Statistics for finance Chapter -2- Probability and Probability Distributions

CHAPTER TWO
PROBABILITY AND PROBABILITY DISTRIBUTIONS
Basic Concepts
Probability is a measure of the likelihood or chance that an uncertain event will occur. It is a

numerical measure of the chance of an outcome’s occurrence. It can assume a value between 0 and

1, inclusive. A probability near zero indicates that the outcome is very unlikely to occur, while a

probability near 1 indicates that the event is almost certain to happen.

Experiment
It is a process that leads to the occurrence of one and only one of several possible observations. Or

simply it can be defined as any process that generates well defined outcomes. For instance, tossing

a coin, rolling a die, football match, etc can be taken as trial or experiments.

Outcome
An outcome is a particular result of an experiment. For example, getting either head or tail is a

possible outcome of the experiment tossing a coin. Winning, loosing or tie/draw are the possible

outcomes of the football experiment, and getting 1, 2, 3, 4, 5, or 6 are possible outcomes of the

rolling a die experiment.

Events:
It is a collection of one or more outcomes of an experiment. An event is a specific collection of basic

outcomes, that is, a set containing one or more of the basic outcomes from the sample space. An

experiment identifies one or more outcomes of an experiment. For example, in the rolling a die

experiment, the simple collection of two or more of the six possible outcomes can be taken as an

event.

Sample Space
A sample space is a complete roster or listing of all possible outcomes of an experiment. The

sample space of an experiment is usually illustrated either by a list or some type of diagram – Venn

diagrams and tree diagrams.

Example: The sample space for tossing a coin is given by (Head, Tail)

The sample space for taking exam in any course consists of the following grades (A, B, C, D, F)

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Statistics for finance Chapter -2- Probability and Probability Distributions

Illustration of an experiment, outcomes, events, and sample space

Tossing/Flipping a coin twice………………. Experiment

Heads or Tails……………………………….. Outcomes/elementary events

HH, HT, TH, TT…………………………….. 4 Events

(HH, HT, TH, TT)…………………………… Sample Space

Examples:
Identify the experiment, outcomes, events and sample space for the following questions.

1. Sitting for an exam ………………………………. Experiment

Scoring A, B, C, D, F ……………………………... Possible outcomes

*A, B, C, D, F+ ……………………………………... Sample Space

Scoring B and above ……………………………… Event

C and above ……………………………… Event

D or below ……………………………….. Event

2.1.2 Classification of Events

1. Independent events
Two or more events are independent if the occurrence or nonoccurrence of one of the events does not affect

the occurrence or nonoccurrence of the others.

In terms of symbolic notation, if X and Y are independent: P(X/Y) = P(X) and P(Y/X) = P(Y), where P(X/Y)

denotes the probability of X occurring given that Y has occurred, and P(Y/X) denotes the probability of Y

occurring given that X has occurred.

Example: The outcomes associated with tossing a fair coin twice in succession are considered to be

independent events, because the outcome of the first toss has no effect on the respective

probabilities of a head or tail occurring on the second toss.

2. Dependent Events
Two or more events are dependent if the occurrence or nonoccurrence of one of the events affects the

occurrence or nonoccurrence of the others.

In terms of symbolic notation, if X and Y are dependent: P(X/Y) ≠ P(X) and P(Y/X) ≠ P(Y), where P(X/Y)

denotes the probability of X occurring given that Y has occurred, and P(Y/X) denotes the probability of Y

occurring given that X has occurred.

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Statistics for finance Chapter -2- Probability and Probability Distributions

Example: Rolling a die, yields dependent events; the occurrence of one of the six events is

dependent on the occurrence or nonoccurrence of other events.

3. Mutually exclusive events/ Disjoint Events

Two or more events are mutually exclusive, or disjoint, if they cannot occur together. That is, the

occurrence of one event automatically precludes the occurrence of the other event (or events). In terms of set

notation, if events X and Y are mutually exclusive, P(X n Y) = 0, or the probability of X intersecting Y is

zero.

Example: In the toss of a single coin, the events of heads and tails are mutually exclusive. The

person tossing the coin gets either a head or a tail but never both. Gender is also another example.

NB: Relating the above three types of events, mutually exclusive events must be dependent, but

dependent events are not expected to be mutually exclusive. Events that are independent cannot

be mutually exclusive.

4. Collectively exhaustive events

At least one of the events must occur when an experiment is conducted.

Example: For a die tossing experiment, every outcome will be either Even or Odd

5. Complementary events
A single event defined in terms of another events nonoccurrence.

P (Ā) = 1 - P (A)

Example: If in rolling one die, event A is getting an even number, the complement of A is getting
an odd number.

2.1.3 Principles of counting

Counting the number of ways in which events may occur in an experiment plays a major role in

probability. Some rules for counting are presented in this section. The first of these is called the

fundamental principle of counting.

I: FUNDAMENTAL PRINCIPLE OF COUNTING (THE MULTIPLICATION FORMULA)

The fundamental principle of counting specifies if there are m ways of doing one thing and n ways of doing

another thing, there are m x n ways of doing both.

In terms of a formula: Total number of arrangements (m)(n)

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Statistics for finance Chapter -2- Probability and Probability Distributions

Example: An automobile dealer wants to advertise that for Br. 100,000 you can buy a Model A, B,

or C Car with your choice of either, a two-door, or a four-doors. How many different arrangements

of models and door numbers can the dealer offer?

Solution: Total possible arrangements = (m) (n) = (3) (2) = 6

A and 2 Doors A and 4 Doors

B and 2 Doors B and 4 Doors
C and 2 Doors C and 4 Doors
Example 2: Tossing a coin two times will bring as 2 x 2 = 4 (HH, HT, TH, TT)

Permutations

It allows one to compute the number of experimental outcomes when n objects are to be selected from a set of

N objects where the order of selection is important.

n!
The number of permutations in n distinct items arranged x at a time is: nPx 
(n  x)!

Where: n! Read as n factorial, is n! = n (n -1) (n-2)……. (1).

n is the total number of objects.

x is the number of objects selected.

By definition, 0! = 1.

Example: Ten members of a social organization have volunteered to serve as officers for the

following year, to take positions as President, Treasurer, and Secretary. The number of different

arrangements of three officers elected from the 10 club members is

10! 10!
P 
10 3   720
(10  3)! 7!
Combinations
In the case of permutations, the order in which the objects are arranged is important. In the case of

combinations, we are concerned with the number of different groupings of objects that can occur without

regard to their order. Therefore, an interest in combinations always concerns the number of different

subgroups that can be taken from n objects. The number of combinations of n objects taken r at a time is

n!
nCx 
(n  x)!x!

