What Is a Probability Distribution?

A probability distribution is a statistical function that describes all the

possible values and likelihoods that a random variable can take within a
given range. This range will be bounded between the minimum and
maximum possible values, but precisely where the possible value is
likely to be plotted on the probability distribution depends on a number of
factors. These factors include the distribution's mean
(average), standard deviation, skewness, and kurtosis.

How Probability Distributions Work

Perhaps the most common probability distribution is the normal
distribution, or "bell curve" although several distributions exist that are
commonly used. Typically, the data generating process of some will
dictate its probability distribution. This process is called the probability
density function.

Probability distributions can also be used to create cumulative

distribution function.Which adds up the probability of occurrences
cumulatively and will always start at zero and end at 100%.

Academics, financial analysts and fund managers alike may determine a

particular stock's probability distribution to evaluate the possible
expected returns that the stock may yield in the future. The stock's
history of returns, which can be measured from any time interval, will
likely be composed of only a fraction of the stock's returns, which will
subject the analysis to sampling error. By increasing the sample
size, this error can be dramatically reduced.

KEY TAKEAWAYS

 A probability distribution depicts the expected outcomes of possible

values for a given data generating process.
 Probability distributions come in many shapes with different
characteristics, as defined by the mean, standard deviation,
skewness, and kurtosis.
 Investors use probability distributions to anticipate returns on
assets such as stocks over time and to hedge their risk.
Types of Probability Distributions
There are many different classifications of probability distributions. Some
of them include the normal distribution, chi square distribution, binomial
distribution, and Poisson distribution. The different probability
distributions serve different purposes and represent different data
generation processes. The binomial distribution, for example, evaluates
the probability of an event occurring several times over a given number
of trials and given the event's probability in each trial. and may be
generated by keeping track of how many free throws a basketball player
makes in a game, where 1 = a basket and 0 = a miss. Another typical
example would be to use a fair coin and figuring the probability of that
coin coming up heads in 10 straight flips. A binomial distribution
is discrete, as opposed to continuous, since only 1 or 0 is a valid
response.

The most commonly used distribution is the normal distribution, which is

used frequently in finance, investing, science, and engineering. The
normal distribution is fully characterized by its mean and standard
deviation, meaning the distribution is not skewed and does exhibit
kurtosis. This makes the distribution symmetric and it is depicted as a
bell-shaped curve when plotted. A normal distribution is defined by a
mean (average) of zero and a standard deviation of 1.0, with a skew of
zero and kurtosis = 3. In a normal distribution, approximately 68% of the
data collected will fall within +/- one standard deviation of the mean;
approximately 95% within +/- two standard deviations; and 99.7% within
three standard deviations. Unlike the binomial distribution, the normal
distribution is continuous, meaning that all possible values are
represented (as opposed to just 0 and 1 with nothing in between).
What is Normal Distribution?
Normal distribution, also known as the Gaussian distribution, is
a probability distribution that is symmetric about the mean, showing that
data near the mean are more frequent in occurrence than data far from
the mean. In graph form, normal distribution will appear as a bell curve.

KEY TAKEAWAYS

 A normal distribution is the proper term for a probability bell curve.

 In a normal distribution the mean is zero and the standard
deviation is 1. It has zero skew and a kurtosis of 3.
 Normal distributions are symmetrical, but not all symmetrical
distributions are normal.
 In reality, most pricing distributions are not perfectly normal.

Understanding Normal Distribution

The normal distribution is the most common type of distribution assumed
in technical stock market analysis and in other types of statistical
analyses. The standard normal distribution has two parameters: the
mean and the standard deviation. For a normal distribution, 68% of the
observations are within +/- one standard deviation of the mean, 95% are
within +/- two standard deviations, and 99.7% are within +- three
standard deviations.

The normal distribution model is motivated by the Central Limit

Theorem. This theory states that averages calculated from independent,
identically distributed random variables have approximately normal
distributions, regardless of the type of distribution from which the
variables are sampled (provided it has finite variance). Normal
distribution is sometimes confused with symmetrical distribution.
Symmetrical distribution is one where a dividing line produces two mirror
images, but the actual data could be two humps or a series of hills in
addition to the bell curve that indicates a normal distribution.
What Is the Binomial Distribution?
The binomial distribution is a probability distribution that summarizes the
likelihood that a value will take one of two independent values under a
given set of parameters or assumptions.

