QF1100 (Week 5)

▶ Probability

▶ Properties of Probability

▶ Random variables

No Gambling!

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Example
A loan of $10, 000 is to be repaid by annual installments of $1000.
The effective interest rate is 4.5% per annum. Determine the total
number of payments to be made and the amount of the last payment,
given that the last payment will be made
(i) together with the last installment payment of $1000
(ii) one year after the last installment payment of $1000 (Exercise).

Strategy.
1. Write down the cash flow:

C1 =

2. Set up the equation L = P V (C1 ) of n.

3. Solve for n (⇒ a real cash flow).

Remark.
Quit often, the solution of n is not an integer. The loan will be repaid
with ⌊n⌋ (the greatest integer less than or equal to n) full payments of
A plus a final payment B made at some time such as ⌊n⌋ or ⌊n⌋ + 1,
according to a predetermined schedule or formula. 2/23
Solution
Assume n to be the total number of payments. We have the present
value of the cash flow (0, 103 , 103 , . . . , 103 ):
| {z }
n years

n
X 103 1 − 1.045−n
P V (C1 ) = 103 × (1 + 4.5%)−k = · .
1.045 1 − 1.045−1
k=1

Then
P V (C1 ) = L = 104 =⇒ n = 13.5.
We need to make ⌊13.5⌋ = 13 payments of 103 .

Next, we have a real cash flow

C2 = (0, 103 , 103 , . . . , 103 , 103 + B).

| {z }
12 years

Our goal is to solve for B such that P V (C2 ) = L = 104 .

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Solution
We have the present value of C2
12
X
P V (C2 ) = 103 × (1 + 4.5%)−k + (103 + B) × (1 + 4.5%)−13
k=1
13
X B
= 103 × (1 + 4.5%)−k + .
(1 + 4.5%)13
k=1

Solve for B satisfying the equation P V (C2 ) = L = 104 and obtain

B = 562.05.

Exercise (ii). The last payment B will be made one year after the last
installment payment of $1000.
▶ True/False: The real cash flow (0, 103 , 103 , . . . , 103 , B).
| {z }
13 years
▶ Solve for B.
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Fixed-income securities
Fixed-income securities are financial instruments that traded in
well-developed markets and promise a fixed (that is, definite) income
to the holder over a span of time.

Example
▶ Savings Deposits: DSB Fixed Deposits, POSB MySavings
Account, etc.
▶ Government Securities: U.S. Treasury bills/bonds/notes,
Singapore Saving bonds.
▶ Other bonds: Municipal bonds, Corporate bonds.
▶ Mortgages
▶ Annuities: pension.

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Derivative Securities
A derivative security is a security whose payoff is explicitly tied to
the value of some other variable, usually based on the price of some
other financial security, the stock price, the price of commodities, the
yield of bonds for instance.
▶ Forward contracts and Future contracts
▶ Options

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Probability

Risk is the possibility of something bad happening.

7/23
Definition of Probability
Consider an experiment (e.g flipping a coin) whose outcome is not
predictable (possibly Tail or Head).
▶ An outcome of the experiment (e.g. T ) is called an element or
a sample point.
▶ The collection S (e.g. S = {T, H}) of all outcomes is called the
sample space.
▶ Any subset of the sample space is an event. (e.g. ∅, {T }, {H},
{T, H}).

Example.
1. Toss a dice. The sample space is S = {1, 2, 3, 4, 5, 6}.
{even sides} = {2, 4, 6} is an event.
2. Flip two coins. The sample space is
S = {(H, H), (H, T ), (T, H), (T, T )}.
3. Toss two dice. How many sample points do the sample space
consist of? (Exercise.).

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Taxes Hold’em (No Gambling)

9/23
TOTO

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Events
▶ The sample space S is an event, called a sure event.
▶ The empty set ∅ is an event, called a null event.
▶ The complement of an event A is Ac = S \ A.
▶ The intersection of events A and B is A ∩ B.
▶ The events A, B are mutually exclusive if A ∩ B = ∅.
▶ The union of events A and B is A ∪ B.

