DISCRETE PROBABILITY

DISTRIBUTIONS
 LEARNING OBJECTIVES

01 02 03 04 05
The properties To compute the To calculate the To compute How to use the
of a probability expected value covariance and probabilities binomial, and
distribution and variance of a understand its from binomial, Poisson
probability use in finance hypergeometric, distributions to
distribution and Poisson solve business
distributions problems
 DEFINITIONS

• A random variable represents a possible numerical value from an uncertain event

• Discrete random variables produce outcomes that come from a counting process (e.g.
number of classes you are taking)

• Continuous random variables produce outcomes that come from a measurement (e.g. your
annual salary, or your weight)
 CLASSIFY EACH RANDOM VARIABLE AS EITHER
DISCRETE OR CONTINUOUS

• The number of arrivals at an emergency room between midnight and 6:00 a.m. Discrete

• The weight of a box of cereal labeled “18 ounces” Continuous

• The duration of the next outgoing telephone call from a business office Continuous

• The number of kernels of popcorn in a 1-pound container

Discrete
• The average amount spent on electricity each July by a randomly selected
Continuous
household in a certain state
 DISCRETE RANDOM VARIABLES

• Can only assume a countable number of values

• Examples:
• Roll a die twice
• Let X be the number of times 4 occurs
• (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)
 PROBABILITY DISTRIBUTION FOR A DISCRETE
RANDOM VARIABLE

• A probability distribution for a discrete random variable is a mutually exclusive listing of all
possible numerical outcomes for that variable and a probability of occurrence associated with
each outcome.

Number of Classes Taken Probability

2 0.20
3 0.40
4 0.24
5 0.16
 EXAMPLE OF A DISCRETE RANDOM VARIABLE
PROBABILITY DISTRIBUTION

PROBABILITY DISTRIBUTION

• Experiment: Toss 2 Coins. X Value Probability

T T
• Let X = # heads. 0 1/4 = 0.25
• 4 possible outcomes T H 1 2/4 = 0.50
2 1/4 = 0.25
H T

Probability
0.50

0.25
H H
0 1 2 X
 DISCRETE RANDOM VARIABLES EXPECTED VALUE

• Expected Value (or mean) of a discrete random variable (Weighted Average)

N X P(X=xi)
 = E(X) =  xi P( X = xi )
i =1 0 0.25

1 0.50

2 0.25
Example:Toss 2 coins,
𝑋 = # of heads,
Compute expected value of 𝑋: 𝑬(𝑿) = ((𝟎)(𝟎. 𝟐𝟓) + (𝟏)(𝟎. 𝟓𝟎) + (𝟐)(𝟎. 𝟐𝟓)) = 𝟏. 𝟎
 DISCRETE RANDOM VARIABLES
MEASURING DISPERSION

• Variance of a discrete random variable

N
σ 2 =  [x i − E(X)]2 P(X = x i )
i =1

• Standard Deviation of a discrete random variable

N
σ= σ =
2
 i
[x
i =1
− E(X)]2
P(X = x i )
• where:
• 𝐸(𝑋) = Expected value of the discrete random variable 𝑋
• 𝑥𝑖 = the 𝑖𝑡ℎ outcome of 𝑋
• 𝑃(𝑋=𝑥𝑖) = Probability of the 𝑖𝑡ℎ occurrence of 𝑋
 COVARIANCE

• The covariance measures the strength of the linear relationship between two discrete
random variables X and Y.
• A positive covariance indicates a positive relationship.
• A negative covariance indicates a negative relationship.
N
σ XY =  [ xi − E ( X )][( yi − E (Y )] P ( xi yi )
i =1

where: 𝑋 = discrete random variable 𝑋

𝑋𝑖 = the 𝑖𝑡ℎ outcome of 𝑋
𝑌 = discrete random variable 𝑌
𝑌𝑖 = the 𝑖𝑡ℎ outcome of 𝑌
𝑃(𝑋𝑖𝑌𝑖) = probability of occurrence of the
𝑖𝑡ℎ outcome of 𝑋 and the 𝑖𝑡ℎ outcome of 𝑌
 LET'S PUT THIS TO THE TEST

Investment
Prob. Economic Condition
Passive Fund X Aggressive Fund Y

0.2 Recession - $25 - $200

0.5 Stable Economy + $50 + $60

0.3 Expanding Economy + $100 + $350

Consider the return per $1000 for two types of investments.

 𝐸(𝑋) = 𝜇𝑋 = (−25)(.2) + (50)(.5) + (100)(.3)
= 50
• Mean
• Interpretation: Fund X is averaging a $50.00 return and fund Y is averaging a $95.00 return
per $1000 invested.
𝐸(𝑌) = 𝜇𝑌 = (−200)(.2) + (60)(.5) + (350)(.3)
= 95
• Standard Deviation
• Interpretation: Even though fund Y has a higher average return, it is subject to much more
variability and the probability of loss is higher

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
 COVARIANCE

• Interpretation: Since the covariance is large and positive, there is a positive relationship
between the two investment funds, meaning that they will likely rise and fall together.

