Statistics for

Business and Economics

8th Edition

Chapter 5

Continuous Random Variables

and Probability Distributions
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-1
 Chapter Goals

After completing this chapter, you should be

able to:
 Explain the difference between a discrete and a
continuous random variable
 Describe the characteristics of the uniform and normal
distributions
 Translate normal distribution problems into standardized
normal distribution problems
 Find probabilities using a normal distribution table

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-2
 Chapter Goals
(continued)

After completing this chapter, you should be

able to:
 Evaluate the normality assumption
 Use the normal approximation to the binomial
distribution
 Recognize when to apply the exponential distribution
 Explain jointly distributed variables and linear
combinations of random variables
 Explain examples to Financial Investment Portfolios

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-3
 Probability Distributions
Probability
Distributions

Ch. 4 Discrete Continuous Ch. 5

Probability Probability
Distributions Distributions

Binomial Uniform

Hypergeometric Normal

Poisson Exponential

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-4
 5.1
Continuous Random Variables
 A continuous random variable is a variable that
can assume any value in an interval
 thickness of an item
 time required to complete a task
 temperature of a solution
 height, in inches

 These can potentially take on any value,

depending only on the ability to measure
accurately.

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-5
 Cumulative Distribution Function

 The cumulative distribution function, F(x), for a

continuous random variable X expresses the
probability that X does not exceed the value of x

F(x)  P(X  x)

 Let a and b be two possible values of X, with

a < b. The probability that X lies between a
and b is

P(a  X  b)  F(b)  F(a)

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-6
 Probability Density Function
The probability density function, f(x), of random variable X
has the following properties:

1. f(x) > 0 for all values of x

2. The area under the probability density function f(x)
over all values of the random variable X within its
range, is equal to 1.0
3. The probability that X lies between two values is the
area under the density function graph between the two
values
b
P(a  X  b)   f(x)dx
a

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-7
 Probability Density Function
(continued)
The probability density function, f(x), of random variable X
has the following properties:

4. The cumulative density function F(x0) is the area under

the probability density function f(x) from the minimum
x value up to x0
x0

F(x 0 )   f(x)dx
xm

where xm is the minimum value of the random variable x

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-8
 Probability as an Area
Shaded area under the curve is the
probability that X is between a and b
f(x)
P (a ≤ x ≤ b)
= P (a < x < b)
(Note that the probability
of any individual value is
zero)

a b x

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-9
 Probability as an Area
(continued)
1. The total area under the curve f(x) is 1
2. The area under the curve f(x) to the left of x0 is
F(x0), where x0 is any value that the random variable
can take.
f(x)

F(x0 )  P(X  x 0 )

0 x0 x

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-10
 The Uniform Distribution
Probability
Distributions

Continuous
Probability
Distributions

Uniform

Normal

Exponential

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-11
 The Uniform Distribution

 The uniform distribution is a probability

distribution that has equal probabilities for all
equal-width intervals within the range of the
random variable

f(x)
Total area under the
uniform probability
density function is 1.0

xmin xmax x

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-12
 The Uniform Distribution
(continued)
The Continuous Uniform Distribution:

1
if a  x  b
ba
f(x) =
0 otherwise

where
f(x) = value of the density function at any x value
a = minimum value of x
b = maximum value of x

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-13
 5.2
Expectations for
Continuous Random Variables

 The mean of X, denoted μX , is defined as the

expected value of X

μX  E[X]

 The variance of X, denoted σX2 , is defined as the

expectation of the squared deviation, (X - μX)2, of a
random variable from its mean

σ 2X  E[(X  μX )2 ]

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-14
 Mean and Variance of the
Uniform Distribution

 The mean of a uniform distribution is

ab
μ
2
 The variance is
2
(b - a)
σ2 
12
Where a = minimum value of x
b = maximum value of x

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-15
 Uniform Distribution Example

Example: Uniform probability distribution

over the range 2 ≤ x ≤ 6:

1
f(x) = 6 - 2 = .25 for 2 ≤ x ≤ 6

f(x)
ab 26
μ  4
.25 2 2

(b - a)2 (6 - 2)2
σ 
2
  1.333
2 6 x 12 12

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-16
 Linear Functions of
Random Variables
(continued)

