Statistics for Managers

Using Microsoft® Excel

5th Edition

Chapter 3 (Textbook Ch5)

Important Discrete Probability

Distribution
1
 Chapter Goals

After completing this chapter, you should be able

to:
§  Interpret the mean and standard deviation for a
discrete probability distribution
§  Explain covariance and its application in finance
§  Use the binomial probability distribution to find
probabilities
§  Describe when to apply the binomial distribution
§  Use the Poisson and hypergeometric discrete
probability distributions to find probabilities
2
 Introduction to Probability
Distributions

§  Random Variable

§  Represents a possible numerical value from
an uncertain event
Random
Variables

Discrete Continuous
Random Variable Random Variable

3
 Discrete Random Variables
§  Can only assume a countable number of values
Examples:

§  Roll a die twice

Let X be the number of times 4 comes up
(then X could be 0, 1, or 2 times)

§  Toss a coin 5 times.

Let X be the number of heads
(then X = 0, 1, 2, 3, 4, or 5)

4
 Discrete Probability Distribution

Experiment: Toss 2 Coins. Let X = # heads.

4 possible outcomes
Probability Distribution
T T X Value Probability
0 1/4 = .25
T H 1 2/4 = .50
2 1/4 = .25
H T Probability
.50

H H .25

0 1 2 X
5
 Discrete Random Variable
Summary Measures
§  Expected Value (or mean) of a discrete
distribution (Weighted Average)
N
µ = E(X) = ∑ Xi P( Xi )
i=1

X P(X)
§  Example: Toss 2 coins, 0 .25
X = # of heads, 1 .50

compute expected value of X: 2 .25

E(X) = (0 x .25) + (1 x .50) + (2 x .25)

= 1.0

6
 Discrete Random Variable
Summary Measures
(continued)
§  Variance of a discrete random variable
N
σ 2 = ∑ [Xi − E(X)]2 P(Xi )
i=1

§  Standard Deviation of a discrete random variable

N
σ = σ2 = ∑ i
[X
i=1
− E(X)]2
P(Xi )

where:
E(X) = Expected value of the discrete random variable X
Xi = the ith outcome of X
P(Xi) = Probability of the ith occurrence of X
7
 Discrete Random Variable
Summary Measures
(continued)

§  Example: Toss 2 coins, X = # heads,

compute standard deviation (recall E(X) = 1)

σ= ∑ [X − E(X)] P(X )
i
2
i

σ = (0 − 1)2 (.25) + (1− 1)2 (.50) + (2 − 1)2 (.25) = .50 = .707

Possible number of heads

= 0, 1, or 2

8
 Example: Investment Payoffs
§  Probability distribution of investment payoffs
Payoff (Value) Probability
$0 0.98
$95 0.02
! = 0 ! 0.98 + 95 ! 0.02 = $1.90
§  The expected payoff is $1.90
§  A compromise between $0 (most of the time) and $
95 (rarely)

! = (0–1.90)2! 0.98 + (95–1.90)2! 0.02 = $13.30

§  Actual payoffs approximately $13.30 above or below
expected
§  A compromise between being $1.90 below average (most of
the time) and $93.10 above average (rarely)
9
 Examples of Random Variables

Random Standard
Variable Mean Deviation

X = $1.40 $1.40 $0

Y= { $1 prob 0.5
$2 prob 0.5
$1.50 $0.50

Z={ $0 prob 0.98
$95 prob 0.02
$1.90 $13.30

10
Example: Profit Scenarios
Scenario Profit ($millions) Probability
Great $10 0.20
Good 5 0.40
OK 1 0.25
Lousy –4 0.15
0.5 Good
0.4
Probability

0.3 OK
Great
0.2 Lousy
0.1
0.0
-5 0 5 10
Profit ($millions)
Standard deviation:
$4.40 million Expected profit: $3.65 million

