Quantitative Methods Module 4 Probability Concepts

1. Suppose you have two buy limit orders outstanding on the same stock. One buy order (Order 1)
was placed at a price limit of $10. The probability that it will execute within one hour is 0.35.
The second buy order (Order 2) was placed at a price limit of $9.75; it has a 0.25 probability of
executing within the same one-hour time frame.
A. What is the probability that either Order 1 or Order 2 will execute?
B. What is the probability that Order 2 executes, given that Order 1 executes?
P(O1) = .35; P(O2) = .25.
A. If Order 2 executes, Order 1 must execute. So P(O1| O2) = 1.
P(O1 and O2) =P(O1 | O2) * P(O2) =1*.25 = .25.
P(O1 or O2) = P(O1) + P(O2) – P(O1 and O2)
= 0.35 + 0.25 – 0.25 = 0.35.
B. P(O2 | O1) = P(O1 and O2) / P (O1) = 0.25 / 0.35 = 0.714

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 Quantitative Methods Module 4 Probability Concepts

2. Suppose an analyst wants to study whether historical performance predicts future performance
for a sample of 500 equity funds. The top 50% of funds are categorized as winners and the
bottom 50% are categorized as losers in each year.
Period 2 Winner Period 2 Loser
Period 1 Winner 140 110
Period 1 Loser 90 160
Answer the following questions:
A. State the four events needed to define the four conditional probabilities.
B. Illustrate the problem using a tree diagram.
C. State the four entries of the table as conditional probabilities using the form P(this event |
that event) = number.
D. Using the information in the table, calculate the probability of the event a fund is a loser in
both Period 1 and Period 2
E. Judge whether or not the period 1 and period 2 performance are independent.
Solution:
A. The four events needed to define the conditional probabilities are as follows:
Fund is a Period 1 winner, Fund is a Period 1 loser,
Fund is a Period 2 loser, Fund is a Period 2 winner.
B.
C. P(fund is a Period 2 winner | fund is a Period 1 winner)=0.56;
P(fund is a Period 2 loser | fund is a Period 1 winner) =0.44;
P(fund is a Period 2 winner | fund is a Period 1 loser) =0.36;
P(fund is a Period 2 loser | fund is a Period 1 loser) =0.64.
D. Using the multiplication Rule for Probability,
P(L1L2) = P(L2|L1)P(L1) = 0.64(0.50) = 0.32
E. If the status of a fund in one period is independent, the joint probability would be
0.5*0.5=0.25

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 Quantitative Methods Module 4 Probability Concepts

3. A banking industry analyst studies BankCorp. The historical record shows that in 55% of recent
quarters BankCorp’s EPS has increased sequentially, and in 45% of quarters EPS has decreased
or remained unchanged.
A. Assuming the changes in sequential EPS are independent.
a. What is the probability of 3Q:2014 will be larger than 2Q:2014 (a positive change in
sequential EPS)?
b. What is the probability that EPS decreases or remains unchanged in the next two
quarters?
B. Suppose 𝑃(𝐴|𝑆 ) = 0.40. Write the statement in probability notation: the probability that
the change in sequential EPS is positive next quarter, given that the change in sequential EPS is
positive in prior quarter and calculate it.
Event Probability

A=change in sequential EPS is positive next quarter 0.55

AC=change in sequential EPS is 0 or negative next quarter 0.45
S=change in sequential EPS is positive in prior quarter 0.55
SC=change in sequential EPS is 0 or negative in prior quarter 0.45
Solution:
a. 55% as the changes are independent.
b. P=0.45*0.45=0.2025.
c. In probability notation, this statement is written as P(A|S).
As 𝑃(𝐴) = 𝑃(𝐴|𝑆)𝑃(𝑆) + 𝑃(𝐴|𝑆 )𝑃(𝑆 )
𝑃(𝐴) − 𝑃(𝐴|𝑆 )𝑃(𝑆 ) 0.55 − 0.4 × 0.45
𝑃(𝐴|𝑆) = = = 0.672727
𝑃(𝑆) 0.55

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 Quantitative Methods Module 4 Probability Concepts

4. Suppose the BankCorp’s estimated operating cost is 𝑌 = 12.5 + 0.65𝑋, with X the # of branch
offices.

Solution:

Operating Costs 𝒀 Probability

12.5+0.65*125=93.75 0.80*0.50=0.40
12.5+0.65*100=77.50 0.80*0.50=0.40
12.5+0.65*80=64.50 0.20*0.85=0.17
12.5+0.65*70=58.00 0.20*0.15=0.03
Sum=1.00
E(OC|H)=0.50*93.75+0.50*77.50= $85.625
E(OC|L)=0.85*64.50+0.15*58.00= $63.52525
E(OC)=P(H)E(OC|H)+P(L)E(OC|L)=0.80*85.625+0.20*63.525=$81.205
𝜎 (𝑂𝐶|𝐻) = 0.5 × (93.75 − 85.625) + 0.5 × (77.50 − 85.625) = 66.015625
𝜎 (𝑂𝐶|𝐿) = 0.85 × (64.50 − 63.52525) + 0.15 × (58.00 − 63.52525) = 5.3868750625
𝜎 (𝑂𝐶) = 0.4 × (93.75 − 81.205) + 0.4 × (77.50 − 81.205) + 0.17 × (64.50 − 81.205)
+ 0.03 × (58.00 − 81.205) = 132.035475

