the result of incorrectly using the asset return standard deviation in place of the asset return variance in the formula for two-
asset portfolio variance.

(Choice C) 25.31 is the result of calculating the weighted average of the return variances. The variance of a portfolio's return is not equal to the
weighted average of the return variances of the assets in a portfolio. Assuming the weighted average of the asset variances is equal to the
portfolio variance ignores that effect of the assets' covariance.

Things to remember:
Portfolio variance depends on the assets' return variances, their covariances, and the weight of each asset in the portfolio. The covariance of an
asset with itself is its variance.

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36. An analyst compiles information on a company's estimated future earnings per share (EPS):

If the company's EPS amount is treated as a random variable, its standard deviation is closest to:

 A. EUR 0.0354

B. EUR 0.0433

C. EUR 0.0612

Explanation

The standard deviation of a random variable is a measure of the variable's dispersion from its expected value (ie, how far values of the variable lie
from its mean). Both standard deviation and variance are used as a measure of risk for assets and portfolios.

In this scenario, calculate the standard deviation of the company's earnings per share (EPS) by finding the expected value of the EPS, then
calculating the variance:

The square root of the variance is the standard deviation:

(Choice B) EUR 0.0433 is the result of incorrectly finding the simple average of the EPS values instead of the expected value based on
probability as the first step in calculating the variance and the standard deviation.

(Choice C) EUR 0.0612 is the result of incorrectly calculating the variance as a simple average instead of the expected value of the squared
differences between the individual estimates and the expected value of the EPS.

Things to remember:
The standard deviation of a random variable is a measure of the dispersion of the values of the variable from its expected value, expressed in the
same units as the random variable. The standard deviation is the square root of the variance.

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37. An investor estimates a covariance matrix for the relative price movements of Asset A and Asset B that is shown below:

Asset A Asset B

Asset A 900 30

Asset B 30 400

If the investor creates a portfolio with 35% invested in Asset A and 65% invested in Asset B, the portfolio's standard deviation is closest to:

A. 16.7%

 B. 17.1%

C. 24.3%

Explanation

A portfolio's standard deviation is the positive square root of its variance. Standard deviation measures the dispersion of the portfolio's returns
around its mean return, which indicates the portfolio's risk relative to its return. A greater standard deviation represents greater risk.

Covariance indicates how the return of one asset moves relative to another asset. These co-movements affect the portfolio's variance. The
covariance of an asset with itself is its variance: σ2(X) = Cov(X, X). In this question, reading the matrix provided shows that:

900 is Asset A's variance,

400 is Asset B's variance, and
30 is the covariance between the assets.

Substituting the assets' weights, variances, and covariance into the equation for standard deviation:

The benefit of the assets' low covariance is risk reduction: A low covariance (relative to each asset's variance) allows a portfolio to be created that
has a lower standard deviation, and thus a lower risk, than either of the individual assets. The assets' standard deviations are 30% (Asset A) and
20% (Asset B) whereas the risk of a portfolio that combines both assets (given this weighting) is approximately 17.1%.

(Choice A) 16.7% results from summing the simple weighted average of each of the asset's variances and then taking the square root of the
result. This method fails to account for the effects of the assets' covariance.

(Choice C) 24.3% results from not squaring the weights of each asset in the first two elements of the equation.

Things to remember:
Covariance of returns measures how the returns of two assets move relative to each other. For assets with a low covariance relative to each
asset's variance, it is possible to combine the assets into a portfolio that has lower risk (as measured by standard deviation) than the risk of either
individual asset.

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38. An analyst estimates the probability of future returns on an asset as follows:

If the asset's return is a random variable, its variance is closest to:

 A. 0.0009

B. 0.0012

C. 0.0013

Explanation

The variance of a random variable is calculated as the probability-weighted average of the squared differences between each possible
outcome and the variable's expected value. The expected value of a random variable, a required input to calculate variance, is the probability-
weighted average of the variable's possible outcomes.

In this scenario, the expected value of the portfolio return is calculated as follows:

Using the expected value, calculate the variance as follows:

Note that the CFA curriculum uses both σ2(X) and Var(X) as equally valid symbols for variance.

(Choice B) 0.0012 is the result of failing to weight the calculation for E(X) by the probability distribution.

(Choice C) 0.0013 is the result of failing to weight the calculation for variance by the probability distribution. When calculating the variance, the
sum of the square differences is weighted by the probability of each outcome. This step corresponds to the last column in the table above.

Things to remember:
The variance of a random variable is the probability-weighted average of the squared differences between each possible outcome and the
variable's expected value. The expected value is the probability-weighted average of the variable's possible outcomes.

