Business Statistics Midterm Exam

Fall 2019: BUS41000

This is a closed-book, closed-notes exam. You may use any calculator.

Please answer all problems in the space provided on the exam.
Read each question carefully and clearly present your answers.
Honor Code Pledge: “I pledge my honor that I have not violated the University Honor Code during this
examination.”
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Name:

Useful formulas

• E(aX + bY ) = aE(X) + bE(Y )

• V ar(aX + bY ) = a2 V ar(X) + b2 V ar(Y ) + 2ab · Cov(X, Y )
Cov(X,Y )
• Cor(X, Y ) = sd(X)·sd(Y )
q 2
sX 2
• The standard error of X̄ is defined as sX̄ = n , where sX denotes the sample variance of X.
• The standard error for the difference in the averages between groups a and b is defined as:
s
s2a s2
s(X̄a −X̄b ) = + b
na nb

where s2a denotes the sample variance of group a and naq the number of observations in group a.
• The standard error for a proportion is defined by: sp̂ = p̂(1− n
p̂)

• The standard error for difference in proportion is defined by:

s
p̂1 (1 − p̂1 ) p̂2 (1 − p̂2 )
sp̂1 −p̂2 = +
n1 n2

where p̂1 and p̂2 denote two independent proportions, and n1 and n2 are the number of trials.
• Bayes’s formula:
P (A and B) P (B|A)P (A)
P (A|B) = =
P (B) P (B)
where A, B are two events.
• For Z ∼ N (0, 1), P (−1 ≤ Z ≤ 1) = 68%, P (−2 ≤ Z ≤ 2) = 95%, P (−3 ≤ Z ≤ 3) = 99%.
• Similarly, X ∼ N (µ, σ 2 ), P (µ − 2σ ≤ X ≤ µ + 2σ) = 95%.
• Standardization to standard normal: assume X ∼ N (µ, σ 2 ), Z ∼ N (0, 1), then

a−µ b−µ
P (a ≤ X ≤ b) = P ( ≤Z≤ ).
σ σ

• The Sharpe Ratio for Stock S: √E(S) .

V ar(S)

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Grading Sheet for TA:

Problem Score
P1

P2

P3

P4

P5

P6

P7

P8

P9

Total

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Problem 1: B-17 flying fortress and Wald. [15 points]

During a period in World War II, the U.S. Army Air Forces (AAF) would send over 300 B-17 bombers daily
to raid factories in Germany. These missions, originating in the U.K., were dangerous. In the peak of the
campaign, the return probability for a B-17 crew was only 80%.
In trying to reduce the probability of a failed mission, a Navy statistician, Abraham Wald, was put in charge
of studying the damage patterns in the B-17’s that successfully made back from a mission. His ultimate goal
was to decide where to add extra armor in the planes (you could not just add heavy armor everywhere, as
the planes would be too heavy to fly!). Wald was able to learn that if a plane made back from a mission,
there was a 67% probability that it was shot in the fuselage, 15% in the fuel systems, 10% in the cockpit area
and 8% in the engines.
From experiments, Wald was also able to deduce that during combat, a B-17 would be shot in the fuselage
with 56% probability, in the fuel systems with 14%, in the cockpit area 14% and engine 16%.
1. Based on this information, what was Wald’s recommendation to the AAF, i.e., if they had to choose one
area of the plane, where should they add extra armor to the B-17’s? (Hint: Wald suggested to improve
on the weakest area: the area with the smallest returning probability given it is shot.) [10 points]

P (success return&area being shot)

P (success return | area being shot) =
P (area being shot)
P (area being shot | success return)P (success return)
=
P (area being shot)
So
0.67 × 0.80
fuselage : = 0.957
0.56
0.15 × 0.80
fuel : = 0.857
0.14
0.1 × 0.80
cockpit : = 0.571
0.14
0.08 × 0.80
engines : = 0.40
0.16
So engines are most weak part, needs extra armor.
2. Can you calculate the probabilities of being hit in the fuel systems and in the engines, respectively,
given the plane did not return? [5 points]