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 Quantitative Methods Module 4 Probability Concepts

5. You have a portfolio of two mutual funds, A and B, 75% invested in A, as shown in the table
below.
Fund A B

Expected return 𝐸(𝑅 ) = 20% 𝐸(𝑅 ) = 12%

Covariance Matrix 𝐴 𝐵

A 625 120

B 120 196
A. Calculate the expected return of the portfolio.
B. Calculate the correlation matrix for this problem.
C. Compute portfolio standard deviation of return.
Solution
A. the expected return of the portfolio, 𝜔 = 1 − 𝜔 = 0.25

𝐸 𝑅 = 𝜔 𝐸(𝑅 ) + 𝜔 𝐸(𝑅 ) = 0.75 × 20% + 0.25 × 12% = 18%

B. The standard deviation of 𝜎 (𝑅 ) = 625 ⇒ 𝜎(𝑅 ) = 25

The standard deviation of 𝜎 (𝑅 ) = 196 ⇒ 𝜎(𝑅 ) = 14
𝐶𝑜𝑣(𝑅 , 𝑅 ) 120
𝜌(𝑅 , 𝑅 ) = = = 0.342857
𝜎(𝑅 )𝜎(𝑅 ) 25 × 14

C. 𝜎 𝑅 = 𝜔 𝜎 (𝑅 ) + 𝜔 𝜎 (𝑅 ) + 2𝜔 𝜔 𝐶𝑜𝑣(𝑅 , 𝑅 )
= 0.75 × 625 + 0.25 × 196 + 2 × 0.75 × 0.25 × 120 = 408.8125

𝜎 𝑅 = √408.8125 = 20.22

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 Quantitative Methods Module 4 Probability Concepts

6. A report form Fitch data service states the following two facts:
 In 2002, the volume of defaulted US high-yield debt was $109.8 billion. The average market
size of the high-yield bond market during 2002 was $669.5 billion.
 The average recovery rate for defaulted US high-yield bonds in 2002 (defined as average price
one month after default) was $0.22 on the dollar.
Address the following three tasks:
A. On the basis of the first fact given above, calculate the default rate on US high-yield debt in
2002. Interpret this default rate as a probability.
B. State the probability computed in Part A as an odds against default.
C. The quantity 1 minus the recovery rate given in the second fact above is the expected loss
per $1 of principal value, given that default has occurred. Suppose you are told that an
institution held a diversified high-yield bond portfolio in 2002. Using the information in
both facts, what was the institution’s expected loss in 2002, per $1 of principal value of the
bond portfolio?
Solution:
.
A. The default rate was = 16.4%. This result can be interpreted as the probability that $1
.
invested in a market-value-weighted portfolio of U.S. high-yield bonds was subject to default in
2002.
( ) .
B. The odds against default denoted 𝐸 = = = 5.098, or 5.1 to 1
( ) .
C. First, note that 𝐸(𝑙𝑜𝑠𝑠|𝑑𝑒𝑓𝑎𝑢𝑙𝑡𝑠) = 1 − 0.22 = 0.78. According to the total probability rule
for expected value
𝐸(𝑙𝑜𝑠𝑠) = 𝐸(𝑙𝑜𝑠𝑠|𝑑𝑒𝑓𝑎𝑢𝑙𝑡𝑠)𝑃(𝑑𝑒𝑓𝑎𝑢𝑙𝑡𝑠) + 𝐸(𝑙𝑜𝑠𝑠|𝑛𝑜𝑡)𝑃(𝑛𝑜𝑡)
= 0.78 × 0.164 + 0 × (1 − 0.164) = 0.128
The institution’s expected loss was approximately 13 cents per dollar or principal value
invested.

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 Quantitative Methods Module 4 Probability Concepts

7. Suppose we have the expected daily returns (in terms of US dollars), standard deviations, and
correlations shown in the table below.
US Dollar Daily Returns in US German Italian
Percent Bonds Bonds Bonds
Expected Return 0.029 0.021 0.073
Standard Deviation 0.409 0.606 0.635
Correlation Matrix US German Italian
Bonds Bonds Bonds
US Bonds 1 0.09 0.10
German Bonds 1 0.70
Italian Bonds 1
A. Using the data given above, construct a covariance matrix for the daily returns on US,
German, and Italian bonds.
B. State the expected return and variance of return on a portfolio 70 percent invested in
US bonds, 20 percent in German bonds, and 10 percent in Italian bonds.
C. Calculate the standard deviation of return for the portfolio in Part B.
Solution:
A.
Covariance Matrix US German Italian
Bonds Bonds Bonds
US Bonds 0.167281 0.022307 0.025972
German Bonds 0.022307 0.367236 0.269367
Italian Bonds 0.025972 0.269367 0.403225
B. 𝐸(𝑅𝑝) = 0.70 × 0.029 + 0.20 × 0.021 + 0.10 × 0.073 = 0.0318
𝜎 (𝑅𝑝) = 0.70 × 0.167281 + 0.20 × 0.367236 + 0.10 × 0.403225
+ 2 × 0.70 × 0.20 × 0.022307 + 2 × 0.70 × 0.10 × 0.025972
+ 2 × 0.20 × 0.10 × 0.269367 = 0.121346
C. The standard deviation is √0.121346 = 0.348348

