BUSINESS ANALYTICS

Probability and Probability Distributions

Introduction
(slide 1 of 3)
A key aspect of solving real business problems is dealing appropriately
with uncertainty.
◦ This involves recognizing explicitly that uncertainty exists and using
quantitative methods to model uncertainty.

In many situations, the uncertain quantity is a numerical quantity. In the

language of probability, it is called a random variable.
A probability distribution lists all of the possible values of the random
variable and their corresponding probabilities.
Flow Chart for Modelling Uncertainty (slide 2 of 3)
Introduction
(slide 3 of 3)
Uncertainty and risk are sometimes used interchangeably, but they are
not really the same.
◦ You typically have no control over uncertainty; it is something that simply
exists.
◦ In contrast, risk depends on your position.
◦ Even if something is uncertain, there is no risk if it makes no difference to you.
Probability Essentials
A probability is a number between 0 and 1 that measures the
likelihood that some event will occur.
◦ An event with probability 0 cannot occur, whereas an event
with probability 1 is certain to occur.
◦ An event with probability greater than 0 and less than 1
involves uncertainty, and the closer its probability is to 1, the
more likely it is to occur.
Probabilities are sometimes expressed as percentages or odds,
but these can be easily converted to probabilities on a 0-to-1
scale.
 Probability Essentials - Events
 Notations
Sample space: S
Sample point: E1, E2 ,... etc.
Event : A, B,C, D, E, etc.

 More definitions
1. The union of A and B or A  B , is the event containing all sample points in
either A or B or both.
2. The intersection of A and B or A  B , is the event containing all sample
points that are both in A and B . Sometimes we use AB for intersection.
3. The complement of A or Ac , is the event containing all sample points that are
not in A . Sometimes we use A for complement.

Mutually exclusive events (disjoint events): Two events are said to be mutually
exclusive (or disjoint) if their intersections is empty, i.e. A  B = 

6
Exercise
An experiment consists of throwing a fair dice.

(i) List all elements in the sample space

(ii) Describe the following events:
a) A = {Observe a number larger than 3}
b) B = {Observe an even number}
c) C = {Observe an odd number}
(iii) Then find:
a) AUB
b) A∩B
c) B∩C
d) Ac
e) Cc
f) AUC
g) A∩C
Probability definition
Conceptual definition of probability

Consider a random experiment whose sample space is S with sample points

E1, E2 ,... . For each event Ei of the sample space S defines a number P (E i )
that satisfies the following conditions:

(i) 0  P(Ei )  1 for all i

(ii) P (S ) = 1
(iii) Additive property

 P (E ) = 1 ,
S
i

where the summation is over all sample points in S . We refer to P (E i ) as the

probability of the event E i .
Steps in calculating probabilities of events

1. Define the experiment

2. List all simple events
3. Assign probabilities to simple events
4. Determine the simple events that constitute an event
5. Add up the simple events’ probabilities to obtain the probability of the event

8
Independent events: Two events A and B are said to be independent if
Probability Rules P ( A  B ) = P ( A)P (B ) .

Complementation law

P( A) = 1 − P( Ac ) .

Additive law

P( A  B) = P( A) + P(B) − P( A  B)

Moreover, if A and B are mutually exclusive, then P ( A  B ) = 0 and

P ( A  B ) = P ( A ) + P (B ) .

Exhaustive events: AUB = S. If A and B are exhaustive, then P(AUB) = 1

Exercise: Referring to the previous exercise, calculate the probability of each

event in (ii) and (iii)

9
Conditional Probability and
the Multiplication Rule (slide 1 of 2)
A formal way to revise probabilities on the basis of new information is
to use conditional probabilities.
Let A and B be any events with probabilities P(A) and P(B). If you are
told that B has occurred, then the probability of A might change.
◦ The new probability of A is called the conditional probability of A given B, or
P(A|B).
◦ It can be calculated with the following formula:
Conditional Probability and
the Multiplication Rule (slide 2 of 2)
◦ The numerator in this formula is the probability that both A and B occur. This
probability must be known to find P(A|B).