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39. For two events A and B, one calculates the probability of (A or B) by adding the probability of A to the probability of B, then:

A. subtracting the conditional probability of A given B [ie, P(A|B)].

 B. subtracting the probability of A and B [ie, P(AB)] to avoid counting it twice.

C. adding the probability of A and B [ie, P(AB)] in case the events are not mutually exclusive.

Explanation

For any two events A and B, the addition rule for probabilities, P(A or B) = P(A) + P(B) − P(AB), describes how to calculate the probability
that Aor B occurs. The formula can be simplified if the events are mutually exclusive, which is true only if their joint probability is equal to zero:
P(AB) = 0. If events are mutually exclusive, there is zero chance of both occurring. Thus, if the events are mutually exclusive, the addition rule
simplifies to P(A or B) = P(A) + P(B).

Consider the probabilities of A and B in the diagram. P(A) and P(B) are represented by their areas. If events are not mutually exclusive, adding
P(A) and P(B) will result in double counting P(AB), which is the overlap of the two areas. This would result in overestimating the probability of A or
B occurring. Thus, after adding P(A) and P(B), P(AB) should be subtracted to avoid double counting this probability (Choices A and C).

Things to remember:
Addition rule for probabilities: The probability of A or B is equal to the probability of A plus the probability of B minus the probability of A and B. If
events are mutually exclusive, this simplifies to: The probability of A or B is equal to the probability of A plus the probability of B.

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40. There is an 80% chance that a hedge fund's return will exceed its benchmark this year. There is a 90% chance that the fund manager will earn
higher total compensation than last year if the fund's return exceeds the benchmark. Suppose that the overall probability that the manager will
earn higher total compensation this year is 73%. Which of the following statements is most accurate?

A. The conditional probability of the fund return exceeding the benchmark is 0.80.

 B. The unconditional probability of earning higher compensation this year is 0.73.

C. The conditional probability of earning higher total compensation this year given that returns exceed the benchmark is 0.72.

Explanation

The conditional probability of an event expresses the likelihood that the event will occur given that another event occurs. In this case, the
conditional probability of the manager earning higher compensation given that the fund return exceeds its benchmark, denoted P(higher comp |
exceeds benchmark), is 0.9.

The unconditional probability (expected probability) of an event expresses the likelihood that an event will occur, regardless of whether
another event occurs. In this case, the unconditional probability of the manager earning higher compensation is 0.73, regardless of the fund's
return.

(Choice A) The unconditional probability of the fund exceeding its benchmark is 0.8. In this question, the event, defined as the fund return
exceeding the benchmark, is not conditioned on another event.

(Choice C) 0.72 is the joint probability of exceeding the benchmark and receiving higher compensation. The joint probability of two events equals
the product of the unconditional probability of one event [P(exceeds benchmark)] and the conditional probability of another event [P(higher comp |
exceeds benchmark)].

Things to remember:
The conditional probability of an event expresses the likelihood that the event will occur given that another event occurs. The unconditional
probability (expected probability) of an event expresses the likelihood that an event will occur, regardless of whether another event occurs.

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41. An analyst determines that two events are independent but not mutually exclusive: a rise in stock prices (S) and a rise in the price of West
Texas intermediate crude oil (T). If P(S|T) = 0.54, P(S or T) = 0.655, and P(T) = 0.25, then the probability of events S and T both occurring is
closest to:

A. 0

B. 0.063

 C. 0.135

Explanation

If P(A|B) = P(A) or P(B|A) = P(B), then

events A and B are independent.

If two events, A and B, are independent, then the occurrence of each event has no effect on the probability of the other event. Therefore,
the probability of A given that B occurs is the same as the probability of A regardless of B, and vice versa.

In this scenario, since events S and T are independent, observe that P(S|T) = P(S) = 0.54. Then, use the multiplication rule for probabilities to
calculate the probability that both S and T occur:

P(S and T) = P(S) × P(T)

= 0.54 × 0.25

= 0.1350

(Choice A) P(S and T) is equal to zero if S and T are mutually exclusive events, since there is no chance of both events happening. However,
since S and T are not mutually exclusive, P(S and T) ≠ 0.

(Choice B) 0.063 is the result of misunderstanding the definition of independent events to be P(T|S) = P(S), and then multiplying the incorrect
value for P(S) by P(T) to obtain P(S and T). An easy way to remember the correct formula is that the first event in the conditional probability is
repeated on the other side of the equation: P(S|T) = P(S) and P(T|S) = P(T).

Things to remember:
If two events, A and B, are independent, the occurrence of each event has no effect on the probability of the other event occurring. Therefore, the
probability of A given that B occurs is the same as the probability of A regardless of B, and vice versa.

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42. An analyst compiles the following data about an equity-indexed annuity that pays one of five possible returns to investors each year:

The expected value of the asset's return is closest to:

 A. 2.89%

B. 3.00%

C. 3.10%

Explanation

The expected value of a random variable is the probability-weighted average of the variable's possible outcomes. The term "expected value"
is used with a random variable, whose value is not yet determined. In calculating the expected value, each outcome is weighted by the likelihood
of its occurrence.