11
 The Covariance

§  The covariance measures the strength of the

linear relationship between two variables
§  The covariance:
N
σ XY = ∑ [ Xi − E( X)][( Yi − E( Y )] P( Xi Yi )
i=1

where: X = discrete variable X

Xi = the ith outcome of X
Y = discrete variable Y
Yi = the ith outcome of Y
P(XiYi) = probability of occurrence of the condition affecting
the ith outcome of X and the ith outcome of Y
12
 Computing the Mean for
Investment Returns
Return per $1,000 for two types of investments

Investment
P(XiYi) Economic condition Passive Fund X Aggressive Fund Y
.2 Recession - $ 25 - $200
.5 Stable Economy + 50 + 60
.3 Expanding Economy + 100 + 350

E(X) = µX = (-25)(.2) +(50)(.5) + (100)(.3) = 50

E(Y) = µY = (-200)(.2) +(60)(.5) + (350)(.3) = 95

13
 Computing the Standard Deviation
for Investment Returns
Investment
P(XiYi) Economic condition Passive Fund X Aggressive Fund Y
.2 Recession - $ 25 - $200
.5 Stable Economy + 50 + 60
.3 Expanding Economy + 100 + 350

σ X = (-25 − 50)2 (.2) + (50 − 50)2 (.5) + (100 − 50)2 (.3)

= 43.30

σ Y = (-200 − 95 )2 (.2) + (60 − 95 )2 (.5) + (350 − 95 )2 (.3)

= 193.71
14
 Computing the Covariance
for Investment Returns
Investment
P(XiYi) Economic condition Passive Fund X Aggressive Fund Y
.2 Recession - $ 25 - $200
.5 Stable Economy + 50 + 60
.3 Expanding Economy + 100 + 350

σ X,Y = (-25 − 50)(-200 − 95)(.2) + (50 − 50)(60 − 95)(.5)

+ (100 − 50)(350 − 95)(.3)
= 8250

15
 Interpreting the Results for
Investment Returns
§  The aggressive fund has a higher expected
return, but much more risk

µY = 95 > µX = 50
but
σY = 193.21 > σX = 43.30

§  The Covariance of 8250 indicates that the two

investments are positively related and will vary
in the same direction
16
 The Sum of
Two Random Variables
§  Expected Value of the sum of two random variables:

E(X + Y) = E( X) + E( Y )

§  Variance of the sum of two random variables:

Var(X + Y) = σ 2X+ Y = σ 2X + σ 2Y + 2σ XY

§  Standard deviation of the sum of two random variables:

σ X+ Y = σ2X+ Y
17
 Portfolio Expected Return
and Portfolio Risk

§  Portfolio expected return (weighted average

return):
E(P) = w E( X) + (1 − w ) E( Y )

§  Portfolio risk (weighted variability)

σP = w 2σ 2X + (1− w )2 σ 2Y + 2w(1- w)σ XY

Where w = portion of portfolio value in asset X

(1 - w) = portion of portfolio value in asset Y

18
 Portfolio Example
Investment X: µX = 50 σX = 43.30
Investment Y: µY = 95 σY = 193.21
σXY = 8250

Suppose 40% of the portfolio is in Investment X and

60% is in Investment Y:
E(P) = .4 (50 ) + (.6) (95 ) = 77

σ P = (.4)2 (43.30) 2 + (.6)2 (193.21)2 + 2(.4)(.6)(8250)

= 133.04

The portfolio return and portfolio variability are between the values
for investments X and Y considered individually
19
 Probability Distributions
Probability
Distributions

Discrete Continuous
Probability Probability
Distributions Distributions

Binomial Normal

Poisson Uniform

Hypergemetric Exponential

20
 The Binomial Distribution
Probability
Distributions

Discrete
Probability
Distributions

Binomial

Poisson

Hypergeometric

21
 Binomial Probability Distribution
§  A fixed number of observations, n
§  e.g., 15 tosses of a coin; ten light bulbs taken from a warehouse
§  Two mutually exclusive and collectively exhaustive
categories
§  e.g., head or tail in each toss of a coin; defective or not defective
light bulb
§  Generally called “success” and “failure”
§  Probability of success is p, probability of failure is 1 – p
§  Constant probability for each observation
§  e.g., Probability of getting a tail is the same each time we toss
the coin