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Statistics for finance Chapter -2- Probability and Probability Distributions

EXAMPLE: Suppose that three members from a small social organization containing a total of 10

members are to be chosen to form a committee. The number of different groups of three people

which can be chosen, without regard to the different orders in which each group might be chosen, is

10! 720
C3    120
(10  3)! 3! 6
10

2.1.4 Methods of assigning probabilities

The three general methods of assigning probabilities are

 The classical method – the equally likely approach

 The relative frequency method

 The subjective method

1. Classical method

Classical probability Probability based on the assumption that each of the outcomes is equally

likely. According to this concept of probability, if there are n possible outcomes, the probability of

a particular outcome is 1/n. Thus, on the toss of a coin, the probability of a head is 1/n = 1/2.

ne
P( E ) 
,
N
where : N  total possible number of outcomes of an exp eriment
ne  the number of outcomes in which the event occurs out of N outcomes

Example: Consider an experiment of rolling a six-sided die. What is the probability of the event

‚an even number of spots appear face up‛

3
Probability of an even number =  0.50
6
As ne can never be greater than N (no more than N outcomes in the population could possibly

possess attribute e), the highest value of any probability is 1. If the probability of an outcome

occurring is 1, the event is certain to occur. The smallest possible probability is zero. If none of the

outcomes of N possibilities possesses the desired characteristic, e, the probability is 0/N = 0, and

the event is certain not to occur.

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2. Relative Frequency of Occurrence Method

Relative frequency or Empirical probability is the probability of an event happening is the fraction

of the time similar events happened in the past.

The probability that event A will occur by the relative frequency approach is

P (A) = No of times an event has occurred in the past

total number of observations

Example; The statistician collects data for 10,000 adults in the appropriate age categories and finds

that 100 people have experienced the particular dental problem during the past year. The

probability of occurrence is thus

n(A) 100
P(A)    0.01  1 %
n 10,000

3. Subjective method

If there is little or no experience or information on which to base a probability, it

may be arrived at subjectively. By the subjective approach, the probability of an event is the degree

of belief by an individual that the event will occur, based on all evidence available to the

individual. Because the probability value is a personal judgment, the subjective approach has also

been called the personalistic approach.

Subjective probability comes from the person’s intuition or reasoning. Although not a scientific

approach to probability, the subjective method often is based on the accumulation of knowledge,

understanding, and experience stored and processed in the human mind. At times it is merely a

guess. At other times, subjective probability can potentially yield accurate probabilities.

Example: Estimating the probability that you will score Grade ‘A’ in this course.

2.1.5 Types of probabilities

There are four types of probabilities. These are:
 Simple probability
 Joint probability
 Marginal probability
 Conditional probability

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Statistics for finance Chapter -2- Probability and Probability Distributions

A. Simple Probability

Simple probabilities are relatively straight forward which are obtained using the formula

n (A)
P (A  = Relative frequency method.
n

B. Joint probability

A 2nd type of probability is the intersection of two events or joint probability. A joint probability
shows the probability that an observation will possess two (or more) characteristics
simultaneously. That is, it measures the probability of two or more events occurring together. The
joint probability of events E1 and E2 occurring is denoted P (E1 n E2). Sometimes P (E1 n E2) is
read as the probability of E1 and E2. To qualify for the intersection, both events must occur.

C. Marginal probability

Marginal probability is denoted by P (E), where E is some event. A marginal probability is usually

computed by dividing some subtotal by the whole. An example of marginal probability is the

probability of a person wearing glasses, this probability is computed by dividing the number of

people wearing glasses by the total number of people.

Example:
ABC Company manufactures window air conditioners in both a deluxe model (D) and a standard

model (S). An auditor engaged in a compliance audit of the firm is validating the sales account for

the month April. She has collected 200 invoices for the month, some of which were sent to

wholesalers (W) and the remainders to retailers (R). Of the 140 retail invoices, 28 are for the

standard model. Only 24 of the wholesale invoices are for the standard model. If the auditor selects

one invoice at random, find the following probabilities.

a) The invoice selected is for the deluxe model.

b) The invoice selected is for the standard model.
c) The invoice selected is a wholesale invoice.
d) The invoice selected is a retail invoice.
e) The invoice selected is a Wholesale invoice and Deluxe model
f) The invoice selected is a retail invoice and Standard model

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Statistics for finance Chapter -2- Probability and Probability Distributions

Solution

Wholesale, W Retail, R Total

Deluxe, D 36 0.18* 112 0.56* 148 0.74**
Standard, S 24 0.12* 28 0.14* 52 0.26**
Total 60 0.30** 140 0.70** 200
a) P (D) = 148/200 = 0.74 d) P (R) = 140/200 = 0.70

b) P (S) = 52/200 = 0.26 e) P (WnD) =36/200 = 0.18

c) P (W) = 60/200 = 0.30 f) P (RnS) = 28/200 =0.14

P (D) = P (WnD) + P (RnD) P (W) = P (WnD) + P (WnS)

= 0.18 + 056 = 0.18 + 0.12

= 0.74 = 0.30

* Joint Probabilities
** Marginal Probabilities
Union probability
Another type of probability is the union of two events. Union probability is denoted by P (E 1 U E2),
where E1 and E2 are two events. P (E1 U E2) is the probability that E1 will occur or that E2 will occur
or that both E1 and E2 will occur.

D. Conditional probability

The fourth type is conditional probability. Conditional probability is denoted by P (E 1 / E2). This
expression is read as: the probability that E1 will occur given that E2 is known to have occurred. The
conditional probability of an event E1, given event E2 is the ratio of the joint probability of two
events to the marginal probability of E2.

 X  P X and Y   X Y   Y  PY and X   Y  X 

For PY  0, P    P  For P X  0, P    P 
Y  PY   Y  X P X   X 

Example:
Blue Nile University recently conducted a survey of undergraduate students in order to gather
information about the usage of the library. The population for this study included all 4000
undergraduate students enrolled in the university. The library officers are interested in increasing
usage, particularly among females (F) and seniors (S) at the university. Of the 4000 students, 800
students are seniors, 1800 students are females and 450 of the 1800 females are seniors.