 An important special case of the result for the linear

function of random variable is the standardized random
variable
X  μX
Z
σX

 which has a mean 0 and variance 1

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-18
 5.3
The Normal Distribution
Probability
Distributions

Continuous
Probability
Distributions

Uniform

Normal

Exponential

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-19
 The Normal Distribution
(continued)

 ‘Bell Shaped’
 Symmetrical f(x)
 Mean, Median and Mode
are Equal
Location is determined by the σ
mean, μ x
μ
Spread is determined by the
standard deviation, σ
Mean
= Median
The random variable has an
infinite theoretical range: = Mode
+  to  
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-20
 The Normal Distribution
(continued)

 The normal distribution closely approximates the

probability distributions of a wide range of random
variables
 Distributions of sample means approach a normal
distribution given a “large” sample size
 Computations of probabilities are direct and elegant
 The normal probability distribution has led to good
business decisions for a number of applications

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 Many Normal Distributions

By varying the parameters μ and σ, we obtain

different normal distributions

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 The Normal Distribution Shape
f(x) Changing μ shifts the
distribution left or right.

Changing σ increases
or decreases the
σ spread.

μ x

Given the mean μ and variance σ2 we define the normal

distribution using the notation
X ~ N(μ,σ 2 )
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-23
 The Normal Probability
Density Function

 The formula for the normal probability density

function is
1 (x μ) 2 /2σ 2
f(x)  e
2π 2

Where e = the mathematical constant approximated by 2.71828

π = the mathematical constant approximated by 3.14159
μ = the population mean
σ2 = the population variance
x = any value of the continuous variable,  < x < 
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-24
 Cumulative Normal Distribution

 For a normal random variable X with mean μ and

variance σ2 , i.e., X~N(μ, σ2), the cumulative
distribution function is

F(x0 )  P(X  x 0 )

f(x)

P(X  x 0 )

µ x0 x

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-25
 Finding Normal Probabilities

The probability for a range of values is

measured by the area under the curve

P(a  X  b)  F(b)  F(a)

a μ b x

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-26
 Finding Normal Probabilities
(continued)

F(b)  P(X  b)

a μ b x

F(a)  P(X  a)

a μ b x

P(a  X  b)  F(b)  F(a)

a μ b x
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-27
 The
Standard Normal Distribution
 Any normal distribution (with any mean and
variance combination) can be transformed into the
standardized normal distribution (Z), with mean 0
and variance 1
f(Z)

Z ~ N(0 ,1) 1
Z
0
 Need to transform X units into Z units by subtracting the
mean of X and dividing by its standard deviation

X μ
Z
σ
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-28
 Example

 If X is distributed normally with mean of 100

and standard deviation of 50, the Z value for
X = 200 is

X  μ 200  100
Z   2.0
σ 50
 This says that X = 200 is two standard
deviations (2 increments of 50 units) above
the mean of 100.

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-29
 Comparing X and Z units

100 200 X (μ = 100, σ = 50)

0 2.0 Z ( μ = 0 , σ = 1)

Note that the distribution is the same, only the

scale has changed. We can express the problem in
original units (X) or in standardized units (Z)

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-30
 Finding Normal Probabilities
 a μ b μ
P(a  X  b)  P Z 
 σ σ 
f(x)  b μ  a μ
 F   F 
 σ   σ 

a µ b x
a μ b μ
0 Z
σ σ

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-31
 Probability as
Area Under the Curve
The total area under the curve is 1.0, and the curve is
symmetric, so half is above the mean, half is below

f(X) P(   X  μ)  0.5
P(μ  X   )  0.5

0.5 0.5

μ X
P(   X   )  1.0
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-32
 Appendix Table 1
 The Standard Normal Distribution table in the
textbook (Appendix Table 1) shows values of
the cumulative normal distribution function

 For a given Z-value a , the table shows F(a)

(the area under the curve from negative infinity to a )

F(a)  P(Z  a)

0 a Z
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-33
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-34
 The Standard Normal Table

 Appendix Table 1 gives the probability F(a) for

any value a

.9772
Example:
P(Z < 2.00) = .9772

0 2.00 Z

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-35
 The Standard Normal Table
(continued)