22
 Binomial Probability Distribution
(continued)

§  Observations are independent

§  The outcome of one observation does not affect the outcome
of the other
§  Two sampling methods
§  Infinite population without replacement
§  Finite population with replacement

23
 Possible Binomial Distribution
Settings

§  A manufacturing plant labels items as

either defective or acceptable
§  A firm bidding for contracts will either get a
contract or not
§  A marketing research firm receives survey
responses of “yes I will buy” or “no I
will not”
§  New job applicants either accept the offer
or reject it
24
 Rule of Combinations

§  The number of combinations of selecting X

objects out of n objects is

⎛n⎞ n!
⎜⎜ ⎟⎟ =
⎝ X ⎠ X! (n − X)!
where:
n! =n(n - 1)(n - 2) . . . (2)(1)
X! = X(X - 1)(X - 2) . . . (2)(1)
0! = 1 (by definition)

25
 Binomial Distribution Formula

n! X n- X
P(X) = p (1-p)
X ! (n - X)!

P(X) = probability of X successes in n trials,

with probability of success p on each trial
Example: Flip a coin four
times, let x = # heads:
X = number of ‘successes’ in sample,
n=4
(X = 0, 1, 2, ..., n)
p = 0.5
n = sample size (number of trials
or observations) 1 - p = (1 - .5) = .5
p = probability of “success” X = 0, 1, 2, 3, 4

26
 Example:
Calculating a Binomial Probability
What is the probability of one success in five
observations if the probability of success is .1?
X = 1, n = 5, and p = .1

n!
P( X = 1) = p X (1 − p)n− X
X! (n − X)!
5!
= (.1)1(1 − .1)5 −1
1! (5 − 1)!

= (5)(.1)(.9)4
= .32805
27
 Binomial Distribution
§  The shape of the binomial distribution depends on the
values of p and n
.6
P(X) n = 5 p = 0.1
§  Here, n = 5 and p = .1 .4
.2
0 X
0 1 2 3 4 5

.6
P(X) n = 5 p = 0.5
§  Here, n = 5 and p = .5
.4
.2
0 X
0 1 2 3 4 5
28
 Binomial Distribution
(continued)
0.4
p=0.05, n=25
0.2
Skewed if p is close to 0
0
0 5 10 15 20 25
0.3
0.2
p=0.5, n=25
0.1
0
Symmetric if p is 0.5 (or close) 0 5 10 15 20 25
§  Approximately normal
0.3 p=0.9, n=25
0.2
0.1
Skewed if p is close to 1 0
0 5 10 15 20 25
29
 Binomial Distribution
Characteristics

§  Mean

µ = E(x) = np
§  Variance and Standard Deviation

σ = np(1- p)
2

σ = np(1- p)
Where n = sample size
p = probability of success
(1 – p) = probability of failure

30
 Binomial Characteristics
Examples
µ = np = (5)(.1) = 0.5 P(X) n = 5 p = 0.1
.6
.4
σ = np(1 - p) = (5)(.1)(1 − .1) .2
0 X
= 0.6708
0 1 2 3 4 5