In this scenario, multiply each return by its probability, and then sum the resulting products to calculate the expected value:

The historical occurrences of the last 10 years are not used in the calculation of the expected value.

(Choice B) 3.00% is the simple arithmetic average of the five returns, not accounting for their number of occurrences.

(Choice C) 3.10% is the average of the values of the samples observed, in this case: [(1 + 1 + 2 + 3 + 3 + 4 + 4 + 4 + 4 + 5) / 10] = 3.10. The
expected value should not be confused with the sample mean, which is used with historical data.

Things to remember:
The expected value of a random variable is the probability-weighted average of the variable's possible outcomes. The expected value is used with
random variables, including future estimates, while the sample mean is used for historical observations, since their value has already been
determined.

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43. An analyst identifies two events and estimates probabilities as follows:

Probability of X 0.5100

Probability of Y 0.3600

Probability of X given Y 0.7222

Events X and Y are most likely:

 A. dependent.

B. mutually exclusive.

C. perfectly correlated.

Explanation

If

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

then events A and B are independent.

If, for two events X and Y, the occurrence of each event has no effect on the probability of the other event, then the events are
independent. Therefore, the probability of X given that Y occurs is the same as the probability of X regardless of Y, and vice versa.

In this scenario, the conditional probability of X given Y, or P(X|Y), is provided: 0.7222. Since P(X) = 0.51 ≠ P(X|Y) = 0.722, events X and Y are
not independent. Therefore, the events are dependent.

(Choice B) Two events X and Y are mutually exclusive if and only if P(X and Y) = 0. Whether the events are independent or not, P(X and Y) =
P(X|Y) × P(Y) = 0.7222 × 0.36 ≈ 0.26 ≠ 0. Therefore, since P(X and Y) ≠ 0, X and Y are not mutually exclusive.

(Choice C) In the context of two random variables with binary outcomes, perfect correlation would mean that whenever one occurs, the other
occurs, and vice versa. This would mean that P(X) = P(Y) = P(X and Y), and that P(X|Y) = 1, which is not the case in this scenario.

Things to remember:
If two events, X and Y, are independent, then each event has no effect (positive or negative) on the probability of the other event. Therefore, the
probability of X given that Y occurs is the same as the probability of X regardless of Y, and vice versa.

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44. A portfolio comprises two stocks, A and B, with the following characteristics:

All values expressed as % A B

Portfolio weight (w) 40 60

Return 3 6

Standard deviation (σ) 5 10

If the portfolio standard deviation equals 5.40%, the correlation between Stocks A and B is closest to:

 A. −0.4517

B. −0.0023

C. 0.1733

Explanation

Portfolio variance and standard deviation can be used to measure the dispersion of portfolio returns. A high overall variance represents a high
degree of dispersion and therefore high overall risk.

A key benefit of holding a diversified portfolio is that the overall variance of a portfolio can be lower than the simple weighted average of the
variance of its component assets. The magnitude of this effect depends on the correlation between the assets held in the portfolio.

As shown in the equation for the variance of a two-stock portfolio, the portfolio weights, stock variances, and correlation between the stocks are
used to calculate the variance. The smaller the correlation's value, the smaller the portfolio variance.

In this scenario, the portfolio standard deviation is given. The variance must first be derived, then the equation above can be used to solve for the
correlation:

The correlation is closest to −0.4517.

(Choice B) −0.0023 is the covariance between Stocks A and B, which is related to correlation and equals the product of the correlation and each
of the standard deviations.

(Choice C) 0.1733 is the result of incorrectly applying Stock A weights to Stock B's standard deviation, and vice versa.

Things to remember:
In a two-stock portfolio, all else equal, a smaller correlation value will result in a smaller variance. The portfolio's variance is a function of the
weight and standard deviation of each asset and the correlation between assets.

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45. An analyst estimates the probability that:

a carbon tax will be enacted is 0.40.

oil prices will fall given that a carbon tax is enacted is 0.75.
either a carbon tax will be enacted or oil prices will fall is 0.80.

The probability that oil prices will fall is closest to:

A. 0.10

B. 0.40

 C. 0.70

Explanation

The addition rule for probabilities is used to calculate the probability that at least one of two events, A or B, occurs. When the events are
independent, this is the sum of P(A) + P(B). However, when the events are not independent, there is a probability that both events could occur (ie,
a joint probability). The joint probability P(AB) must be subtracted from the sum of the individual probabilities.

Since oil prices falling is related to the imposition of the tax, there is a probability that both events could occur. The probability that oil prices fall
given the imposition of the tax is 0.75. Using the joint probability rule, the probability of both a fall in oil prices AND the imposition of the tax is 0.75
× 0.40 = 0.30.