 For negative Z-values, use the fact that the

distribution is symmetric to find the needed
probability:
.9772

.0228
Example:
0 2.00 Z
P(Z < -2.00) = 1 – 0.9772
= 0.0228 .9772
.0228

-2.00 0 Z
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-36
 General Procedure for Finding
Probabilities

To find P(a < X < b) when X is

distributed normally:
 Draw the normal curve for the problem in
terms of X

 Translate X-values to Z-values

 Use the Cumulative Normal Table

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-37
 Finding Normal Probabilities

 Suppose X is normal with mean 8.0 and

standard deviation 5.0
 Find P(X < 8.6)

X
8.0
8.6
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-38
 Finding Normal Probabilities
(continued)
 Suppose X is normal with mean 8.0 and
standard deviation 5.0. Find P(X < 8.6)
X  μ 8.6  8.0
Z   0.12
σ 5.0

μ=8 μ=0
σ = 10 σ=1

8 8.6 X 0 0.12 Z

P(X < 8.6) P(Z < 0.12)

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-39
 Solution: Finding P(Z < 0.12)

Standardized Normal Probability P(X < 8.6)

Table (Portion) = P(Z < 0.12)
z F(z) F(0.12) = 0.5478
.10 .5398

.11 .5438

.12 .5478
Z
.13 .5517 0.00
0.12

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-40
 Upper Tail Probabilities

 Suppose X is normal with mean 8.0 and

standard deviation 5.0.
 Now Find P(X > 8.6)

X
8.0
8.6
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-41
 Upper Tail Probabilities
(continued)

 Now Find P(X > 8.6)…

P(X > 8.6) = P(Z > 0.12) = 1.0 - P(Z ≤ 0.12)
= 1.0 - 0.5478 = 0.4522

0.5478
1.000 1.0 - 0.5478
= 0.4522

Z Z
0 0
0.12 0.12
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-42
 Finding the X value for a
Known Probability

 Steps to find the X value for a known

probability:
1. Find the Z value for the known probability
2. Convert to X units using the formula:

X  μ  Zσ

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-43
 Finding the X value for a
Known Probability
(continued)

Example:
 Suppose X is normal with mean 8.0 and

standard deviation 5.0.

 Now find the X value so that only 20% of all
values are below this X

.2000

? 8.0 X
? 0 Z
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-44
 Find the Z value for
20% in the Lower Tail
1. Find the Z value for the known probability
Standardized Normal Probability  20% area in the lower
Table (Portion) tail is consistent with a
z F(z) Z value of -0.84
.82 .7939 .80
.20
.83 .7967

.84 .7995
? 8.0 X
.85 .8023 -0.84 0 Z

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-45
 Finding the X value

2. Convert to X units using the formula:

X  μ  Zσ
 8.0  ( 0.84)5.0
 3.80

So 20% of the values from a distribution

with mean 8.0 and standard deviation
5.0 are less than 3.80

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-46
Let the random variable Z follow a standard normal
distribution.

a. Find P(Z < 1.20)

b. Find P(Z > 1.33)

c. Find P(Z < -1.70)

d. Find P(1.20 < Z < 1.33)

e. Find P( -1.70 < Z < 1.20)

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-47
Let the random variable Z follow a standard normal
distribution.

a. The probability is 0.70 that Z is less than what number?

b. The probability is 0.25 that Z is less than what number?

c. The probability is 0.2 that Z is greater than what number?

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-48
 Assessing Normality

 Not all continuous random variables are

normally distributed

 It is important to evaluate how well the data is

approximated by a normal distribution

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-49
 The Normal Probability Plot

 Normal probability plot

 Arrange data from low to high values
 Find cumulative normal probabilities for all values
 Examine a plot of the observed values vs. cumulative
probabilities (with the cumulative normal probability
on the vertical axis and the observed data values on
the horizontal axis)
 Evaluate the plot for evidence of linearity

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-50
 The Normal Probability Plot
(continued)

A normal probability plot for data

from a normal distribution will be
approximately linear:

100

Percent

0
Data

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-51
 The Normal Probability Plot
(continued)