However, in some applications, P(A|B) and P(B) are known. Then you
can multiply both sides of the equation by P(B) to obtain the
multiplication rule for P(A and B):
Assessing Uncertainty at Bender Company
(slide 1 of 2)

Objective: To apply probability rules to calculate the probability that Bender

(a company that supplies contractors with materials for construction of
houses) will meet its end-of-July deadline, given the information it has at the
beginning of July.
Solution: Let A be the event that Bender meets its end-of-July deadline, and
let B be the event that Bender receives the materials it needs from its
supplier by the middle of July.
Bender estimates that the chances of getting the materials on time are 2 out
of 3, so that P(B) = 2/3.
Bender estimates that if it receives the required materials on time, the
chances of meeting the deadline are 3 out of 4, so that P(A|B) = 3/4.
Bender estimates that the chances of meeting the deadline are 1 out of 5 if
the materials do not arrive on time, so that P(A|B) = 1/5.
Assessing Uncertainty at Bender Company
(slide 2 of 2)

The uncertain situation is depicted graphically in the form of a

probability tree.

◦ The addition rule for mutually exclusive events implies that

Probabilistic Independence
There are situations where the probabilities P(A), P(A|B), and P(A|B)
are equal. In this case, A and B are probabilistic independent events.
◦ This does not mean that they are mutually exclusive.
◦ Rather, it means that knowledge of one event is of no value when assessing
the probability of the other.

When two events are probabilistically independent, the multiplication

rule simplifies to:

To tell whether events are probabilistically independent, you typically

need empirical data.
Exercise 1
1. A box contains four black and six white balls

(i) If a ball is selected at random, what is the probability that it is white?

black?

(ii) If two balls are selected without replacement, what is the probability that
both balls are black? both are white? the first is white and the second is
black? The first is black and the second is white? one ball is black?

(iii) Repeat (ii) if the balls are selected with replacement.

15
Exercise 2
Suppose that the following two weather forecasts were
reported on two local TV stations for the same period. First
report: The chances of rain are today 30%, tomorrow 40%,
both today and tomorrow 20%, either today or tomorrow
60%. Second report: The chances of rain are today 30%,
tomorrow 40%, both today and tomorrow 10%, either today
or tomorrow 60%. Which of the two reports, if any, is more
believable? Why? (Hint: Let A and B be the events of rain
today and rain tomorrow).

16
Subjective vs. Objective
Probabilities
Objective probabilities are those that can be estimated from long-run
proportions.
The relative frequency of an event is the proportion of times the event
occurs out of the number of times the random experiment is run.
◦ A relative frequency can be recorded as a proportion or a
percentage.
◦ A famous result called the law of large numbers states that this
relative frequency, in the long run, will get closer and closer to the
“true” probability of an event.
However, many business situations cannot be repeated under identical
conditions, so you must use subjective probabilities in these cases.
◦ A subjective probability is one person’s assessment of the likelihood
that a certain event will occur.
Probability Distribution of a
Single Random Variable (slide 1 of 4)
A discrete random variable has only a discrete (often finite)
number of possible values.
A continuous random variable has a continuum of possible
values.
Usually a discrete distribution results from a count, whereas a
continuous distribution results from a measurement.
◦ This distinction between counts and measurements is not
always clear-cut.
Mathematically, there is an important difference between
discrete and continuous probability distributions.
◦ Specifically, a proper treatment of continuous distributions
requires calculus.
Probability Distribution of a
Single Random Variable (slide 2 of 4)
The essential properties of a discrete random
variable and its associated probability distribution are
quite simple.
◦ To specify the probability distribution of X, we need to
specify its possible values and their probabilities.
◦ We assume that there are k possible values, denoted
v1, v2, …, vk, which form the sample space S
◦ The probability of a typical value vi is denoted in one of two
ways, either P(X = vi) or p(vi).
◦ Probability distributions must satisfy two criteria:
◦ The probabilities must be nonnegative.
◦ They must sum to 1.
 Probability Distribution of a
Single Random Variable (slide 3 of 4)
Example: Toss a coin 3 times, then

S = {HHH, HHT , HTH, HTT ,THH,THT ,TTH,TTT } .

Let the variable of interest X be the number of heads observed, and then the
relevant events would be
{X = 0} = {TTT }
{X = 1} = {HTT ,THT ,TTH }
{X = 2} = {HHT , HTH,THH }
{X = 3} = {HHH }.