In this question, the P(oil prices fall OR carbon tax enacted) is given as 0.80. The calculation using the addition rule is shown below (the formula
is rearranged in the second line to isolate the unknown variable):

(Choice A) 0.10 results from incorrectly specifying the rearranged formula by subtracting the joint probability instead of adding it.

(Choice B) 0.40 results by not subtracting the joint probability of both events.

Things to remember:
The addition rule for probabilities is used to calculate the probability that at least one of two events will occur. When the events are not
independent, the joint probability of both events must be subtracted from the sum of the individual probabilities of either event to avoid double-
counting.

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46. A company generates substantial income from a major foreign subsidiary. The company's net profitability is impacted by changes to the
foreign exchange rate. There is a

0.3 probability that the foreign currency will depreciate relative to the company's domestic currency.

0.2 probability of the company recording a net loss this year given that the foreign currency depreciates.

0.1 probability of the company recording a net loss this year given that the foreign currency does not depreciate.

At year-end, the company did not record a net loss. The probability that the foreign currency did not depreciate is closest to:

A. 0.70

 B. 0.72

C. 0.87

Explanation

The probability of an event is often impacted by the occurrence of a related preceding event. In this question, the probability of the company
recording a net loss is related to whether the foreign currency depreciates.

Bayes' formula calculates a type of "inverse" probability that revises the probability of a preceding event given that the subsequent event
has occurred. Bayes' formula uses the occurrence of a subsequent event to infer the probability of a preceding event.

New information confirms that the company did not experience a net loss at year-end. Work backward to deduce the probability of this being
attributed to the foreign currency not depreciating:

Originally, there is a 0.87 (or 0.24 + 0.63) probability of the company not recording a net loss.

Since the company did not have a net loss, the updated (posterior) probability that the foreign currency depreciated is 0.72 [or 0.63 / (0.24 +
0.63)]. This is revised from its original (prior) probability of 0.7.

Alternatively, one can use the Bayes' formula to answer this question; however, the formula is complex and requires detailed memorization. For
the exam, the decision tree approach detailed here is highly recommended.

(Choice A) 0.7 is the original (prior) probability of the foreign currency not depreciating.

(Choice C) 0.87 is the original expected probability of the company not experiencing a net loss.

Things to remember:
Bayes' formula calculates a type of "inverse" probability that revises the probability of a preceding event given that the subsequent event has
occurred.

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47. An analyst has developed a screening test to determine whether a company's earnings will decrease. If the company does not pass the test, it
is likely that its earnings will decrease in the next quarter. The table below shows relevant information:

Event Probability

Probability of an earnings decrease in the next quarter 0.47

Probability of passing the test 0.62

Probability of an earnings decrease in the next quarter

0.90
given it did not pass the test

Based on this information, the probability that the company's earnings will decrease in the next quarter given that the company passes the test is
closest to:

A. 0.13

 B. 0.21

C. 0.34

Explanation

This question asks the candidate to calculate the probability that a company's earnings will decrease given that it passes a screening test
[P(Earnings decrease | Passes test)]. This is an example of a conditional probability. The question does not provide the information needed to
directly solve for the answer, but the solution can be derived using the total probability rule.

The total probability of an event is the sum of the joint probabilities of its mutually exclusive and exhaustive scenarios. In this question, the
total probability of an earnings decrease is the sum of:

P(Passes test AND Earnings decrease) and

P(Does not pass the test AND Earnings decrease).

Each joint probability is the product of two probabilities. The first term is the unconditional probability of the company passing (or does not
pass) the test, and the second is a conditional probability (ie, its earnings decrease given that it passes (or not passes) the test). The joint
probability is P(A and B) = P(A) × P(B | A). The information needed to calculate the probability that the company will not pass the test AND have
an earnings decrease [P(Does not pass test AND Earnings decrease)] is given: (1 − 0.62) × 0.90 ≈ 0.34 (Choice C).

The information needed to calculate the probability that the company will pass the test AND have an earnings decrease is not given; however, it
can be deduced since the total probability of an earnings decrease is given as 0.47. These two joint probabilities of an earnings decrease are
mutually exclusive and exhaustive and sum to the total probability (0.47); therefore, the unknown joint probability is 0.47 − 0.342 = 0.128 (Choice
A).

Once the joint probability P(Passes test AND Earnings decrease) is known, and since the unconditional probability of passing the test is given
[P(Passes test) = 0.62], the conditional probability can be calculated by rearranging the formula for joint probability: P(B | A) = P(A and B) / P(A), or

P(Passes test AND Earnings decrease) / P(Passes test) = 0.128 / 0.62 ≈ 0.21

Things to remember:
The total probability of an event is the sum of the probabilities of its mutually exclusive and exhaustive scenarios. Each scenario can consist of a
joint probability of two events, where one probability is unconditional and the other is conditioned on whether the first event occurs.

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