σ XY = (-25 − 50)(-200 − 95)(.2) + (50 − 50)(60 − 95)(.5)

+ (100 − 50)(350 − 95)(.3)
= 8,250
 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 = σ 2X + Y
 BINOMIAL PROBABILITY DISTRIBUTION

• A fixed number of observations, n

• e.g., 15 tosses of a coin; ten light bulbs taken from a warehouse

• Each observation is categorized as to whether or not the “event of interest” occurred

• e.g., head or tail in each toss of a coin; defective or not defective light bulb

• Since these two categories are mutually exclusive and collectively exhaustive, when the probability
of the event of interest is represented as π, then the probability of the event of interest not
occurring is 1 - π
• Constant probability for the event of interest occurring (π) for each observation

• e.g., probability of getting a tail is the same each time we toss the coin

• Observations are independent

• The outcome of one observation does not affect the outcome of the other
• Two sampling methods deliver independence
◼ Infinite population without replacement

◼ Finite population with replacement

 APPLICATIONS

• 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
 THE BINOMIAL DISTRIBUTION COUNTING
TECHNIQUES

• Suppose the event of interest is obtaining heads on the toss of a fair coin. You are to toss the
coin three times. In how many ways can you get two heads?

• Possible ways: HHT, HTH, THH, so there are three ways you can getting two heads.

• This situation is fairly simple. We need to be able to count the number of ways for more
complicated situations.
 COUNTING TECHNIQUES
RULE OF COMBINATIONS

• The number of combinations of selecting X objects out of n objects is

n!
n Cx =
x!(n − x)!

where:
𝑛! = 𝑛 𝑛 − 1 𝑛 − 2 … (2)(1)
𝑋! = 𝑋 𝑋 − 1 𝑋 − 2 … (2)(1)
0! = 1 (by definition)
 EXAMPLE:

• How many possible 3 scoop combinations could you create at an ice cream parlor if you have
31 flavors to select from?
• The total choices is n = 31, and we select X = 3.

31! 31! 31 • 30 • 29 • 28!

31 C 3 = = = = 31 • 5 • 29 = 4,495
3!(31 − 3)! 3!28! 3 • 2 • 1 • 28!
 BINOMIAL DISTRIBUTION FORMULA

n! x n−x
P(X=x |n,π) = π (1-π)
x! ( n − x )!

𝑃 𝑋 = 𝑥 𝑛, 𝜋) = probability of x events of interest in n trials, with Example: Flip a coin four

the probability of an “event of interest” being π for each trial times, let x = # heads:
n=4
𝑥 = number of “events of interest” in sample, (x = 0, 1, 2, ..., n)
π = 0.5
𝑛 = sample size (number of trials or observations)
1 - π = (1 - 0.5) = 0.5
𝜋 = probability of “event of interest”
X = 0, 1, 2, 3, 4
 EXAMPLE:

• What is the probability of one success in five observations if the probability of an event of
interest is 0.1?
• 𝑥 = 1, 𝑛 = 5, 𝑎𝑛𝑑 𝜋 = 0.1

n!
P(X = 1 | 5,0.1) =  x (1 −  ) n − x
x!(n − x)!
5!
= (0.1)1 (1 − 0.1) 5−1
1!(5 − 1)!
= (5)(0.1)(0.9) 4
= 0.32805
 THE BINOMIAL DISTRIBUTION SHAPE

• The shape of the binomial distribution depends on the values of π and n

P (X=x|5, 0.1)
.6
• Here, 𝑛 = 5 𝑎𝑛𝑑 𝜋 = .1 .4
.2
0
0 1 2 3 4 5 x

P (X=x|5, 0.5)
• Here, 𝑛 = 5 𝑎𝑛𝑑 𝜋 = .5 .6
.4
.2
0
0 1 2 3 4 5 x
 BINOMIAL DISTRIBUTION CHARACTERISTICS

• Mean
μ = E(X) = n
• Variance and Standard Deviation

2
σ = nπ (1 - π )
σ = nπ (1 - π )
Where n = sample size
π = probability of the event of interest for any trial
(1 – π) = probability of no event of interest for any trial
THE BINOMIAL DISTRIBUTION CHARACTERISTICS

P(X=x|5, 0.1)
μ = nπ = (5)(.1) = 0.5 .6
.4
.2
σ = nπ (1 - π ) = (5)(.1)(1 − .1)
0
= 0.6708 0 1 2 3 4 5 x

P(X=x|5, 0.5)
μ = nπ = (5)(.5) = 2.5 .6
.4
σ = nπ (1 - π ) = (5)(.5)(1 − .5) .2
= 1.118 0
0 1 2 3 4 5 x
 THE POISSON DISTRIBUTION DEFINITIONS

• You use the Poisson distribution when you are interested in the number of times an event
occurs in a given area of opportunity.
• An area of opportunity is a continuous unit or interval of time, volume, or such area in which
more than one occurrence of an event can occur.

• The number of scratches in a car’s paint

• The number of mosquito bites on a person
• The number of computer crashes in a day
• 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)
 POISSON DISTRIBUTION FORMULA

−
e  x
P( X = x |  ) =
x!
where:
𝑥 = number of events in an area of opportunity
 = expected number of events
𝑒 = base of the natural logarithm system (2.71828...)
 POISSON DISTRIBUTION CHARACTERISTICS

Mean
μ=λ
Variance and Standard Deviation

σ2 = λ
σ= λ
where  = expected number of events
 POISSON DISTRIBUTION SHAPE

• The shape of the Poisson Distribution depends on the parameter  :

 = 0.50  = 3.00
 CHAPTER SUMMARY

ADDRESSED THE DEFINED COVARIANCE DISCUSSED THE DISCUSSED THE DISCUSSED THE
PROBABILITY AND DISCUSSED ITS BINOMIAL POISSON DISTRIBUTION HYPERGEOMETRIC
DISTRIBUTION OF A APPLICATION IN DISTRIBUTION DISTRIBUTION
DISCRETE RANDOM FINANCE
VARIABLE