P (not return&area being shot)

P (area being shot | not return) =
P (not return)
P (not return | area being shot)P (area being shot)
=
P (not return)
(1 − 0.857) × 0.14
fuel : = 0.10
0.2
(1 − 0.4) × 0.16
engines : = 0.48
0.2

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Problem 2: Choosing an agent. [10 points]

You are considering to purchase a house. On a rating site, you have collected data on the two potential
real estate agents in Chicago. For each rating, there are only two categories, YES (recommend) or NO (not
recommend).

Recommend? Agent BIG Agent SMALL

YES 1644 192
NO 548 48

Is the Agent SMALL better? Justify your answer using either hypothesis testing or confidence interval (with
95% confidence guarantee). [10 points]

1644 192
= 0.75, = 0.8
1644 + 548 192 + 48
Difference is
0.75 − 0.8 = −0.05
Standard deviation is r
0.75(1 − 0.75) 0.8(1 − 0.8)
s= + = 0.0274
1644 + 548 192 + 48
Confidence interval at 95% level

[−0.05 ± 2 × 0.0274] = [−0.1048, 0.0048]

The confidence interval contains 0, we cannot reject the null hypothesis.

Or by hypothesis testing
0.05
= 1.825 < 2
0.0274
We cannot reject the null hypothesis.

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Problem 3: Which insurance to purchase? [10 points]

The next step is to choose a house insurance policy. Suppose there are three options available: standard
policy, premium policy, and no policy (not insured). If you decide on a policy, you will have to buy it for the
whole year.

Policy Cost per month Deductible if you file claim for house damage
Standard $50 $5000
Premium $55 $500

Suppose in one year, there is a 1% chance of house damage, and you estimate that the damage will cost you
$200,000.
1. For one year, which one of the three options you would like to choose in expectation? Which option
has the smallest amount of variability? [5 points]

If the house is damaged, you pay deductible if you have insurance, otherwise 200,000.
Standard
50 ∗ 12 + 5000 ∗ 0.01 = 650
Premium
55 ∗ 12 + 500 ∗ 0.01 = 665
No insurance
200000 ∗ 0.01 = 2000
Variance
Standard
0.99 ∗ (600 − 650)2 + 0.01 ∗ (5600 − 650)2 = 247500

Premium
0.99 ∗ (660 − 665)2 + 0.01 ∗ (1160 − 665)2 = 2475

No insurance
0.99 ∗ (0 − 2000)2 + 0.01 ∗ (200000 − 2000)2 = 3.96 ∗ 108
2. Now suppose you want to stick to a policy for two years. The insurance company is currently running
a promotion: if you do not file a claim in the first year, your monthly cost will be zero; otherwise,
your monthly fee will stay the same. Suppose the probability of house damage is 1% each year and is
independent. Now, which policy you prefer in expectation? [5 points]

Four possible cases: no damage happens, one damage happens in the first year, one damage happens in
the second year and damages happen in both years, with probability 0.9801, 0.0099, 0.0099 and 0.0001
respectively.
Standard
0.9801 ∗ 50 ∗ 12 + 0.0099 ∗ (50 ∗ 12 + 5000) + 0.0099 ∗ (50 ∗ 24 + 5000) + 0.0001 ∗ (50 ∗ 24 + 5000 ∗ 2) = 706

Premium
0.9801 ∗ 55 ∗ 12 + 0.0099 ∗ (55 ∗ 12 + 500) + 0.0099 ∗ (55 ∗ 24 + 500) + 0.0001 ∗ (55 ∗ 24 + 500 ∗ 2) = 676.6

No insurance
0.01 ∗ 200000 ∗ 2 = 4000

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Problem 4: Portfolio. [10 points]

