Level I - Quantitative Methods

Probability Concepts

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Graphs, charts, tables, examples, and figures are copyright 2020, CFA Institute.
nstitute.

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Reproduced and republished with permission from CFA Institute. All rights
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 Contents
1. Introduction

2. Probability, Expected Value, and Variance

3. Portfolio Expected Return and Variance of Return

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4. Topics in Probability

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 1. Introduction
• Investment decision require an evaluation of risk

• We can use probabilities to evaluate risk

• We will explore probability related concepts which are most

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relevant for investment managers

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 2. Probability, Expected Value, and Variance
• Random variable is an uncertain quantity / number

• Event is a single outcome or a set of outcomes

• Mutually exclusive events

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• Exhaustive events

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• Probability of an event, P(Ei), is between 0 and 1

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• Sum of the probabilities of mutually exclusive and exhaustive events
ents = 1

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 Ways of Estimating Probability
• Empirical Probability: calculated by analyzing past data

• A Priori Probability: calculated by using formal reasoning and

inspection

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• Subjective Probability: less formal and involves personal judgment
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 Practice Question
Which of the following type of probability is most likely to be based on logical analysis?
A. Empirical probability
B. A Priori probability
C. Subjective probability

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Answer: B

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 Probability Stated as Odds
• Given P(E), odds for E = P(E) / [1 – P(E)]

• Given odds for E of “a to b”, the implied probability of E is a/(a + b)

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• Odds against E = [1 – P(E)]/P(E), reciprocal of the odds for E

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• Give odds against E of “a to b”, the implied probability of E is b/(a + b))

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 Practice Question
Given that the odds for the company’s share price to fall below $45 are 1 to 5, which of
the following is most likely to be the probability of this event?
A. 0.17
B. 0.20
C. 0.83

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Answer: A

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 Conditional vs. Unconditional
Unconditional probability: P(A), the probability of an event regardless of the
outcomes of other events

Conditional probability: P(A|B), the probability of A given that B has occurred

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 Joint Probability and Multiplication Rule
The probability that both A and B will occur is their joint probability: P(AB)
Compute joint probability using the multiplication rule
P(AB) = P(A|B) x P(B)
P(A|B) = P(AB)/ P(B), P(B) ≠ 0

P (interest rates will decrease) = P(D) = 40%

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P (stock price increases) = P(S)

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P (stock price will increase given interest rates decrease) = P(S|D) = 70%

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Probability of a stock price increase and a interest rate decrease:

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P(SD) = P(S|D) x P(D) = 0.7 x 0.4 = 0.28 = 28%

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 Addition Rule for Probabilities
The probability that A or B occurs, or both occur, is equal to:
P(A or B) = P(A) + P(B) – P(AB)

Example:
P(Price of A increases) = P(A) = 0.5
P(Price of B increases) = P(B) = 0.7

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P(Price of A and B increases) = P(AB) = 0.3

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P(A or B) = 0.5 + 0.7 – 0.3 = 0.9

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 Practice Question
Irfanullah & Co. has issued two callable bonds with a maturity of 2 and 5 years
respectively. The probability that Bond A will be called is 60% and the probability that
Bond B will be called is 50%. The probability that at least one of the bonds will be
called is closest to?
A. 0.8
B. 0.3
C. 0.83

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Answer: A

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The probability that at least one of the bonds will be called can be calculated using

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Addition rule of probability which is:

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P(A or B) = P(A) + P(B) – P(A and B) where P(A and B) is P(A) x (PB)

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P(A or B) = 0.6 + 0.5 – 0.6 x 0.5 = 0.8

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 Independent and Dependent Events
Independent Events
Occurrence of one event does not influence the occurrence of the other
P(A|B) = P(A) or equivalently P(B|A) = P(B)
Multiplication rule: P(AB) = P(A)P(B)
Concept Checker: What is the addition rule for independent events?

Dependent Events

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Two events are not independent

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Knowing the outcome of one tells you something about the probability of thee other
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Concept Checker: What is the relationship between dependent events and d

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conditional probability?

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 Practice Question
If events A and B are mutually exclusive, then which of the following is true?
A. P(A|B) = P(A)
B. P(AB) = P(A) x P(B)
C. P(A or B) = P(A) + P(B)

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Mutually exclusive events are those events which cannot happen together, i.e.