µ = np = (5)(.5) = 2.5 P(X) n = 5 p = 0.5

.6
.4
σ = np(1 - p) = (5)(.5)(1 − .5) .2
0 X
= 1.118
0 1 2 3 4 5

31
 Using Binomial Tables
n = 10
x … p=.20 p=.25 p=.30 p=.35 p=.40 p=.45 p=.50
0 … 0.1074 0.0563 0.0282 0.0135 0.0060 0.0025 0.0010 10
1 … 0.2684 0.1877 0.1211 0.0725 0.0403 0.0207 0.0098 9
2 … 0.3020 0.2816 0.2335 0.1757 0.1209 0.0763 0.0439 8
3 … 0.2013 0.2503 0.2668 0.2522 0.2150 0.1665 0.1172 7
4 … 0.0881 0.1460 0.2001 0.2377 0.2508 0.2384 0.2051 6
5 … 0.0264 0.0584 0.1029 0.1536 0.2007 0.2340 0.2461 5
6 … 0.0055 0.0162 0.0368 0.0689 0.1115 0.1596 0.2051 4
7 … 0.0008 0.0031 0.0090 0.0212 0.0425 0.0746 0.1172 3
8 … 0.0001 0.0004 0.0014 0.0043 0.0106 0.0229 0.0439 2
9 … 0.0000 0.0000 0.0001 0.0005 0.0016 0.0042 0.0098 1
10 … 0.0000 0.0000 0.0000 0.0000 0.0001 0.0003 0.0010 0
… p=.80 p=.75 p=.70 p=.65 p=.60 p=.55 p=.50 x

Examples:
n = 10, p = .35, x = 3: P(x = 3|n =10, p = .35) = .2522
n = 10, p = .75, x = 2: P(x = 2|n =10, p = .75) = .0004

32
 Using PHStat

§  Select PHStat / Probability & Prob. Distributions / Binomial…

33
 Using PHStat
(continued)

§  Enter desired values in dialog box

Here: n = 10
p = .35

Output for X = 0
to X = 10 will be
generated by PHStat

Optional check boxes

for additional output

34
PHStat Output

P(X = 3 | n = 10, p = .35) = .2522

P(X > 5 | n = 10, p = .35) = .0949

35
 The Poisson Distribution
Probability
Distributions

Discrete
Probability
Distributions

Binomial

Poisson

Hypergeometric

36
 The Poisson Distribution

§  Apply the Poisson Distribution when:

§  You wish to count the number of times an event occurs in a given area of
opportunity
§  The probability that an event occurs in one area of opportunity is the
same for all areas of opportunity
§  The number of events that occur in one area of opportunity is
independent of the number of events that occur in the other areas of
opportunity
§  The probability that two or more events occur in an area of opportunity
approaches zero as the area of opportunity becomes smaller
§  The average number of events per unit is ! (lambda)

e.g. 1. The number of orders your firm receives tomorrow.

2. The number of calls you receives within a week.

37
 Poisson Distribution Formula

−λ x
e λ
P( X) =
X!
where:
X = number of successes per unit
! = expected number of successes per unit
e = base of the natural logarithm system (2.71828...)

38
 Poisson Distribution
Characteristics

§  Mean

µ=λ
§  Variance and Standard Deviation

σ2 = λ
σ= λ
where ! = expected number of successes per unit

39
 Using Poisson Tables
!

X 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90

0 0.9048 0.8187 0.7408 0.6703 0.6065 0.5488 0.4966 0.4493 0.4066

1 0.0905 0.1637 0.2222 0.2681 0.3033 0.3293 0.3476 0.3595 0.3659
2 0.0045 0.0164 0.0333 0.0536 0.0758 0.0988 0.1217 0.1438 0.1647
3 0.0002 0.0011 0.0033 0.0072 0.0126 0.0198 0.0284 0.0383 0.0494
4 0.0000 0.0001 0.0003 0.0007 0.0016 0.0030 0.0050 0.0077 0.0111
5 0.0000 0.0000 0.0000 0.0001 0.0002 0.0004 0.0007 0.0012 0.0020
6 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0001 0.0002 0.0003
7 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

Example: Find P(X = 2) if ! = .50

e−λ λX e−0.50 (0.50)2

P( X = 2) = = = .0758
X! 2!
40
 Graph of Poisson Probabilities
0.70

Graphically: 0.60

! = .50 0.50

!= 0.40

P(x)
X 0.50
0.30
0 0.6065
0.20
1 0.3033
2 0.0758 0.10

3 0.0126 0.00
0 1 2 3 4 5 6 7
4 0.0016
5 0.0002 x
6 0.0000
P(X = 2) = .0758
7 0.0000