The underlying assumptions of the binomial distribution are that there is

only one outcome for each trial, that each trial has the same probability
of success, and that each trial is mutually exclusive, or independent of
one another.

KEY TAKEAWAYS

 The binomial distribution is a probability distribution that

summarizes the likelihood that a value will take one of two
independent values under a given set of parameters or
assumptions.
 The underlying assumptions of the binomial distribution are that
there is only one outcome for each trial, that each trial has the
same probability of success, and that each trial is mutually
exclusive or independent of one another.
 The binomial distribution is a common discrete distribution used in
statistics, as opposed to a continuous distribution, such as the
normal distribution.
Understanding Binomial Distribution
The binomial distribution is a common discrete distribution used in
statistics, as opposed to a continuous distribution, such as the normal
distribution. This is because the binomial distribution only counts two
states, typically represented as 1 (for a success) or 0 (for a failure) given
a number of trials in the data. The binomial distribution thus represents
the probability for x successes in n trials, given a success probability p
for each trial.

Binomial distribution summarizes the number of trials, or observations

when each trial has the same probability of attaining one particular
value. The binomial distribution determines the probability of observing a
specified number of successful outcomes in a specified number of trials.

The binomial distribution is often used in social science statistics as a

building block for models for dichotomous outcome variables, like
whether a Republican or Democrat will win an upcoming election or
whether an individual will die within a specified period of time, etc.
What Is a Poisson Distribution?
In statistics, a Poisson distribution is a probability distribution that is used
to show how many times an event is likely to occur over a specified
period. In other words, it is a count distribution. Poisson distributions are
often used to understand independent events that occur at a constant
rate within a given interval of time. It was named after French
mathematician Siméon Denis Poisson.

The Poisson distribution is a discrete function, meaning that the variable

can only take specific values in a (potentially infinite) list. Put differently,
the variable cannot take all values in any continuous range. For the
Poisson distribution (a discrete distribution), the variable can only take
the values 0, 1, 2, 3, etc., with no fractions or decimals.

KEY TAKEAWAYS

 A Poisson distribution, named after French mathematician Siméon

Denis Poisson, can be used to estimate how many times an event
is likely to occur within "X" periods of time.
 Poisson distributions are used when the variable of interest is a
discrete count variable.
 Many economic and financial data appear as count variables, such
as how many times a person becomes unemployed in a given
year, thus lending themselves to analysis with a Poisson
distribution.

Understanding Poisson Distributions

A Poisson distribution can be used to estimate how likely it is that
something will happen "X" number of times. For example, if the average
number of people who buy cheeseburgers from a fast-food chain on a
Friday night at a single restaurant location is 200, a Poisson distribution
can answer questions such as, "What is the probability that more than
300 people will buy burgers?" The application of the Poisson distribution
thereby enables managers to introduce optimal scheduling systems that
would not work with, say, a normal distribution.
One of the most famous historical, practical uses of the Poisson
distribution was estimating the annual number of Prussian cavalry
soldiers killed due to horse-kicks. Modern examples include estimating
the number of car crashes in a city of a given size; in physiology, this
distribution is often used to calculate the probabilistic frequencies of
different types of neurotransmitter secretions. Or, if a video store
averaged 400 customers every Friday night, what would have been the
probability that 600 customers would come in on any given Friday night?

What Is a Chi-Square Statistic?

A chi-square (χ2) statistic is a test that measures how a model compares
to actual observed data. The data used in calculating a chi-
square statistic must be random, raw, mutually exclusive, drawn from
independent variables, and drawn from a large enough sample. For
example, the results of tossing a fair coin meet these criteria.

Chi-square tests are often used in hypothesis testing. The chi-square

statistic compares the size any discrepancies between the expected
results and the actual results, given the size of the sample and the
number of variables in the relationship. For these tests, degrees of
freedom are utilized to determine if a certain null hypothesis can be
rejected based on the total number of variables and samples within the
experiment. As with any statistic, the larger the sample size, the more
reliable the results.