I am building a portfolio composed of SP500 and Bonds. Assume that SP 500 ∼ N (11, 192 ) and Bonds ∼
N (4, 62 ). Here we measure the annual return in percentage (i.e., the Bond has an expected annual return of
4%, with a standard deviation of 6%).
1. Consider the 50-50 split between SP500 and Bonds, assume the standard deviation of this 50-50 portfolio
is
sd(0.5SP 500 + 0.5Bonds) = 11.000
Can you figure out the covariance between SP500 and Bonds, as well as the correlation? [3 points]
Because

V ar(aX + bY ) = a2 V ar(X) + b2 V ar(Y ) + 2 × a × b × Cov(X, Y )

So
112 = 0.52 × 192 + 0.52 × 62 + 2 × 0.5 × 0.5 × Cov(X, Y )
Solve the equation above, we have Cov(X, Y ) = 43.5
Cov(X, Y ) 43.5
Corr(X, Y ) = = = 0.382
SD(X) × SD(Y ) 19 × 6

2. Using the covariance you calculated in sub-problem 1, can you calculate

sd(0.8SP 500 + 0.2Bonds) =?
Also, which portfolio is better: the 80-20 split between SP500 and Bonds, or the 50-50 split? Justify
your answer. [2 points] The variance of 80/20 portfolio is

0.82 × 192 + 0.22 × 62 + 2 × 0.8 × 0.2 × (43.5) = 246.4 ≈ 15.702

7.5 9.6
Sharp ratio of 50/50 portfolio is 11 = 0.68 and 80/20 portfolio is 15.70 = 0.61. 50/50 portfolio has larger
Sharp ratio so we prefer it.

3. Suppose that you decide to invest $50,000 in a 50-50 split portfolio based on SP500 and Bonds, at the
beginning of 2020. By the end of 2020, you would need to pay for the property tax, which follows a
normal distribution with a mean $9,750, and a standard deviation $2,398. What is the probability that
the return of your portfolio would be enough to cover your 2020’s property tax? [5 points] My return

will be X = 50000 ∗ (r/100) = 500r where r ∼ N (7.5, 112 ). So X ∼ N (3750, 55002 ). The tax follows
T ∼ N (9750, 23982 ). Suppose X and T are independent,
X − T ∼ N (−6000, 55002 + 23982 )
6000
P (X − T > 0) = P (Z > √ ) ≈ P (Z > 1) = 0.16
55002 + 23982

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Problem 5: Confidence interval and hypothesis testing. [15 points]

The following table summarizes the annual returns on the SP500 from 1900 until the end of 2015, in total of
116 years (in percentage terms):

116 years of SP500

Sample average 7.2
Sample std. deviation 13.0

1. Based on these results, what is the probability of the SP500 returning less than 20% next year? In
addition, give a 95% prediction interval for next year’s SP500 return. [3 points]

 
0.2 − 0.072
P (X < 0.2) = P Z< = P (Z < 0.98) ≈ 0.84
0.13
The predictive interval is
[7.2 − 2 ∗ 13, 7.2 + 2 ∗ 13] = [−18.8, 33.2]
2. Use a 99% confidence interval, to test the hypothesis that the expected return (true mean) of the SP500 is
equal to 4% a year. [2 points]

p
The standard deviation is 132 /116 = 1.21, confidence interval is 7.2 ± 3 × 1.21 = [3.58, 10.82]. We see that
4% is inside the interval so cannot reject the null hypothesis.

3. In addition, suppose the 95% confidence interval (constructed based on our dataset) for the population
mean of SP500 return µ is [4.7, 9.6]. Which one below best describes the statistical meaning? [5 points]
• (a) P (µ lies in [4.7, 9.6]) = 95%, in other words, the probability that true mean of SP500 µ lies in the
interval [4.7, 9.6] is 95%.
• (b) If we recollect datasets and build confidence intervals many times, 95% of the times, these intervals
will cover the true µ. Correct
• (c) We are 95% sure that the true mean is in the interval [4.7, 9.6].