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there is no intersection between two events. Therefore, both P (A|B) and P (AB)
AB
B)

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must be equal to zero.

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 The Total Probability Rule
In investment analysis we often formulate a set of mutually exclusive and exhaustive
scenarios and then estimate the probability of a particular event

Say we have two scenarios: S and non-S

According to the total probability rule:
P(A) = P(AS) + P(ASC) = P(A|S) P(S) + P(A|SC) P(SC)

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If we have more than two scenarios:

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P(A) = P(AS1) + P(AS2) +… + P(ASn) = P(A|S1) P(S1) + P(A|S2) P(S2) + … + P(A|Sn) P(Sn)

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The total probability rule enables us to state unconditional probabilities
es in terms
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conditional probabilities

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 Expected Value of a Random Variable
Probability-weighted average of the possible outcomes of the random variable

E(X) = P(X1)X1 + P(X2)X2 + … + P(Xn)Xn

Example: A project’s cash flow for the upcoming year depends on the state of the economy, as
shown in the table below. What is the expected value of the cash flow?

State of Economy Probability Cash Flow

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Good 0.3 50

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Average 0.5 40

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Weak 0.2 20

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Expected value = 39

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 Practice Question
The probability distribution for the dividend yield of Donna Diamonds Ltd is tabulated
as follows:
Probability Dividend Yield
0.40 6.4%
0.20 7.2%
0.15 8.1%
0.25 6.8%

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Which of the following is most likely to be the expected dividend yield?

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A. 6.40%

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B. 6.92%

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C. 7.13%

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 Solution
Answer: B

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E ( X )   P ( Xi ) Xi
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E(X) = (0.4 × 6.4) + (0.2 × 7.2) + (0.15× 8.1) + (0.25× 6.8) = 6.92%

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 Variance of a Random Variable
Expected value of squared deviations from the random variable’s expected value
Recall: Expected value is the probability weighted average

Example: A project’s cash flow for the upcoming year depends on the state of the economy, as
shown in the table below. What is the variance of the cash flow? What is the standard deviation?

State of Economy Probability Cash Flow Sqrd Deviation P x Sqrd Dev

Good 0.3 50 (50 – 39)2 = 121 36.30

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Average 0.5 40

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(40 – 39)2 = 1 0.50

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Weak 0.2 20 (20 – 39)2 = 361 72.20

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Variance 109.00

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Std Dev 10.44
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σ2(X) = E{[xi – E(X)]2} = ΣP(xi)[xi – E(X)]2

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 Practice Question
The probability distribution for the rate of return for Imogen Investments Ltd is
tabulated as follows:
Probability Rate of Return
0.30 12.4%
0.25 7.2%
0.20 10.8%
0.25 8.6%

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Which of the following is most likely to be the variance for the above distribution??

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A. 2.07

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B. 4.28

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C. 9.83

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 Solution
Answer: B
n
 (X) =  P (X) [X - E(X)]2


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E (X) = (12.4 x 0.3) + (7.2 x 0.25) + (10.8 x 0.2) + (8.6 x 0.25) = 9.83

 2 (X) = (0.30) (12.4 - 9.83)2 + (0.25) (7.2 - 9.83)2 + (0.20) (10.8 - 9.83)2 + (0.25) (8.60 - 9.83)2 = 4.28

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 Compute σ of a Random Variable using the Calculator
State Prob. CF Keystrokes Explanation Display
Good 0.3 50 [2nd] [DATA] Enter data entry mode
Average 0.5 40 [2nd] [CLR WRK] Clear data registers X01
Weak 0.2 20 50 [ENTER] 1st possible value of random variable X01 = 50
[↓] 30 [ENTER] Probability of 30% for X01 Y01 = 30
[↓] 40 [ENTER] 2nd possible value of random variable X02 = 40
[↓] 50 [ENTER] Probability of 50% for X02 Y02 = 50
[↓] 20 [ENTER] 3rd possible value of random variable X03 = 20
[↓] 20 [ENTER] Probability of 20% for X03 Y03 = 20

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[2nd] [STAT] Puts calculator into stats mode.