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Statistics for finance Chapter -2- Probability and Probability Distributions

Required:
A) What is the probability that a student selected at random is a senior given that the selected
student is female?
B) What is the probability that a student selected at random is female given that the selected
student is senior?
Solution:

Senior, S Non-Senior, N Total

Female, F 450 0.1125 1,350 0.3375 1,800 0.45
Male, M 350 0.0875 1,850 0.4625 2,200 .055
Total 800 0.20 3,200 0.80 4,000
1. P (S/F) = P (SnF)/ P (F) = 0.1125/.45 = 0.25

2. P (F/S) = P (SnF)/ P (S) = 0.1125/.20 = 0.5625

Using conditional probability, joint probability of X and Y is calculated as:

P X  Y   P X
Y
 
* P Y   P Y 
X
*P (X )
Example 2: Promotion status of 1,200 officers over the past two years is given below
Men (M) Women (W) Total
Promoted (P) 288 36 324
Not Promoted (N) 672 204 876
Total 960 240 1,200
I) Determine Joint probabilities of:

A. The probability that a randomly selected officer is a man and is promoted P(MnP) = Ans 0.24

B. probability that a randomly selected officer is a man and is not promoted P(MnN) = Ans 0.56

C. P(WnP) = Ans 0.03

D. P(WnN) = Ans 0.17

II) Determine Marginal Probabilities of

P(M), P(W), P(P), P(N) = Ans 0.80, 0.20, 0.27 and 0.73 respectively

III) Determine conditional Probabilities of

A) P(P/M) = Ans 0.30

B) P(P/W)= Ans 0.15

Thus, the conditional probability P(P/M) can be computed as the ratio of the joint probability

P(PnM) to the marginal probability P(M).

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Statistics for finance Chapter -2- Probability and Probability Distributions

2.1.6 The Bayes’ Rule

An extension to the Conditional Law of Probabilities is Bayes’ rule, which was developed by and
named for an English Clergy man Thomas Bayes (1702-1761). Bayes’ rule is a formula that extends
the use of the law of conditional probabilities to allow revision of original probabilities when new
information is needed.

In its simplest algebraic form, Bayes’ theorem is concerned with determining the conditional probability
of event A given that event B has occurred.

The two core ideas in Bayes’ Rule are the prior probability and posterior/revised probability.

Prior probability – is initial probability which is determined before new information is obtained. It
is the starting point for Bayes theorem.

Posterior probability - a probability that has been revised based on new information, because it
represents a probability calculated after new information is obtained.

Prior New Application of Bayes’ Posterior

Probability Information Theorem Probability

The Bayes’ theorem simplifies the computation of P(X/Y) when P (XnY) and P(Y) are not given
directly.
Conditional Probability Rule (The Bayes’ Theorem for One Event)
 
P Y   P X 
P X  Y
 
 X 
P (Y )
.

Bayes’ Theorem for Two Events

P 
 Y X   P X i 
 i 
P 
Xi
 Y 
.
 
P   
 Y X   P  X 1   P Y X   P  X 2 
 1   2 

Bayes’ Theorem for Three Events

P Y   P X 

 Xi 
i
P 
Xi
Y 
.
  
P Y   P X 


 P Y 
  P  X 2   P X   P  X 3 
Y
 X 1  X2  3 
1

The general Bayes’ rule is presented below.

P Y   P X 
 P ( X i ) * P Y 
 Xi   X i 
P i 
i
X
  n .
 Y  P Y   P  X   P Y   P X   .......  P Y   P X   
 X   X   X   P X I * P Y 
 1  2  n
1 2 n
i 1  Xi 

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Example:

1. A company has three machines A, B and C which all produce the same two parts, X and Y. of
all the parts produced, machine A produces 60%, machine B produces 30%, and machine C
produces the rest. 40% of the parts made by machine A are part X, 50% of the parts made by
machine B are part X, and 70% of the parts made by machine C are part X. A part produced by
this company is randomly sampled and is determined to be an X part. With the knowledge that
it is an X part, find the probabilities that the part came from machine A, B or C.
Solution:
P (A) = 0.6 P (X/A) = 0.4 P (A/X) =?
P (B) = 0.3 P (X/B) = 0.5 P (B/X) =?
P (C) = 0.1 P (X/C) = 0.7 P (C/X) =?
Method 1: USING THE FORMULA

 
 X  X    X  PA X     PPAX X 
A
PX
PA
P P A P P B P P C
A B C
(0.6 * 0.4) 0.24
   0.52
0.6 * 0.4  0.3 * 0.5  0.1 * 0.7  0.46
   P B 
 X  X    X    X     PPBX X 
B
PX
PB
P P A P P B P P C
A B C
(0.3 * 0.5) 0.15
   0.33
0.6 * 0.4  0.3 * 0.5  0.1 * 0.7  0.46

PC  X  PX  P A  PX C  PPCB  PX  PC   PCPX X 

PX

A B C
(0.1 * 0.7) 0.07
   0.15
0.6 * 0.4  0.3 * 0.5  0.1 * 0.7  0.46
NB: P (A/X) + P (B/X) + P (C/X) = 1.00

P (A/X) + P (A’/X) = 1.00

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Method 2: USING TABLE

Machine
Product A (0.60) B(0.30) C (0.10) Total
X 0.24 0.15 0.07 0.46
Y 0.36 0.15 0.03 0.54
Total 0.6 0.3 0.1 1.00
P (A/X) = 0.24/0.46 = 0.52
P (B/X) = 0.15/0.46 = 0.33
P (C/X) = 0.07/0.46 = 0.15
1.00 The sum of joint and conditional prob. should be equal to one.

Method 3 – USING BAYESIAN TABLE

Event, Prior probability, Conditional Joint prob., Posterior/Revised

Ei P(Ei) Prob., P(X/Ei) P(EinX) prob., P(Ei/X)
A 0.60 0.40 0.24 0.24/0.46 = 0.52
B 0.30 0.50 0.15 0.15/0.46 = 0.33
C 0.10 0.70 0.07 0.07/0.46 = 0.15
P(X) = 0.46 1.00