41
 Poisson Distribution Shape

§  The shape of the Poisson Distribution

depends on the parameter ! :

0.70
!= 0.25
!=
0.60
0.50 3.00
0.20
0.50

0.15
0.40

P(x)
P(x)

0.30 0.10

0.20
0.05
0.10

0.00 0.00
0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 8 9 10 11 12

x x

42
 Poisson Distribution
in PHStat
§  Select:
PHStat / Probability & Prob. Distributions / Poisson…

43
 Poisson Distribution
in PHStat
(continued)

§  Complete dialog box entries and get output …

P(X = 2) = 0.0758
44
Example: Suppose that the number of wire-bonding
defects per unit that occur in a semiconductor device is
Poisson distribution with parameter ! = 4.

The probability that a randomly selected semiconductor

device will contain two or fewer wire-bonding defect is

45
The Hypergeometric Distribution
Probability
Distributions

Discrete
Probability
Distributions

Binomial

Poisson

Hypergeometric

46
 The Hypergeometric Distribution

§  “n” trials in a sample taken from a finite

population of size N
§  Sample taken without replacement
§  Outcomes of trials are dependent
§  Concerned with finding the probability of “X”
successes in the sample where there are “A”
successes in the population

47
 Hypergeometric Distribution
Formula

⎛ A ⎞⎛ N − A ⎞
⎜ ⎟⎜ ⎟
⎜ X ⎟⎜ n − X ⎟
P( X) = ⎝ ⎠⎝ ⎠
⎛ N⎞
⎜ ⎟
⎜n ⎟
⎝ ⎠
Where
N = population size
A = number of successes in the population
N – A = number of failures in the population
n = sample size
X = number of successes in the sample
n – X = number of failures in the sample
48
 Using the
Hypergeometric Distribution
■  Example: 3 different computers are checked from 10 in
the department. 4 of the 10 computers have illegal
software loaded. What is the probability that 2 of the 3
selected computers have illegal software loaded?
N = 10 n=3
A=4 X=2

⎛ A ⎞⎛ N − A ⎞ ⎛ 4 ⎞⎛ 6 ⎞
⎜ ⎟⎜ ⎟ ⎜ ⎟⎜ ⎟
⎜ X ⎟⎜ n − X ⎟ ⎜ 2 ⎟⎜1 ⎟ (6)(6)
P(X = 2) = ⎝ ⎠⎝ ⎠ = ⎝ ⎠⎝ ⎠ = = 0.3
⎛ N⎞ ⎛10 ⎞ 120
⎜ ⎟ ⎜ ⎟
⎜n ⎟ ⎜3 ⎟
⎝ ⎠ ⎝ ⎠
The probability that 2 of the 3 selected computers have illegal
software loaded is .30, or 30%.
49
Example:

Suppose that a lot contains 100 items, 5 of which do not

conform to requirements. If 10 items are selected at random
without replacement, then the probability of finding one or
fewer nonconforming items in the sample is

P{ x · 1 } = P{ x=0 } + P{ x=1 }

50
 Hypergeometric Distribution
in PHStat
§  Select:
PHStat / Probability & Prob. Distributions / Hypergeometric …

51
 Hypergeometric Distribution
in PHStat
(continued)

§  Complete dialog box entries and get output …

N = 10 n=3
A=4 X=2

P(X = 2) = 0.3
52
 Properties of the
Hypergeometric Distribution

§  The mean of the hypergeometric distribution is

nA
µ = E(x) =
N
§  The standard deviation is

nA(N - A) N - n
σ= 2
⋅
N N -1
N-n
Where is called the “Finite Population Correction Factor”
N -1
from sampling without replacement from a
finite population
53
 Chapter Summary

§  Addressed the probability of a discrete random

variable
§  Defined covariance and discussed its application in
finance
§  Discussed the Binomial distribution
§  Reviewed the Poisson distribution
§  Discussed the Hypergeometric distribution

(End of Chapter 3)

54