Example
1. Let S = {1, 2, 3, 4, 5, 6} be the sample space.
Then neither T , H, nor 10 is a sample point.
2. Let S = {(i, j) | 1 ≤ i, j ≤ 6} and E = {(i, j) ∈ S | i + j = 7}.
Then E is an event and
E = {(1, 6)} ∪ {(2, 5)} ∪ {(3, 4)} ∪ {(4, 3)} ∪ {(5, 2)} ∪ {(6, 1)}.
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Axioms of Probability
The probability P(E) of E gives a precise measure of the chance that
the event E will occur.

Define the probability P of S that satisfies the three axioms:

Axiom 1 0 ≤ P(E) ≤ 1 for any E ⊆ S.
Axiom 2 P(S) = 1.
Axiom 3 If E1 , E2 , . . . are
! mutually exclusive events (Ei ∩ Ej = ∅, ∀i ̸= j),
[∞ X∞
then P Ei = P(Ei ).
i=1 i=1
Facts. (The proofs are not required.)
1. 0 indicates impossibility of the event and 1 indicates certainty.
P∞
2. Axiom 3 implies i=1 P(Ei ) is convergent to a number in [0, 1].
S S∞ P∞
3. P(∅) = 0 because P(S) = P(S i=2 ∅) = P(S) + i=2 P(∅).
n
[ Xn
4. Axiom 3 ⇒ P( Ei ) = P(Ei ) ( ⇐⇒ Axiom 3 if S is finite).
i=1 i=1

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Example
Exercise.
Let S = {T, H}. Define a funtion P of the subsets of S by
P ∅ {T } {H} {T, H} Y/N
1 1 3
P1 0 2 4 4
1 1
P2 0 2 2 1
3
P3 0 2 − 21 1
1 2
P4 0 3 3 1

Example. Toss a fair dice. Let S = {1, 2, 3, 4, 5, 6}. We expect that

the natural probability of S satisfies
1
P({1}) = P({2}) = P({3}) = P({4}) = P({5}) = P({6}) = .
6
It follows from Axiom 3 that
3 1 2 1 5
P({1, 2, 3}) = = , P({3, 6}) = = , P({6}c ) = .
6 2 6 3 6
Remark. Sample spaces have equally likely outcomes. 13/23
Equally likely outcomes
Let a sample space S be a finite set, say S = {1, 2, . . . , N }.
Having equally likely outcomes means
P({1}) = P({2}) = · · · = P({N }).
1
Axioms 2 and 3 imply that P({i}) = N for all i.

Define the function P of the events by

the number of points in E |E|
P(E) = = .
the number of points in S |S|
Show that P is a probability of S. (That is, P satisfies Axioms 1–3.)
Proof.
Axiom 1: For E ⊆ S, by 0 ≤ |E| ≤ |S|, we have 0 ≤ P(E) ≤ 1.
Axiom 2: P(E) = |S|/|S| = 1.
Axiom 3: If P E1 , E2 , · · · , En are mutually exclusive events, then
n
| ∪ni=1 Ei | = i=1 |Ei |. It follows that
Pn n n
| ∪ni=1 Ei | |Ei | X |Ei | X
P(∪ni=1 Ei ) = = i=1 = = P(Ei ).
|S| |S| i=1
|S| i=1
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Example
If two dices are rolled, what is the probability that the sum of the
upturned faces will equal 7?

Solution. Let S = {(i, j) | 1 ≤ i, j ≤ 6} be the sample space.

The event is

E ={the sum of the upturned faces equal 7}

={(i, j) ∈ S | i + j = 7}
={(1, 6), (2, 5), (3, 4), (4, 3), (5, 2), (6, 1)}.

Then
|E| 6 1
P(E) = = = .
|S| 36 6
Question: What is the probability that the sum of the upturned faces
will equal 8? Which sum is of the maximal probability?
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Exercise: Texas Hold’em
A 5-card poker hand is said to be a straight flush if it is straight of the
same suit. What is the probability that one is dealt a straight flush?
1. Let S be the sample space, i.e.,
S = {all possible 5-card poker hand}. Find |S|.

2. Let E = {all possible straight flushes}. Find |E|.

3. Compute P(E).

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Properties of Probability
Theorem. Let S be the sample space.
1. P(Ac ) = 1 − P(A)
2. P is monotonic, i.e., if A ⊆ B then P(A) ≤ P(B).

Proof. (Not required.) By Axioms 2 and 3, we have

1 = P(S) = P(A ∪ Ac ) = P(A) + P(Ac ) ⇒ P(Ac ) = 1 − P(A).