Method 4 – USING TREE DIAGRAM

Probability of outcome

X 40 % = X/A : P (AnX) = P (A) x P(X/A) = 0.24: P (A/X) = 0.24/0.46 = 0.52

A: 0.60 Y 60 % = Y/A: P (AnY) = P (A) x P(Y/A) = 0.36: P (A/Y) = 0.36/0.54 = 0.667

X 50 % = X/B: P (BnX) = 0.15: P (B/X) = P(BnX)/P(X) = 0.15/0.46 = 0.33

B: 0.30 Y 50 % = Y/B: P (BnY) = 0.15: P (B/Y) = P(BnY)/P(Y) = 0.15/0.54 = 0.278

X 70 % = X/C: P (CnX) = 0.07: P(C/X) = P(CnX)/P(X) = 0.07/0.46 = 0.15

C: 0.10 Y 30 % = Y/C: P (CnY) = 0.03: P (C/Y) = P(CnY)/P(Y) = 0.03/0.54 = 0.055

Then, P(X) = 0.24 + 0.15 + 0.07 = 0.46 and

P(Y) = 0.36 + 0.15 + 0.03 = 0.54
So, P (A/X) = P(AnX)/P(X) = 0.24/0.46 = 0.52 And P (A/Y) = 0.36/0.54 = 0.667
P (B/X) = P(BnX)/P(X) = 0.15/0.46 = 0.33 P (B/Y) = 0.15/0.54 = 0.278
P(C/X) = P(CnX)/P(X) = 0.07/0.46 = 0.15 P (C/Y) = 0.03/0.54 = 0.055
Total = 1.00 Total = 1.00

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EXERCISES:

Bruk, Alemayehu and yohannes fill orders in a fast food restaurant. Bruk fills incorrectly 20% of
the orders he takes. Alemayehu fills incorrectly 12% of the orders he takes, and Yohannes fills
incorrectly 5% of the orders he takes. Bruk fills 30% of all orders, Alemayehu fills 45% of all orders,
and Yohannes fills 25% of all orders. An order has just been filled.

a) What is the probability that Alemayehu filled the order? Ans. 0.45

b) If the order was filled by Yohannes, what is the probability that it would was filled correctly?
Ans 0.95

c) Who filled the order is unknown, but the order was filled correctly. What are the revised
probabilities that Bruk, Alemayehu or Yohannes filled the order?

Ans. 0.2748, 0.4533 and 0.2719

d) Who filled the order is unknown, but the order was filled incorrectly. What are the revised
probabilities that Bruk, Alemayehu or Yohannes filled the order?

Ans 0.4743, 0.4269 and 0.0988

2. A major league baseball team has four starting pitchers: Girma, Robel, Solomon, and Asrat.
Each pitcher starts every fourth game. The team wins 60% of all games that Girma starts, 45% of all
games that Robel starts, 35% of all games that Solomon starts, 40% of all games that Asrat starts.
An avid fan has just returned from a three week vacation in the wilderness and found out that the
team played yesterday.

a. What is the probability that Girma started the game? Ans. 0.25

b. What is the probability that Solomon started the game? Ans. 0.25

If the team won yesterday, revise the probability of each pitcher starting the game?

Ans. 0.333, 0.250, 0.194 and 0.222

2.1.7 Laws of Probability

Additive Law

The rules of addition are used when we wish to determine the probability of one event or another
(or both) occurring in a single observation. Symbolically, we can represent the probability of event
A or event B occurring by P(A or B). In the language of set theory this is called the union of A and
B and the probability is designated by P(A U B) (read ‚probability of A union B‛).

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The general law of addition is used to find the probability of the union of two events, P (E 1 U E2).
The general Law of Addition is presented as follows:

PE1  E2   PE1   PE2   PE1  E2 

Where E1 , E2 are events and E1  E2  is the int er sec tion of E1 and E2 .

Special Rule of Addition

If two events are mutually exclusive, the probability of the union of the two events is the
probability of the first event plus the probability of the second event. Because mutually exclusive
events do not intersect, nothing has to be subtracted out. The formula is shown below.

If E1 and E2 are mutually exclusive events,

p E1  E2  PE1  PE2 .

Example:
During a given week the probability that a particular common stock issue will increase (I) in price,
remain unchanged (U), or decline (D) in price is estimated to be 0.30, 0.20, and 0.50, respectively.
(a) What is the probability that the stock issue will increase in price or remain unchanged? Ans.0.50
(b) What is the probability that the price of the issue will change during the week? Ans. 0.80

Example:
2. A husband and a wife, each 20 years old, are debating whether to setup a retirement program for
themselves. Benefits are paid to the man or woman at the age of 70. If both have died before
reaching age 70, no benefits are paid. Assume that the probability that a man aged 20 lives up to
age 70 is approximately 0.6 and women aged 20 lives upto age 70 is approximately 0.7. If the
husband and wife join the program, what is the probability that either the man or the woman will
collect benefits? Assume that the chances of the man or woman dying are independent of each
other.
Solution:
Let M= man lives up to age 70, W = woman lives up to age 70.
P (M) = 0.60 P (W) = 0.70
P (WUM) = P (W) + P (M) – P (WnM)
= 0.70 + 0.60 – P (WnM). Since the two events are independent, the joint probability that
both the man and the woman lives up to age 70 is equal to the product of the
individual marginal probabilities. P(WnM) = P (M) * P (W)
= 0.70 + 0.60 – (0.60 * 0.70)
= 0.70 + 0.60 – 0.42
= 0.88

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Statistics for finance Chapter -2- Probability and Probability Distributions

EXERCISE:
According to a recent study conducted by businessmen, 76% of all shareholders have some college
education. Suppose that 37% of all adults have some college education and that 22% of all adults
are shareholders. For a randomly selected adult:
a) What is the probability that the person did not own shares of stock?
Ans. 0.78
b) What is the probability that the person owns shares of stock or had some college
education?
Ans. 0.4228
c) What is the probability that the person has neither some college education nor owns
shares of stock?
Ans. P( A  B ) = 1 – P(AUB) = 0.5772
d) What is the probability that the person does not own shares of stock or has no college
education?
Ans. P( A  B ) = 1 – P(AnB) = 0.8328
e) What is the probability that the person owns only shares of stock or had some college
education but not both?
Ans. P(AUB) – P(AnB) = 0.4228 – 0.1672 = 0.2556

Multiplicative law
The rules of multiplication are concerned with determining the probability of the joint occurrence
of A and B. This concerns the intersection of A and B: P(A n B). The probability of the intersection
of two events (E1  E2) is called the joint probability. The general law of multiplication is used to
find the probability of the intersection of two events or joint probability. The general law of
multiplication is stated as follows:

PE1  E 2   PE1   P E 2   PE   P E1

 
.

 E1  E 2 
2

Special Rule of Multiplication

If events E1 and E2 are independent, a special law of multiplication can be used to find the
intersection of E1 and E2.

If E1 and E 2 are independen t events,

p E1  E2   PE1  PE2 .

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Statistics for finance Chapter -2- Probability and Probability Distributions

Example:

1. Test the matrix for the 200 executive responses to determine whether industry type is
independent of geographic location.