KEY TAKEAWAYS

 A chi-square (χ2) statistic is a measure of the difference between

the observed and expected frequencies of the outcomes of a set of
events or variables.
 χ2 depends on the size of the difference between actual and
observed values, the degrees of freedom, and the samples size.
 χ2 can be used to test whether two variables are related or
independent from one another or to test the goodness-of-fit
between an observed distribution and a theoretical distribution of
frequencies.
What Does a Chi-Square Statistic Tell You?
There are two main kinds of chi-square tests: the test of independence,
which asks a question of relationship, such as, "Is there a relationship
between student sex and course choice?"; and the goodness-of-fit test,
which asks something like "How well does the coin in my hand match a
theoretically fair coin?"

dependence
When considering student sex and course choice, a χ2 test for
independence could be used. To do this test, the researcher would
collect data on the two chosen variables (sex and courses picked) and
then compare the frequencies at which male and female students select
among the offered classes using the formula given above and
a χ2 statistical table.

If there is no relationship between sex and course selection (that is, if

they are independent), then the actual frequencies at which male and
female students select each offered course should be expected to be
approximately equal, or conversely, the proportion of male and female
students in any selected course should be approximately equal to the
proportion of male and female students in the sample. A χ2 test for
independence can tell us how likely it is that random chance can explain
any observed difference between the actual frequencies in the data and
these theoretical expectations.

Goodness-of-Fit
χ2 provides a way to test how well a sample of data matches the (known
or assumed) characteristics of the larger population that the sample is
intended to represent. If the sample data do not fit the expected
properties of the population that we are interested in, then we would not
want to use this sample to draw conclusions about the larger population.

For example consider an imaginary coin with exactly 50/50 chance of

landing heads or tails and a real coin that you toss 100 times. If this real
coin has an is fair, then it will also have an equal probability of landing on
either side, and the expected result of tossing the coin 100 times is that
heads will come up 50 times and tails will come up 50 times. In this
case, χ2 can tell us how well the actual results of 100 coin flips compare
to the theoretical model that a fair coin will give 50/50 results. The actual
 toss could come up 50/50, or 60/40, or even 90/10. The farther away the
actual results of the 100 tosses is from 50/50, the less good the fit of this
set of tosses is to the theoretical expectation of 50/50 and the more likely
we might conclude that this coin is not actually a fair coin.

t-Distribution
Definition: The t-Distribution, also known as Student’s
t-Distribution is the probability distribution that
estimates the population parameters when the sample
size is small and the population standard deviation is
unknown
It resembles the normal distribution and as the sample size increases
the t-distribution looks more normally distributed with the values of
means and standard deviation of 0 and 1 respectively.

Properties of t-Distribution
 

1. Like, standard normal distribution the shape of the student

distribution is also bell-shaped and symmetrical with mean zero.
2. The student distribution ranges from –∞ to ∞ (infinity).
3. The shape of the t-distribution changes with the change in the
degrees of freedom.
4. The variance is always greater than one and can be defined only
when the degrees of freedom ν ≥ 3 and is given as: Var (t) = [ν/ν -2]
5. It is less peaked at the center and higher in tails, thus it assumes
platykurtic shape.
6. The t-distribution has a greater dispersion than the standard
normal distribution. And as the sample size ‘n’ increases, it assumes
the normal distribution. Here the sample size is said to be large
when n ≥ 30.
 The following are the important Applications of the t-distribution:

 Test of the Hypothesis of the population mean.

 Test of Hypothesis of the difference between the two means.
 Test of Hypothesis of the difference between two means with
dependent samples.
 Test of Hypothesis about the coefficient of correlation.
Thus, student distribution is the statistical measure that compares the
observed data with the expected data obtained with a specific
hypothesis. It complies with the central limit theorem which says that
the distribution approaches the standard normal distribution as long as
the sample size is large.