4. We want to test the null hypothesis H0 : µ = 11 vs. H1 : µ 6= 11. We calculate the t-statistics, which is
t = −3.48. Which one below describes the statistical meaning? [5 points]
• (a) We reject the null hypothesis with 95% confidence. Here the 95% confidence means that when the
null is wrong, the probability of correctly rejecting the null is 95%.
• (b) We reject the null hypothesis with 95% confidence. Here the 95% confidence means that when the
null is correct, the probability of wrongfully rejecting the null is 5%. Correct
• (c) Both (a) and (b).

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A 95% confidence level means that there is a 5% chance that your test results are the result of a type 1 error
(false positive).

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Problem 6: Regression. [15 points]

7 10

5 5
3 0
Y1

Y2
1
−5
−1
−10
−3
−5 −15

−3 −2 −1 0 1 2 3 −3 −2 −1 0 1 2 3
X X
5

1
Y3

−1

−3

−5

−3 −2 −1 0 1 2 3
X
In the above scatterplots, three different variables Y 1, Y 2, Y 3 are regressed onto the same X (in all three
scatterplot we have the exact same n = 200 values for X). The line is the least square regression line. In this
question, we can think of residual standard error (s) for each regression as the uncertainty of the error term,
Y = b0 + b1 X + ,  ∼ N (0, s2 ).
Carefully examine the plots and answer the questions below:
1. Which of the following is the least square estimates of the slope (b1 ) and intercept (b0 ) for the regression
of Y 3 on X? [3 points]
• (a) b1 = 0.34, b0 = −0.24 Correct
• (b) b1 = 0.78, b0 = 0.02
• (c) b1 = 2.53, b0 = −0.05

2. Which of the following is the least square estimates of the slope (b1 ) and residual standard error (s),
for regression Y 2 on X? [2 points]
• (a) b1 = −0.9, s = 6.3
• (b) b1 = −2.0, s = 3.2 Correct
• (c) b1 = −4.3, s = 3.1

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3. Which of the following is the correlation (R) and residual standard error (s), for regression Y 1 on X?
[3 points]
• (a) R = 0.988, s = 0.5 Correct
• (b) R = 0.707, s = 0.97
• (c) R = 0.261, s = 0.1

4. What is the correlation between Y 2 and X? [2 points]

• (a) -0.71 Correct
• (b) -0.97
• (c) -0.26

5. Using all the information provided so far, give a rough approximation for the 99% prediction interval
for Y 1 given X = 0. [2 points]

Y1 | X ∼ N (1, 0.5)
[1 ± 3 × 0.5] = [−0.5, 2.5]

6. What is the residual standard error s for Y 3?

• (a) 2.05 Correct
• (b) 0.49
• (c) 3.50
In addition, give an approximation for P (Y 3 > 4|X = 3). [3 points]

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Problem 7: Boston housing data. [10 points]

In this question, we take a look at a dataset that contains information collected by the U.S Census Service
concerning housing in the area of Boston Massachusetts. In total, there are 506 areas in the dataset.

variables
medv median value of owner-occupied homes in $1000s
rm average number of rooms per dwelling
dis weighted mean of distances to five Boston employment centers
lstat lower status of the population (percent)

We run three simple linear regression, aiming to figure out the quality of rm, dist, lstat in explaining medv.
50 50

40 40

30
medv

medv
30
20
20
10
10
0

4 5 6 7 8 9 2.5 5.0 7.5 10.0 12.5

rm dis

50

40

30
medv

20

10

0
0 10 20 30
lstat
1. Based on the least square regression plot, which one of the variables is the worst in terms of explaining
medv? [2 points] dis

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 2. For the simple linear regression using dis to predict medv (the top-right plot in sub-problem 1), let us
look at the residual
residi = medvi − f ittedi
against f ittedi for each data point i.

30

20

10
.resid

−10

20 24 28 32
.fitted

Suppose we run a new linear regression, based on the plot above, using resid and f itted

resid = b0 + b1 · f itted.