Geographic Location
Industry type North East, D South East, E Mid-West, F West, G Total
Finance, A 24 10 8 14 56
Manufacturing, B 30 6 22 12 70
Communication, C 28 18 12 16 74
Total 82 34 42 42 200
Solution:
Select one industry type and one geographic location (Say A – Finance and G – West). Does P
(A/G) = P (A)?
P (A/G) = P (AnG)/P (G) = 0.07/0.21 = 0.33
P (A) = 56/200 = 0.28
Since P (A/G) ≠P (A), industry type and geographic location are not independent.

Exercise:
1. Considering the above Example, if a respondent is randomly selected from these data:
a) What is the probability that this executive is from the mid-west?
Ans. 0.21
b) What is the probability that a respondent is from the communication industry or from north
east?
Ans. 0.64
c) What is the probability that a respondent is from the south east or from finance industry?
Ans. 0.40
d) What is the probability that this executive is from the south east or the west?
Ans. 0.38
2. The results of a survey asking, ‚Do you have a calculator and/or a computer in your home?‛
are as follows:
Calculator
Yes No
Computer Yes 46 3
No 11 15
Is the variable calculator independent of the variable computer? Why or why not? NO

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Laws of conditional probability

Conditional probabilities are based on knowledge of one of the variables. If E1 and E2 are two
events, the conditional probability of E1 occurring given that E2 is known or has occurred is

expressed as P E1  . The formula for finding a conditional probability is given below.
 E2 

  P E2 E   PE1 

 
 E  P E E 1
P 1 E   1 2

 2  
P E2  PE2 

Special Law of Conditional Probability (Independent events)

If E1 and E2 are independent events, the conditional probability and marginal probability of the
two events are equal. That is, P (E1/E2) = P (E1), and P (E2/E1) = P (E2). Otherwise, they are dependent

Example: Of 500 employees, 200 participate in a company’s profit-sharing plan (P), 400 have major-
medical insurance coverage (M), and 200 employees participate in both programs.

(a) Determine the probability that an employee will be a participant in the profit-sharing plan (P)
given that the employee has major-medical insurance coverage (M) Ans. 0.50,

(b) Determine if the two events are independent or dependent by reference to the conditional
probability value. Ans. Dependent

2.2. Probability Distributions

Basic concepts
A variable is a characteristic that can have different values or outcomes. A variable whose
numerical value is determined by an outcome of a random experiment, or, a variable whose
outcomes occur by chance is called a random variable. Depending on the values a random variable
can take, there are two types of random variables: Discrete random variables and Continuous
random variables.

Discrete Random Variables: these are random variables which can only assume non-negative
whole numbers such as 0, 1, 2, 3………, n for example, the number of students in a class, the
number of telephone calls received in a given hour, the number of people living in certain area and
the like can take only non-negative whole numbers. As a result, there are gaps or voids in them
along an interval.

Continuous Random Variables: these are random variables which can take any value, that is, it
can take any value over an interval. Thus, continuous random variables have no gaps or
unassumed values. These are random variables that can assume an uncountably infinite number of

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Statistics for finance Chapter -2- Probability and Probability Distributions

values. For example, the height of an individual, the distance traveled by a truck driver in a given
hour, the temperature of a room on a given day, and the like produces a continuous random
variable.

NB. Continuous random variables typically record the value of a measurement such as time,
weight, volume, or length. While discrete random variable counts the number of times a particular
attribute is observed.

Probability Distribution: is a listing of the possible values that a random variable can assume
along with their probabilities. It is any representation of the values of a random variable and the
associated probabilities. Depending on the types of random variables with which we deal with, we
do have two types of Probability Distributions.: Discrete Probability Distributions and Continuous
Probability Distributions.
2.2.1 Discrete Probability Distribution is any representation of the values of discrete random
variable and the associated probabilities. The most commonly used discrete probability
distributions include the Binomial, hypergeometric and the Poisson distributions.

2.2.1.1 The Binomial Distribution

The binomial distribution is a discrete probability distribution that is applicable as a model for decision

making situations in which a sampling process can be assumed to conform to a Bernoulli process. A

Bernoulli trial is that experiment that has only two outcomes. Those two outcomes are mutually exclusive,

i.e. cannot happen at the same time, and they are labeled as S, for a success, or F, for a failure, with constant

probability of success as p, i.e. P(S) = p, and that of a failure as q, or P (F) = q, with p + q = 1.

Perhaps the most widely known of all discrete probability distribution is the binomial distribution.
The binomial distribution has the following underlying assumptions:

The experiment involves n identical trials or sampling is done with replacement.

Each trial has only two possible mutually exclusive outcomes.[Bi = Two]

Each trial is independent of the previous trials

The probability of success (P) and failure (q = 1-P) remain constant for each trial.

In n trials, only X successes are possible where X is a whole number between 0 and n *0≤ X≤ n+

It is applicable if the sample size n is less than 5% of the population size N or if samples are
taken with replacement.

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To compute the probability of occurrences in binomial distribution we do have the Binomial

Formula. It is stated as follows:

The probabilit y of exactly X success in n trials

P X    p x q  Where : Px   probabilit y of X success in n trial

n! nx

x!n  x !
n  number of trials sample size
x  number of successes desired
P  probabilti y of success
q 1  p  probabilti y of failure

Example
1. The probability that a randomly chosen sales prospect will make a purchase is 0.20. If a sales
representative calls on six prospects, the probability that exactly four sales will be made is
determined as follows:

P(x=4) = nCx * PX * qn-x

For the above Example, the probability that the salesperson will make four or more sales is
determined as follow: (Cumulative Probabilities)

Because use of the binomial formula involves considerable arithmetic when the sample is relatively
large, tables of binomial probabilities are often used.