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[2nd] [SET] Press repeatedly till you see Æ 1-V

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[↓] Total number of entries N=1
100
00
0

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[↓] Expected value of random variable X = 39

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[↓] Sample standard deviation Sx = 10
10.49

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[↓] Population standard deviation σx = 10.44

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 Total Probability Rule for Expected Value
Recall that the total probability rule enables Similarly, we can state expected values in
us to state unconditional probabilities in terms of conditional expected values
terms of conditional probabilities

P(A) = P(A|S) P(S) + P(A|SC) P(SC) E(X) = E(X|S) P(S) + E(X|SC) P(SC)

P(A) = P(A|S1) P(S1) + P(A|S2) P(S2) + … + E(X) = E(X|S1) P(S1) + E(X|S2) P(S2) + … +

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P(A|Sn) P(Sn) E(X|Sn) P(Sn)

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 Example
What is the expected price of a stock at the end of the current period given the following
information: probability that interest rates will decline = 0.4. If interest rates decline there is a 75%
chance that stock price will be $100 versus a 25% chance that the stock price will be $90. If interest
rates do not decline there is a 50% chance that the stock price will be 80 versus a 50% chance that
stock price will be 70.
Price = 100
E(X) = E(X|S) P(S) + E(X|SC) P(SC) Prob = 0.3
0.75

Price = 90
0.4 0.25

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Prob = 0.1

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Exp Stock

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Price=? Price = 80

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0.50 Prob = 0.3

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0.6

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0.50 Price = 70

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Prob = 0.3

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 3. Portfolio Expected Return and Variance
Portfolio expected return is the weighted average expected return of
a portfolio with n securities

E(RP) = w1R1 + w2R2 + …+ wnRn

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Computing portfolio variance is a more complicated

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Understand covariance and correlation first

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 Covariance
Covariance is a measure of how two variables move together

Cov(Ri, Rj) = E[(Ri – ERi) (Rj – ERj)] Returns RB = 40% RB = 20% RB = 0%

RA = 20% 0.15
E(RA) = 13%
RA = 15% 0.6
RA = 4% 0.25
E(RB) = 18%

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Covariance between RA and RB is:

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0.15 (0.20 – 0.13) (0.40 – 0.18) + 0.6 (0.15 – 0.13) (0.20 – 0.18) + 0.25 (0.04 – 0.13) (0 – 0.18))

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= 0.0066

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The sample covariance is the average value of n
  Ri,t  Ri R j,t  R j 

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the product of the deviations of observations on Cov Ri , R j  n  1

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 Covariance and Correlation
Covariance is a measure of how two variables move together
ƒ Values range from minus infinity to positive infinity
ƒ Difficult to interpret

Correlation is a standardized measure of the linear relationship between two

variables with values ranging between -1 and +1

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ρ (Ri, Rj) = Cov(Ri, Rj) / σ (Ri) σ (Rj) Æ this represents forward-looking population correlation.

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 Correlation
What is the correlation between the returns on A and B?

Returns RB = 40% RB = 20% RB = 0% Covariance: 0.0066

RA = 20% 0.15
σ(A) = 5.48% = 0.0548
RA = 15% 0.6
RA = 4% 0.25 σ(B) = 12.29% = 0.1229

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ρ (Ri, Rj) = Cov(Ri, Rj) / σ (Ri) σ (Rj)

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= 0.0066 / (0.0548 x 0.1229)

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= 0.98

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 Practice Question
Two companies, Lemon Co. and Demon Co. have the following probability
distributions in different economic situations:
Scenario P(Scenario) Expected Expected
Calculate the covariance of the
Returns of Returns of
Lemon Co. Demon Co. expected returns for Lemon and
Recession 0.25 2% 4% Demon.
Normal 0.5 8% 10%
Boom 0.25 12% 16%

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 Solution
E[L] = (2% x 0.25) + (8% x 0.5) + (12% x 0.25) = 7.5%

E[D] = (4% x 0.25) + (10% x 0.5) + (16% x 0.25) = 10%

Covariance of the expected returns of Lemon and Demon:

0.25(2% - 7.5%)(4% - 10%) + 0.5(8% - 7.5%)(10% - 10%) + 0.25(12% - 7.5%)(16% - 10%)