Then P(X=0) = ; P(X=1) = ; P(X=2) = ; P(X=3) =

Probability Distribution of a
Single Random Variable (slide 4 of 4)
A cumulative probability is the probability that the
random variable is less than or equal to some
particular value.
◦ Assume that 10, 20, 30, and 40 are the possible values of
a random variable X, with corresponding probabilities
0.15, 0.25, 0.35, and 0.25.
◦ From the addition rule, the cumulative probability
P(X≤30) can be calculated as:
Summary Measures of a
Probability Distribution (slide 1 of 2)
 The mean, often denoted μ, is a weighted sum
of the possible values, weighted by their
probabilities:

◦ It is also called the expected value of X and denoted E(X).

 To measure the variability in a distribution, we
calculate its variance or standard deviation.
◦ The variance, denoted by σ2 or Var(X), is a weighted sum of the
squared deviations of the possible values from the mean, where the
weights are again the probabilities.
Summary Measures of a
Probability Distribution (slide 2 of 2)
◦ Variance of a probability distribution, σ2:

◦ Variance (computing formula):

 A more natural measure of variability is the standard

deviation, denoted by σ or Stdev(X). It is the square root
of the variance:
Example 4.2:
Market Return.xlsx (slide 1 of 2)
Objective: To compute the mean, variance, and standard deviation of
the probability distribution of the market return for the coming year.
Solution: Market returns for five economic scenarios are estimated at
23%, 18%, 15%, 9%, and 3%. The probabilities of these outcomes are
estimated at 0.12, 0.40, 0.25, 0.15, and 0.08.
 Example 4.2:
Market Return.xlsx (slide 2 of 2)
Procedure for Calculating the Summary Measures:
1. Calculate the mean return in cell B11 with the formula:

2. To get ready to compute the variance, calculate the squared deviations from the
mean by entering this formula in cell D4:

and copy it down through cell D8.

3. Calculate the variance of the market return in cell B12 with the formula:

OR skip Step 2, and use this simplified formula for variance:

4. Calculate the standard deviation of the market return in cell B13 with the
formula:
Conditional Mean and
Variance
There are many situations where the mean and variance of a random
variable depend on some external event.
◦ In this case, you can condition on the outcome of the external event to find
the overall mean and variance (or standard deviation) of the random
variable.
Conditional mean formula:
Conditional variance formula:

All calculations can be done easily in Excel®.

◦ See the file Stock Price and Economy.xlsx for details.
Introduction to Simulation
(slide 1 of 2)
Simulation is an extremely useful tool that can be used to incorporate
uncertainty explicitly into spreadsheet models.
A simulation model is the same as a regular spreadsheet model except
that some cells contain random quantities.
◦ Each time the spreadsheet recalculates, new values of the random
quantities are generated, and these typically lead to different
bottom-line results.
The key to simulating random variables is Excel’s RAND function, which
generates a random number between 0 and 1.
◦ It has no arguments, so it is always entered:

Optional
Introduction to Simulation
(slide 2 of 2)
Random numbers generated with Excel’s RAND function are said to be
uniformly distributed between 0 and 1 because all decimal values
between 0 and 1 are equally likely.
◦ These uniformly distributed random numbers can then be used to
generate numbers from any discrete distribution.
◦ This procedure is accomplished most easily in Excel through the use
of a lookup table—by applying the VLOOKUP function.

Optional
Simulation of Market Returns

Optional
Procedure for Generating
Random Market Returns in Excel
(slide 1 of 2)
1. Copy the possible returns to the range E13:E17. Then enter the
cumulative probabilities next to them in the range D13:D17. To do this,
enter the value 0 in cell D13. Then enter the formula:

in cell D14 and copy it down through cell D17. The table in the range
D13:E17 becomes the lookup range (LTable).
2. Enter random numbers in the range A13:A412. To do this, select the
range, then type the formula:

and press Ctrl + Enter.

Optional
Procedure for Generating
Random Market Returns in Excel
(slide 2 of 2)
3. Generate the random market returns by referring the
random numbers in column A to the lookup table. Enter
the formula:

in cell B13 and copy it down through cell B412.

4. Summarize the 400 market returns by entering the
formulas:

in cells B4 and B5.

Optional