Left-Skewed Right-Skewed
100 100
Percent

Percent
0 0
Data Data

Uniform
100
Nonlinear plots
indicate a deviation
Percent

from normality
0
Data
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-52
 5.4
Normal Distribution Approximation
for Binomial Distribution

 Recall the binomial distribution:

 n independent trials
 probability of success on any given trial = P

 Random variable X:
 Xi =1 if the ith trial is “success”
 Xi =0 if the ith trial is “failure”

E[X]  μ  nP
Var(X)  σ  nP(1- P) 2

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-53
 Normal Distribution Approximation
for Binomial Distribution
(continued)

 The shape of the binomial distribution is approximately

normal if n is large

 The normal is a good approximation to the binomial

when nP(1 – P) > 5

 Standardize to Z from a binomial distribution:

X  E[X] X  np
Z 
Var(X) nP(1  P)

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-54
 Normal Distribution Approximation
for Binomial Distribution
(continued)

 Let X be the number of successes from n independent

trials, each with probability of success P.

 If nP(1 - P) > 5,

 a  nP b  nP 
P(a  X  b)  P Z 

 nP(1  P) nP(1  P) 

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-55
 Binomial Approximation Example
 40% of all voters support ballot proposition A. What
is the probability that between 76 and 80 voters
indicate support in a sample of n = 200 ?
 E[X] = µ = nP = 200(0.40) = 80
 Var(X) = σ2 = nP(1 – P) = 200(0.40)(1 – 0.40) = 48
( note: nP(1 – P) = 48 > 5 )

 76  80 80  80 

P(76  X  80)  P Z 
 200(0.4)(1  0.4) 200(0.4)(1  0.4) 
 P(0.58  Z  0)
 F(0)  F(0.58)
 0.5000  0.2810  0.2190

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-56
 5.5
The Exponential Distribution
Probability
Distributions

Continuous
Probability
Distributions

Normal

Uniform

Exponential

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-57
 The Exponential Distribution

 Used to model the length of time between two

occurrences of an event (the time between
arrivals)

 Examples:
 Time between trucks arriving at an unloading dock
 Time between transactions at an ATM Machine
 Time between phone calls to the main operator

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-58
 The Exponential Distribution
(continued)

λ t
f(t)  λ e for t  0

he exponential random variable T (t>0) has a

robability density function

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-59
 The Exponential Distribution
(continued)

 Defined by a single parameter, its mean  (lambda)

 The cumulative distribution function (the probability that
an arrival time is less than some specified time t) is
F(t)  1 e  λ t
where e = mathematical constant approximated by 2.71828
 = the population mean number of arrivals per unit
t = any value of the continuous variable where t > 0

 The probability that an arrival time is greater than

some specified time t) is
P(T > t) = 𝟏 − 𝑭 𝒕 = 𝒆−𝝀𝒕

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-60
 The Exponential Distribution
(continued)

Memoryless property:
A random variable X is said to be memoryless if
P(X > t + s | X > s) = P(X > t) for all s, t > 0

Exponential distribution is the only continuous

distribution with the memoryless property.

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-61
 Relationship between Poisson
and Exponential Distributions
If events (customer arrivals at a post office, phone calls to
a call center, failures of an equipment, truck arrivals to a
loading dock etc.) occur according to a Poisson
distribution with parameter  then the time between
successive arrivals has an exponential distribution with
parameter .
Let X = number of arrivals in one unit time interval where
X follows a Poisson distribution with rate  and E[X]= .
Now let T = interarrival times.
Then T follows an exponential probability distribution with
rate  and E[T]= 1/.

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-62
 Exponential Distribution
Example
Example: Customers arrive at a service counter at the
rate of 15 per hour according to a Poisson distribution.
a) What is the probability that the arrival time between
consecutive customers is less than three minutes?
b) What is the mean interarrival time between
consecutive customers?
c) What is the mean number of customers arriving to the
service counter in two hours?
d) What is the mean number of customers arriving to the
service counter in 45 minutes?