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2. If we toss a coin three times, what is the probability of getting exactly two heads?
Solution:
In a single toss, the probability of getting a head or a tail is 0.5. In tossing the coin three times, the
following are the possible outcomes. HHH, HHT, HTH, HTT, THH, THT, TTH, TTH, TTT
The probability of getting exactly two heads is, therefore, computed as
= (0.5*0.5*0.5) + (0.5*0.5*0.5) + (0.5*0.5*0.5)
= 0.125 * 3 = 0.375
Using the Binomial formula
P = 0.50 q = 1 – 0.50 = 0.50 n=3 x=2
P(x=2) = ncx * P * q
X 1-x

= 3c2 *0.52*0.51
=
3(0.25*0.5) = 3(0.125) = 0.375
There are three ways of choosing exactly two heads from a total of three trials.
3. A researcher wants to test the claim that 10% of all people are left-handed by randomly
selecting forty students at a university. What is the probability of getting six left handed
students among forty?
Solution:
P = 0.10 q = 1 – 0.10 = 0.90 n = 40 x=6
P(x=6) = 0.1068
If 10% of the population is left-handed, about 10.68% of the time the researcher would get six
who are left handed in a sample of forty.
4. Based on past data, approximately 30% of the oil wells drilled in areas having a certain
favorable geological formation have struck oil. A company has identified 5 locations that
possess this information. Assuming that the chance of striking oil on any location is
independent of any others, calculate the probability that exactly 2 of the 5 wells strike oil.
Solution:
P = 0.30 q = 1 – 0.30 = 0.70 n=5 x=2
P(x = 2) = 0.3087
If the probability of getting oil in areas having certain favorable geological formation is 0.3, 31%
of the time we can get 2 drills which have oil in a sample of 5 drills.

Using Individual Binomial Probability Table

Tables have been developed that give the probability of x successes in n trials for a binomial

experiment. These tables are generally easy to use and quicker than the Binomial Formula,

especially when the number of trials involved or sample size, n is large. In order to use this table, it

is necessary to specify the values of n, p and x.

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Some Binomial tables only show values up to 0.5. Thus, it would appear these tables are cannot be

used when the probability of success exceeds p= 0.5. However, such tables can be used by noting

that the probability of n-x failures is also the probability of x successes. That is, finding the

probability of x successes is equal to finding the probability of n-x failures. ncx and ncn-x are always

equal.

Example:

Suppose that 70% of all cola drinkers select non diet colas. If 10 cola drinkers are randomly
selected, what is the probability that 4 of them will be diet cola drinkers?

Solution:

Finding the probability of 4 diet cola drinkers is equivalent to finding the probability of 6 non diet
cola drinkers.

n = 10 p= 0.7 q= 0.3 x= 6

P(x=6) = 0.2001

Finding the Probabilities that the Number of Successes X Lie In a Given Interval (Cumulative

Probabilities)

Often there is an interest in the cumulative probability of ‚X or more‛ successes or ‚X or fewer‛

successes occurring in n trials. In such a case, the probability of each outcome included within the

designated interval must be determined, and then these probabilities are summed.

Cumulative probabilities are the sum of individual probability values. The Binomial formula

P( X )    X * P X * q n  X gives us the probability of exactly x successes in n trials/sample size n. to

find cumulative probabilities such as P(x≥3), P(x≤2), P(x›10) or P(X1≤X≤X2) = P(10≤X≤20), we

should add the respective exact/individual probability values.

Example 1:

Because of economic conditions, a firm reports that 30 percent of its accounts receivable from other
business firms are overdue. If an accountant takes a random sample of five such accounts,
determine the probability of each of the following events by use of the formula for binomial
probabilities: (a) none of the accounts is overdue, (b) exactly two accounts are overdue, (c) most of
the accounts are overdue, (d) exactly 20 percent of the accounts are overdue.

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Solution:

Example 2:

1. A project manager has determined that a subcontractor fails to deliver standard orders 20% of
the time. The project manager has six orders that his subcontractor has agreed to deliver. What is
the probability that

a) The subcontractor will deliver all of the orders? 0.2621

b) The subcontractor will deliver at least four of the orders? 0.9011

c) The subcontractor will deliver exactly five orders? 0.3932

d) The subcontractor will fail to deliver at most two of the orders? 0.9011

e) What do you conclude from your answers in parts (b) and (d)? Finding the probability of x
successes is equal to finding the probability of n-x failures.

Using Cumulative Binomial Probability Table

If cumulative probability table is given, one must subtract from the cumulative probability of X the
cumulative probability of X-1 to get the exact/individual probability value of X. That is,

P (X=a) = P (X≤a) – P (X≤a-1)

E.g. P (X=3) = P (X≤3) – P (X≤2)

P (X≥a) = 1- P (X≤a-1)

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E.g. P (X≥3) = 1- P (X≤2)

P (X>a) = 1- P (X≤a)

E.g. P (X>3) = 1- P (X≤3)

P (a1≤X≤a2) = P (X≤a2) - P (X≤a1)

E.g. P (10≤X≤20) = P (X≤20) - P (X≤10)

P (a1<X<a2) = P (X≤a2-1) - P (X≤a1-1)

E.g. P (10<X<20) = P (X≤19) - P (X≤9)

Computation of Mean (µ) and Variance (δ2) of a Discrete Random Variable

Expected value or mean of a random variable is a measure of the central location for the random
variable. It is a long run average of occurrences. We must realize that on any one trail using a
discrete random variable, there will be one outcome. However, if the process is repeated long
enough, there is some likelihood that the results will begin to approach some expected value or
mean. This mean or expected value is computed as

µ = E(X) = ∑*X*P(X) =
 Xifi
 fi
Where: E(X) = long run average
X = an outcome
P(X) = the probability of that outcome
Variance of a discrete random variable, which measures how far the variables are dispersed
around the mean, is calculated as
δ2 = ∑(X-µ) 2*P(X)
Where: X = an outcome
µ = mean
P(X) = the probability of that outcome
And the standard deviation of a discrete random variable is calculated simply by taking the square
root of the variance. δ = √∑(X-µ) 2*P(X).
Example:
1. Compute the mean and variance of the following discrete probability distribution.
x P(x)
2 .50
8 .30
10 .20
Ans: Mean = 5.4 and Variance = 12.04

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Mean, Variance and Standard Deviation of a Binomial Distribution

Binomial probability distribution is a discrete probability distribution. And hence, the method
used to compute mean and standard deviation for a discrete random variable is similar with the
method used to compute  and  for a binomial distribution.

A binomial distribution has an expected value or long run average, which is denoted by µ. The
value of µ is determined by n*p. the long run average or expected value means that if n items are
sampled over and over again for a long period of time and if P is the probability of getting a
success on one trial, the average number of success per sample is expected to be n*p.