8. Calculate the covariance of the returns on Bedolf Corporation (RB) with the returns on Zedock
Corporation (RZ), using the following data.
𝑅 = 15% 𝑅 = 10% 𝑅 = 5%
𝑅 = 30% 0.25 0 0
𝑅 = 15% 0 0.50 0
𝑅 = 10% 0 0 0.25
Solution:
𝐸(𝑅 ) = 0.25 × 30% + 0.50 × 15% + 0.15 × 10% = 17.5%
𝐸(𝑅 ) = 0.25 × 15% + 0.50 × 10% + 0.15 × 5% = 10%
The covariance as follows
𝐶𝑜𝑣(𝑅 , 𝑅 ) = 𝑃1(30 − 17.5)(15 − 10) + 𝑃2(15 − 17.5)(10 − 10)
+ 𝑃3(10 − 17.5)(5 − 10) = 0.25 × 12.5 × 5 + 0.25 × 7.5 × 5 = 25

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 Quantitative Methods Module 4 Probability Concepts

9. You have developed a set of criteria for evaluating distressed credits. Companies that do not
receive a passing score are classed as likely to go bankrupt within 12 months. You gathered the
following information when validating the criteria:
 Forty percent of the companies to which the test is administered will go bankrupt within 12
months: P(nonsurvivor) = 0.40.
 Fifty-five percent of the companies to which the test is administered pass it: P(pass test)
=0.55.
 The probability that a company will pass the test given that it will subsequently survive 12
months, is 0.85: P(pass test | survivor) = 0.85.
A. What is P(pass test | nonsurvivor)?
B. Using Bayes’ formula, calculate the probability that a company is a survivor, given that it
passes the test; that is, calculate P(survivor | pass test).
C. What is the probability that a company is a nonsurvivor, given that it fails the test?
D. Is the test effective?
Solution:
A. We can set up the equation using the total probability rule:
𝑃(𝑝𝑎𝑠𝑠) = 𝑃(𝑝𝑎𝑠𝑠|𝑠)𝑃(𝑠) + 𝑃(𝑝𝑎𝑠𝑠|𝑛𝑠)𝑃(𝑛𝑠) = 0.55
We know that 𝑃(𝑠) = 1 − 𝑃(𝑛𝑠) = 0.60. Therefore,
𝑃(𝑝𝑎𝑠𝑠) − 𝑃(𝑝𝑎𝑠𝑠|𝑠)𝑃(𝑠) 0.55 − 0.85 × 0.60
𝑃(𝑝𝑎𝑠𝑠|𝑛𝑠) = = = 0.10
𝑃(𝑛𝑠) 0.40
𝑝𝑎𝑠𝑠 𝑠 ( ) . × .
B. 𝑃(𝑠|𝑝𝑎𝑠𝑠) = = = 0.927273
( ) .
𝑓𝑎𝑖𝑙 𝑛𝑠 ( ) .
C. According to Bayes’ formula, 𝑃(𝑛𝑠|𝑓𝑎𝑖𝑙) = = 𝑃(𝑓𝑎𝑖𝑙|𝑛𝑠)
( ) .
𝑃(𝑓𝑎𝑖𝑙) = 𝑃(𝑓𝑎𝑖𝑙|𝑠)𝑃(𝑠) + 𝑃(𝑓𝑎𝑖𝑙|𝑛𝑠)𝑃(𝑛𝑠) = 0.45
Given 𝑃(𝑝𝑎𝑠𝑠|𝑠) + 𝑃(𝑓𝑎𝑖𝑙|𝑠) = 1 ⇒ 𝑃(𝑓𝑎𝑖𝑙|𝑠) = 1 − 0.85 = 0.15
0.45 − 0.15 × 0.60
𝑃(𝑓𝑎𝑖𝑙|𝑛𝑠) = = 0.90
0.40
.
Thus, , 𝑃(𝑛𝑠|𝑓𝑎𝑖𝑙) = × 0.90 = 0.80, a company fails the test causes us to update the
.
probability that it is a nonsurvivor from 0.40 to 0.80.
D. A company passing the test greatly increases our confidence that it is a survivor, updating from
0.6 to 0.927273. A company failing the test doubles the probability that it is a nonsurvivor,
from 0.4 to 0.8. Therefore, the test appears to be useful.