What is your best guess on b0 and b1 ? [3 points]

• (a) b0 < 0, b1 < 0
• (b) b0 > 0, b1 = 0
• (c) b0 = 0, b1 = 0 Correct
• (d) b0 = 0, b1 < 0
• (e) b0 = 0, b1 > 0

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 3. We want to understand the weak positive correlation between dis and medv, namely, why the further
the distance is to the employment center, the more expensive the house is. To simplify the discussion,
we look at the following subset of the data according to the variable log(crim), which quantifies the
per capita crime rate. In the following plots, ‘40 denotes data with a low crime rate, and ‘+0 indicates
data with a high crime rate.
50

7.5
40

medv
dis

5.0 30

20
2.5

−3 −2 −1 0 1 2.5 5.0 7.5

log(crim) dis
50
50

40 40
medv

medv

30
30

20
20

2.5 5.0 7.5 2.5 5.0 7.5

dis dis
Choose the options that make sense, combining all the information above. (Hint: you can choose multiple.)
[4 points]
• (a) The above plot shows when holding the crime rate fixed, houses that are far away from the Boston
employment centers tend to be less expensive than houses that are close, on average.
• (b) The above plot shows that for houses with a high crime rate, it is likely that they are closer to
Boston employment centers.
• (c) The above color plot shows that for houses that are very far away from the Boston employment
centers, it is most likely they have a low crime rate.
• (d) The weak positive coefficient of dis in explaining medv is because variables dis and log(crim)
are negatively correlated. It means that a larger distance usually correlates with a low crime rate.
The low crime rate is the reason behind a higher price on average.

ABCD

What is this phenomenon called in statistics? [1 point]

lurking variable (confounding)

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Problem 8: Envelope game. [10 points]

At the end of BUS41000 class, Professor Liang decides to reward Tom for his hard work, and how much
reward he can get depends on his probability skills. Professor Liang places two checks (one check is $30, the
other is $70) into two envelopes. Note Tom has no idea about the value of the checks.
1. First, Tom decides to pick one envelope randomly. How much is his reward, in expectation? [2 points]

30 × 0.5 + 70 × 0.5 = 50

2. Suppose that the rule is changed slightly: Tom is allowed to choose one envelope, open it, and review
the value of the check. Then he can decide whether to stick with the opened envelope or to swap to the
other one. Tom recalls that one could use a randomized strategy to win more money. Here is Tom’s
new strategy: he draws a random number X using R/Excel from a normal distribution X ∼ N (50, 102 ),
then compares this X with the value of the check he just opened. He will only keep the check if its
value is larger than X. Otherwise, he will swap to the other envelope. Using this strategy, how much is
Tom’s reward, in expectation? How much more money he is going to get compared to the sub-problem
1? [8 points]

Suppose Y is value of check you first pick

Table X>Y X<Y

Y = 30 70, with probability 0.5 × 0.975 30, with probability 0.5 × 0.025
Y = 70 30, with probability 0.5 × 0.025 70, with probability 0.5 × 0.975

So the expectation is
70 × 0.5 × 0.975 + 30 × 0.5 × 0.025 × 2 = 69
and 69 − 50 = 19

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Problem 9: Your intuition about correlation. [5 points]

1. Consider three stocks: A, B and C. Suppose Corr(A, B) = 0, Corr(A, C) = 0, what is the possible
range of Corr(B, C)? [1 points]
• (a) [-1, 1] Correct
• (b) 0
• (c) None of the above

2. Suppose Corr(A, B) = 1, Corr(A, C) = −1, what is the possible range of Corr(B, C)? [1 points]
• (a) -1 Correct
• (b) 1
• (c) None of the above

3. Suppose Corr(A, B) = 0.5, Corr(A, C) = 0.5, what is the possible range of Corr(B, C)? [3 points]
• (a) [0.5, 1]
• (b) [-0.5, 1] Correct
• (c) [-1, 0.5]
• (d) None of the above

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Extra Page for Calculations

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