Like for other discrete variables, the variance of the binomial distribution is calculated as δ 2 = ∑(X-
µ) 2*P(X) which is also equal to npq. The standard deviation of the binomial distribution is also
calculated by taking the square root of the variance. δ = √∑(X-µ) 2*P(X) = √npq.
Example:
If the probability that a randomly chosen sales prospect will make a purchase is 0.20, the
probability that a salesperson who calls on 15 prospects will make fewer than three sales is:

Thus, the expected number of sales (as a long-run average), the variance, and the standard
deviation associated with making calls on 15 prospects are:

2.2.1. 2 Hyper-geometric Distribution

There is a distinct difference in sampling for the binomial and hyper geometric distributions. In the
binomial case, the sampling is done with replacement in order to keep the probability of a success
as a constant throughout the experiment. On the other hand the sampling for the hyper geometric
is done without replacement, and thus the repeated trials are not independent. This kind of
sampling will affect the probability of a success.
The binomial distribution assumes that the probability of success (p) and failure (q = 1 - p) are the
same throughout the experiment. This is because
– events are independent
– sampling is done with replacement
– n < 0.05N
– population is infinite

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However, in cases where sampling is without replacement and the sample size exceeds 5% of the
population size, it is necessary to use the hyper-geometric distribution to determine correct
probability.
The hyper-geometric distribution has the following characteristics.
- It is a discrete distribution.
- Each outcome consists of either a success or a failure.
- Sampling is done without replacement.
- The population size is finite and known.
- It is described by three parameters: N, r and n. because of the multitude of possible
combinations of these three parameters, creating tables for the hyper geometric distribution
is practically impossible.
- The number of successes in the population, r, is known.
- The sample size is ≥ 5% of the population.
Under the above conditions, we can use the hyper geometric distribution for determining the
correct probability, with the following formula:

 nNxr *  rx
P( X ) 
 nN
Where: P(X) = the probability N = population size
n = sample size
r = number of successes in the population
x = number of successes in the sample for which a probability is desired
C = combination
N-r = the number of items in the population that are labeled as success
NCn = the number of ways a sample of size n can be selected from a
population of size N.
rCx = the number of ways x successes can be selected from a total of r
successes in the population.
N-rCn-x = the number of ways n-x failures can be selected from a total of N-r
failures in the population
Example:
1. 24 people, of whom eight are women, have applied for a job. If five of the applicants are
randomly selected, what is the probability that three of those sampled are women?
Solution:
N = 24 n=5 r=8 x=3
24 8
 * 8
P( X  3)  53 3
= 120x56/42,504 = 0.1581
 24
5

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3. Suppose that there are 18 major insurance companies in Ethiopia and that 12 are located in
Addis. If three insurance companies are randomly selected from the entire list, what is the
probability that one or more of the selected companies are located in Addis?
Solution:
N = 18 n=3 r = 12 x≥1
P(x ≥ 1) = P(x = 1) + P(x = 2) + P(x = 3)
= 0.2206 + 0.4853 + 0.2696 = 0.9755
3. A company produces and ships 16 personal computers knowing that 4 of them have defective
wiring. The company that has purchased the computers is going to test thoroughly 3 of the
computers. The purchasing company can detect the defective wiring when it is there. What is the
probability that the purchasing company will find:
a) No defective computer? Ans: 0.3932
b) Exactly three defective computers? Ans: 0.0071
c) Two or more defective computers? Ans: 0.1357
d) One or less defective computers? Ans: 0.8643

The Binomial Approximation to Hyper geometric Distribution

The binomial probability distribution with parameters n and p=r/N provides a good
approximation of hyper geometric probability distribution if the sample size, n, is no more than
five percent of the population size, N. That is n ≤ 5%N. And as n/N decreases, the binomial
distribution better approximates the hyper geometric distribution.

Example:
1. An internal revenue service district office has files on 500 income tax returns that were audited
in 1996. After the audit, additional taxes were required on 350 of these. In order to verify that
proper audit procedures were followed, a supervisor randomly selects and examines 10 of the 500
returns. What is the probability that additional taxes were required exactly on six of the 10 returns
sampled?
Solution:
Using hypergeometric distribution
N = 500 n = 10 r = 350 x≥6
P(x=6) = 0.2016
Using binomial distribution
n= 10 p=r/N = 350/500 = 0.7 q= 0.3 x=6
P(x=6) = 0.2001
2. Of a group of 300 men, 240 are physically fit. If five men are randomly selected, what is the
probability that three of them are physically fit?

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Solution:
Using hyper geometric distribution
N = 300 n=5 r = 240 x=3
P(x=3) = 0.2057
Using binomial distribution
n= 5 p=r/N = 240/300 = 0.8 q= 0.2 x=3
P(x=6) = 0.2048

2.2.1.3 The Poisson distribution

The Poisson probability distribution describes the number of times some event occurs during a

specified interval. The interval may be time, distance, area, or volume. It can be used to determine

the probability of a designated number of events occurring when the events occur in a continuum

of time or space. Such a process is called a Poisson process; it is similar to the Bernoulli process

(see binomial above) except that the events occur over a continuum (e.g., during a time interval)

and there are no trials as such. An example of such a process is the arrival of incoming calls at a

telephone switchboard.

While a binomial random variable counts the number of successes that occur in a fixed number of

trials, a Poisson random variable counts the number of rare events (successes) that occur in a

specified continuous time interval or specified region.

The Poisson distribution has the following characteristics.

1. The probability of an occurrence is the same throughout the time interval or space per unit.

2. The number of occurrences in one interval is independent of the number of occurrences in

another interval.

3. The probability of two or more occurrences in a subinterval is small enough to be ignored.

4. It must be possible to divide the time interval of interest in to many sub intervals.

5. The expected number of occurrences in an interval is proportional to the size of the interval.

Examples of Poisson random variable

1. The number of air planes arriving at an airport in an hour.
2. The number of accidents at a factory in a day.
3. The number of cars crossing a bridge during a five second interval

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The formula for Poisson distribution is:

 x e  t x  e t 
P X    , Where :   mean number of arrivals per unit of time or space
X! X!
X  number of arrivals for which the probabilit y is desired
e  the base of natural log arithm
  exp ected number of occurrences in a specified int erval
t  the proportion of this specifird int erval for the question of int erest
(number of units of time )
Example:
(1) Assume that a bank knows from past experience that between 10 and 11 a.m. of each day, the
mean arrival rate is 60 customers per hour. Suppose that the bank wants to determine the
probability that exactly two customers will arrive in a given minute time minute interval
between 10 and 11 a.m. Arrivals are assumed to be constant over a given time interval.
Calculate the probability.
Solution:
λ = 60 customers/hr t= 1 minute x = 2 customers
µ = λ* ι = 60customers/60minutes * 1 minutes = 1

 xe 12 e 1
P(x=2) = = = 0.1839
X! 2!
The probability of getting 2 customers during the next one minute in a bank is 0.1839. Or there is
18.39% chance that exactly 2 customers will arrive in one minute at a bank.