F-Distribution
Definition: The F-Distribution is also called as Variance Ratio
Distribution as it usually defines the ratio of the variances of the two
normally distributed populations. The F-distribution got its name after
the name of R.A. Fisher, who studied this test for the first time in 1924

Properties of F-Distribution
 There are several properties of F-distribution which are explained
below:

1. The F-distribution is positively skewed and with the increase in

the degrees of freedom ν1 and ν2, its skewness decreases.
2. The value of the F-distribution is always positive, or zero since
the variances are the square of the deviations and hence cannot
assume negative values. Its value lies between 0 and ∞.
3. The statistic used to calculate the value of mean and variance is:

4. The shape of the F-distribution depends on its

parameters ν1 and ν2 degrees of freedom.
5. The values of the area lying on the left-hand side of the
distribution can be found out by taking the reciprocal of F values
corresponding to the right-hand side and the degrees of freedom in
the numerator and the denominator are interchanged. This is called
as Reciprocal Property of F-distribution. Symbolically, it can be
represented as:This property is mainly used in the situations when the
values of the lower tail F values are to be determined corresponding to
the upper tail F values.
Thus, these are the properties of F-distribution that tells how the
sample is distributed under study and what statistical inferences can
be drawn therefrom
Probability Distributions Used in Investing
Stock returns are often assumed to be normally distributed but in reality,
they exhibit kurtosis with large negative and positive returns seeming to
occur more than would be predicted by a normal distribution. In fact,
because stock prices are bounded by zero but offer a potential unlimited
upside, the distribution of stock returns has been described as log-
normal. This shows up on a plot of stock returns with the tails of the
distribution having greater thickness.

Probability distributions are often used in risk management as well to

evaluate the probability and amount of losses that an investment
portfolio would incur based on a distribution of historical returns. One
popular risk management metric used in investing is value-at-risk (VaR).
VaR yields the minimum loss that can occur given a probability and time
frame for a portfolio. Alternatively, an investor can get a probability of
loss for an amount of loss and time frame using VaR

Disscrete vs. Continuous Distributions

Discrete refers to a random variable drawn from a finite set of possible
outcomes. A six-sided die, for example, has six discrete outcomes. A
continuous distribution refers to a random variable drawn from an infinite
set. Examples of continuous random variables include speed, distance,
and some asset returns. A discrete random variable is illustrated
typically with dots or dashes, while a continuous variable is illustrated
with a solid line. The figure below shows discrete and continuous
distributions for a normal distribution with mean (expected value) of 50
and a standard deviation of 10

Discrete probability distributions

Several specialized discrete probability distributions are useful for

specific applications. For business applications, three frequently used
discrete distributions are:

 Binomial

 Geometric

 Poisson
Continuous probability distributions

Many continuous distributions may be used for business applications;

two of the most widely used are:

 Uniform

 Normal

Probability Distribution
A probability distribution is a statistical model that shows the possible
outcomes of a particular event or course of action as well as the statistical
likelihood of each event. For example, a company might have a probability
distribution for the change in sales given a particular marketing campaign.
The values on the "tails" or the left and right end of the distribution are much
less likely to occur than those in the middle of the curve.

Scenario Analysis
Probability distributions can be used to create scenario analyses. A scenario
analysis uses probability distributions to create several, theoretically distinct
possibilities for the outcome of a particular course of action or future event.
For example, a business might create three scenarios: worst-case, likely and
best-case. The worst-case scenario would contain some value from the
lower end of the probability distribution; the likely scenario would contain a
value towards the middle of the distribution; and the best-case scenario
would contain a value in the upper end of the scenario.

Sales Forecasting
One practical use for probability distributions and scenario analysis in
business is to predict future levels of sales. It is essentially impossible to
predict the precise value of a future sales level; however, businesses still
need to be able to plan for future events. Using a scenario analysis based on
a probability distribution can help a company frame its possible future values
in terms of a likely sales level and a worst-case and best-case scenario. By
doing so, the company can base its business plans on the likely scenario but
still be aware of the alternative possibilities.

Risk Evaluation
In addition to predicting future sales levels, probability distribution can be a
useful tool for evaluating risk. Consider, for example, a company considering
entering a new business line. If the company needs to generate $500,000 in
revenue in order to break even and their probability distribution tells them
that there is a 10 percent chance that revenues will be less than $500,000,
the company knows roughly what level of risk it is facing if it decides to
pursue that new business line