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-63
 Exponential Distribution
Example
a) The mean number of arrivals per hour is 15, so  = 15
 Three minutes is .05 hours (3/60).
 P(arrival time < .05) = 1 – e- X = 1 – e-(15)(.05) = 0.5276
 So there is a 52.76% probability that the arrival time
between successive customers is less than three
minutes
b) The mean interarrival time is 1/ and
1/ is 1/15 = 0.0667 hours = 4 minutes
c) The mean number of arrivals in two hours is 2(15) = 30
d) The number of arrivals in 45 minutes has a Possion
distribution with mean (3/4)(15) = 11.25.

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-64
 Exponential Distribution
Example
(continued)
e) What is the probability that no customers arrive in the
next ten minutes?

Method 1: using the Exponential Distribution

 No arrivals in the next ten minutes means T > 1/6
hours.
P(T > 1/6) = e- t = e-(15)(1/6) = 0.082
Method 2: using the Poisson Distribution
 No arrivals in the next ten minutes means X = 0 where X
has a Poisson distribution with rate 15/6. Rate of 15 per
hour drops down to 15/6 per 10 minutes.
P(X = 0) = (15/6)0 𝑒 −15/6 /0!= 0.082
Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-65
 Exponential Distribution
Example
(continued)
f) What is the probability of a customer arrival in the next
five minutes?

A customer arrival in the next five minutes means

T < 1/12 hours where T has an exponential distribution
with rate 15.
P(T < 1/12) = 1- e- t = 1- e-(15)(1/12) = 1 - 0.287 = 0.713

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-66
 Correlation

 Let X and Y be jointly distributed random variables.

 The correlation between X and Y is

Cov(X, Y)
ρ  Corr(X, Y) 
σ Xσ Y

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-70
 Linear Combinations of
Random Variables
(continued)

 The variance of W is

σ 2W  a2σ 2X  b2σ 2Y  2abCov(X, Y)

 Or using the correlation,

σ 2W  a2σ 2X  b2σ 2Y  2ab ρ(X, Y)σ Xσ Y

 If both X and Y are joint normally distributed random

variables then the linear combination, W, is also
normally distributed

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-75
 Example

 Two tasks must be performed by the same worker.

 X = minutes to complete task 1; μx = 20, σx = 5

 Y = minutes to complete task 2; μy = 20, σy = 5

 X and Y are normally distributed and independent

 What is the mean and standard deviation of the time to

complete both tasks?

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-76
 Example
(continued)
 X = minutes to complete task 1; μx = 20, σx = 5
 Y = minutes to complete task 2; μy = 30, σy = 8

 What are the mean and standard deviation for the time to complete
both tasks?
W  XY
μW  μX  μY  20  30  50
 Since X and Y are independent, Cov(X,Y) = 0, so

σ 2W  σ 2X  σ 2Y  2Cov(X, Y)  (5)2  (8)2  89

 The standard deviation is

σ W  89  9.434
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 Financial Investment Portfolios

 A financial portfolio can be viewed as a linear

combination of separate financial instruments

 Proportion of   Proportion of 
 Return on     Stock 1    Stock 2 
    portfolio value       portfolio value    
 portfolio   in stock1   return   in stock2   return 
   

 Proportion of 
   Stock N 
   portfolio value    
 in stock N   return 
 

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 Portfolio Analysis Example

 Consider two stocks, A and B

 The price of Stock A is normally distributed with mean
12 and variance 4
 The price of Stock B is normally distributed with mean
20 and variance 16
 The stock prices have a positive correlation, ρAB = .50
 Suppose you own
 10 shares of Stock A
 30 shares of Stock B

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 Portfolio Analysis Example
(continued)

 The mean and variance of this stock portfolio

are: (Let W denote the distribution of portfolio value)

μW  10μA  20μB  (10)(12)  (30)(20)  720

σ 2W  102 σ 2A  302 σB2  (2)(10)(30 )Corr(A,B)σ A σB

 102 (4)2  302 (16)2  (2)(10)(30 )(.50)(4)( 16)
 251,200

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 Portfolio Analysis Example
(continued)

 What is the probability that your portfolio value is

less than $500?
μW  720
σ W  251,200  501.20
500  720
 The Z value for 500 is Z   0.44
501.20

 P(Z < -0.44) = 0.3300

 So the probability is 0.33 that your portfolio value is less than $500.

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-81