Recall that B = (A ∩ B) ∪ (Ac ∩ B). By A ⊆ B, we have (A ∩ B) = A

and then B = A ∪ (Ac ∩ B).

Since A and (Ac ∩ B) are mutually exclusive, by Axiom 3, we have

P(B) = P(A) + P(Ac ∩ B).

Thus, P(B) − P(A) = P(Ac ∩ B).

Since P(Ac ∩ B) ≥ 0, P(B) − P(A) ≥ 0.
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Random Variable
A random variable (r.v.) is a real-valued function defined on the
sample space X : S → R.

Example.
(i) Toss a fair dice. Let X be the upturned face. Then
X = 1, 2, 3, 4, 5, 6. X ≤ 3 means “small” (or “si”, “sai”?), i.e., the
upturned face less or equal to 3.
(ii) Toss a pair of fair dice. Let X be the sum of the faces.

X : (x, y) → x+y, X : (3, 4) → 7, X : (1, 1) → 2, X : (6, 6) → 12.

X = 7 means the event {(1, 6), (2, 5), (3, 4), (4, 3), (5, 2), (6, 1)}.
X ≤ 4 means the event {(1, 1), (2, 1), (1, 2), (3, 1), (2, 2), (1, 3)}.
(iii) A die is thrown until 5 occurs. Let X be the number of trials.

X = 1, 2, 3, . . . , 1000, . . . .

(iv) Let X be the waiting time for a bus.

X ≥ 0.
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Distribution Function and Density Function
Let X be a random variable.
The cumulative distribution function (c.d.f.) FX is defined by

FX (x) = P{X ≤ x}, x ∈ R.

Some properties of the c.d.f. F are

1. FX is a non-decreasing function, i.e., if a < b then
FX (a) ≤ FX (b) because {a < X ≤ b} ⊆ {X ≤ b}.
2. P{a < X ≤ b} = P{X ≤ b} − P{X ≤ a} = FX (b) − FX (a) because

{X ≤ b} = {X ≤ a} ∪ {a < X ≤ b}.

3. FX (+∞) = 1, i.e., X < ∞ is the sure event S.

4. FX (−∞) = 0, i.e, X = −∞ is the null event.
5. 0 ≤ FX (x) ≤ 1.
Example. Toss a pair of fair dice. Let X be the sum of the faces.
Then
6 1
FX (4) = , FX (2) = , FX (1) = 0, FX (12) = 1.
36 36
Exercise. Find FX (5). 19/23
Discrete Random Variable
A random variable X is called discrete if its possible values are finite
or countably infinite.
Given a discrete random variable X. Its probability density
function is defined by

fX (x) = P{X = x}.

Remark. If X must assume one of the values x1 , x2 , . . . , then

fX (xi ) ≥ 0 for i = 1, 2, . . . and fX (x) = 0 for all other values of x.
Moreover
X∞
fX (xi ) = 1.
i=1

Example. Toss a pair of fair dice. Let X be the sum of the faces.
Then X is discrete since its possible values are 2, 3, . . . , 12.

X 2 3 4 5 6 7 8 9 10 11 12
1 2 3 4 5 6 3 2 1
fX (x) 36 36 36 36 36 36 36 36 36

For instance, fX (1) = fX (100) = 0.

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Continuous Random Variables
A random variable X is continuous if its c.d.f. FX (x) is a
continuous function on R. In further, we assume that there exists a
nonnegative function fX defined for x ∈ (−∞, ∞) having the property
that for any set B of R
Z
P{X ∈ B} = fX (x) dx.
B

The function fX is called the probability density function of X.

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Standard Normal Distribution

Z a
1 x2 1 x2
FX (a) = P(X ≤ a) = √ e− 2 dx and f (x) = √ e− 2 .
−∞ 2π 2π
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Remarks

1. fX (x) ≥ 0 for all x ∈ R.

Z x Z ∞
2. FX (x) = fX (t) dt, and FX (∞) = fX (x) dx = 1.
−∞ −∞
3. We may assume
Z a
P(X = a) = f (x) dx = 0 for any a ∈ R.
a
Z a
4. P{X < a} = P{X ≤ a} = FX (a) = fX (x) dx.
−∞
Z b
5. P{a < X ≤ b} = P{a ≤ X ≤ b} = fX (x) dx.
a

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