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= 0.000825 + 0 + 0.000675

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= 0.0015

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 Practice Question
Two companies, Lemon Co. and Demon Co. have the following probability
distributions in different economic situations:
Scenario P(Scenario) Expected Expected
Calculate the correlation of the
Returns of Returns of
Lemon Co. Demon Co. expected returns for Lemon and
Recession 0.25 2% 4% Demon.
Normal 0.5 8% 10%
Boom 0.25 12% 16%

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ρ (Ri, Rj) = Cov(Ri, Rj) / σ (Ri) σ (Rj)

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= 0.0015 / (0.0357 x 0.0424)

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= 0.99

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 Portfolio Expected Return and Variance
My portfolio consists of two stocks, Oracle and Mindtree. Oracle represents 60% percent of the
portfolio and Mindtree the remaining 40%. Oracle has an expected return of 12% and a
standard deviation of 16%. Mindtree has an expected return of 16% and a standard deviation
of 24%. The covariance is 0.0269. What is the expected return and variance of my portfolio?

E(RP) = w1R1 + w2R2

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σ2(RP) = w12σ12(R1) + w22σ22(R2) + 2w1w2Cov(R1R2)

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 Scatter Plot
• A scatter plot is a graphical representation of correlation.
• In a scatter plot, each observation is represented as a point, and the points are not
connected.

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 Limitations of Correlation Analysis
1) Correlation only assesses the strength
of a linear relationship.

2) The correlation coefficient is sensitive

to outliers.

3) A strong correlation does not imply

cause and effect relationship.

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4) Correlations can be spurious.

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 • Bayes’ Formula

• Principles of Counting

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4. Topics In Probability

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 4.1 Bayes’ Formula
Bayes' formula allows us to adjust our viewpoint when we receive new information
P(E | I) = P(E) x P(I|E) / P(I)
Example:
Event: P(EPS exceed expectation) = 0.50
P(EPS meet expectation) = 0.30
P(EPS below expectation) = 0.20
P (Company expands | EPS exceed) = 0.75

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P (Company expands | EPS meet) = 0.20

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P (Company expands | EPS below) = 0.05

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New Information: Company expands

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Calculate P(I) using the total probability rule

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Calculate P(E | I)

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 4.2 Principles of Counting

• Multiplication Rule and Factorial

• Labeling

• Combinations

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• Permutations

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 Multiplication Rule

• If one task can be done in n1 ways

• Given first task, second task can be done in n2

ways

• Given first two tasks, third task can be in n3

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ways

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• Number of ways in which k tasks can be done

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is: n1 x n2 x n3 … x nk

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 n factorial = n! = n(n-1)(n-2)…1

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Factorial

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 Labeling
You have n items of which each can receive one of k labels. The number of items that
receive label "1" is n1 and the number that receive label "2" is n2, and so on.

Number of way is which labels can be assigned = n! / [(n1!) * (n2!) *...*(nk!)]

For example: A portfolio consists of eight stocks. The goal is to designate four of the
stocks as "long-term holds," designate three of the stocks as "short-term holds," and
designate one stock a "sell." How many ways can these labels be assigned to the eight gh

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stocks?

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Answer: (8!) / (4!x3!x1!) = 280

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 Permutations
Number of ways to choose r objects from a total of
n objects when the order in which the r objects are
chosen does matter

n Pr = n! / (n - r)!

Example: In a portfolio of eight stocks, we decide

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to sell three stocks. How many ways can we choose

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three of the eight to sell if order of sale does

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matter?

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 Combinations
Number of ways to choose r objects from total of n
objects when the order in which the r objects are
chosen does NOT matter.

nCr = n! / (n - r)!r!

Example: A portfolio manager wants to eliminate four

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stocks from a portfolio that consists of six

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stocks. How many ways can the four stocks be

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sold when the order of the sale is NOT

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important?

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 Summary
• Probability
ƒ Mutually exclusive and exhaustive
ƒ Conditional probability
ƒ Multiplication rule
ƒ Addition rule
ƒ Total probability rule
• Expected Value

om 1
.c 60
oo 6 r
• Variance

ib 20 te
ks 65
al 98 en
ak / C
• Covariance, Correlation, Scatter plot

ah 58 ok
.m 1 o
• Expected value and variance of a portfolio

w 11 B
w 4 li
w 20 aka
• Counting

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 Conclusion

• Review learning objectives

• Examples and practice problems from the curriculum

• Practice questions from other sources

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
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M
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