(2) Suppose that bank customers arrive randomly on weekday afternoons at an average rate of 3.2
customers every four minutes. What is the probability of getting 10 customers during an eight
minute interval?
λ = 3.2 customers/4 minute t= 8 minutes x =10 customers
µ = λ* ι = 3.2 customers/4 minutes * 8minutes = 6.4 customers

 xe 6.410 e 6.4

P(x=10) = = = 0.0528
X! 10!
The probability of getting 10 customers during the next eight minutes in a bank is 0.0528. Or there
is 5.28% chance that exactly 10 customers will arrive in eight minutes at a bank.

Mean and Variance of Poisson distribution

The Poisson distribution has only one parameter, the expected value λt = µ. Additionally, for the
poison distribution, the expected value and variance are equal. The expected vale and variance a
Poisson probability distribution are E(X) = µ = λt = δ2.

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Poisson Approximation to Binomial Probability Distribution

The Poisson probability distribution can be used as an approximation to the binomial probability
distribution when P, the probability of success is small and n, the number of trials/sample size, is
large. Simply set µ = np and use the Poisson tables. As a rule of thumb, the approximation will be
good whenever P≤0.05 and n≥20. However, this approximation is reasonably accurate if n>20 and
np≤5.
Binomial tables are often not available for large values of n, so in these cases the approximation can
be useful. So in cases where P≤0.05 and n≥20, substitute the mean of the binomial distribution (µ =
np) in place of the mean of the Poisson distribution (µ = λι), so that the formula becomes

np x e np
P(X) =
X!
In general, the larger n is and smaller p is, the better will be the approximation.
Why approximation?
- The Poisson formula is easier to use than the binomial formula.
- It can be tabulated more efficiently than binomial probabilities because Poisson distribution has
only one parameter µ (λι), whereas binomial distribution has two parameters n and p.
Example
Suppose that the probability of a bank making a mistake processing a deposit is 0.0003. If 10,000
deposits are audited, what is the probability that exactly six mistakes were made in processing
deposits?
Solution:
Steps: 1. Make sure P≤0.05 and n≥20
P = 0.0003 n = 10,000…………. Both requirements satisfied
2. Calculate µ = np = 10,000*0.0003 = 3
3. Calculate P(X)

36 e 3
P (X=6) =
6!
= 0.0504

2.2.2 Continuous Probability Distribution

Up to this point, we have focused our attention on discrete distributions of random variables that
have either a finite number of possible value (E.g. 0, 1, 2, 3 …n) or a countably infinite number of
values (E.g. 0, 1, 2, 3 …), and we can also list all of the possible values of a discrete random variable
and it is meaningful to consider the probability that a particular individual value will be assumed.
In contrast, a continuous random variable has an uncountably infinite number of possible values
and can assume any value in the interval between two points and b(a<x<b).

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As a result the only meaningful way to compute a probability is the probability that the variable
will fall within a specified region. That is, the probability that a continuous random variable X will
assume any particular value is zero. It is any representation of the values of continuous random
variable and the associated probabilities. The continuous probability distribution includes the
normal distribution and exponential distribution.

2.2.2.1 The Normal Distribution

The normal distribution is a continuous distribution that has a bell shape and is determined by its
mean and standard deviation. It occupies a place of central importance in continuous probability
distribution in particular and statistics in general. It is the most important theoretical distribution
because of the following three reasons:
1. The normal distribution approximates the observed frequency distributions of many natural
and physical measurements, such as, IQS, weights, heights, sales, product life times, etc.
2. The normal distribution can often be used to estimate binomial probabilities when n (sample
size) is greater than 20.
3. The normal distribution is a good approximation of distributions of both sample means and
sample proportions of large samples (n > 30).

Characteristics of normal distribution

i. It is a continuous distribution.
ii. It has a bell shape and is symmetrical about its mean.
iii. It is asymptotic to the X- axis.
iv. It extends infinitely in either direction from the mean.
v. It is defined by two parameters: µ and δ. Each combination of these two parameters
specifies a unique normal distribution. The value of µ indicates where the center of the bell
lies, while δ represents how spread out (or wide) the distribution is.
vi. It is measured on a continuous scale and the probability of obtaining a precise value is zero.
vii. The total area under the curve is equal to 1.0 or 100%; 50% of the area is above the mean and
50% is below the mean.
viii. The probability that a random variable will have a value between any two points is equal
the area under the curve between those two points.

Each combination of µ and δ specifies a unique normal distribution. This brings about having an
infinite family of normal distributions. This problem of dealing with an infinite family of
distributions can be solved by transforming all normal distributions to the standard normal
distribution, which has a mean equal to 0 and a standard deviation equal to 1. Standard Normal
Distribution is a normal distribution in which the mean is 0 and the standard deviation is 1. It is
denoted by z.

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Any normal distribution can be converted to the standard normal distribution by standardizing
each of its observations in terms of Z- values. The Z- value measures the distance in standard
deviations between the mean of the normal curve and the X- value of interest. Any random
variable can be transformed to a standard random variable by subtracting the mean and dividing
by the standard deviation.

If a random variable X has mean µ and standard deviation δ, the standardized variable Z is
defined as:
X 
Z , Where : Z  number of s tan dard deviations from the mean.

X  value of int erest
  mean of the distributi on
  s tan dard deviation of distributi on
A Z- score is the number of standard deviations that a value, X, is away from the mean. If the value
of X is less than the mean, the Z-score is negative; if the value of X is greater than the mean, the Z-
score is positive. Z-score is also known as z-value. A standardized score in which the mean is zero
and the standard deviation is 1. The Z score is used to represent the standard normal distribution
The probability calculations in normal distribution are made by computing areas under the graph.
Thus, to find the probability that a random variable lies within any specific interval we must
compute the area under the normal curve over that interval.
Probabilities for some commonly used intervals are:
a) 68.26% of the time, a normal random variable assumes a value within ±1δ of its mean.
b) 95.44% of the time, a normal random variable assumes a value within ±2δ of its mean.
c) 99.72% of the time, a normal random variable assumes a value within ±3δ of its mean.

Example:
1. The Graduate Management Admission Test (GMAT) is widely used by graduate school of
business as an entrance requirement. In one particular year, the mean score for the GMAT was
485, with a standard deviation of 105. assuming that GMAT scores are normally distributed,
what is the probability that a randomly selected score from this administration of the GMAT:
a) Falls between 600 and the mean, inclusive?

b) Is greater than 650?

c) Is less than 300?

d) Falls between 350 and 550, inclusive?

e) Is less than 700?

f) Is exactly 500?

g) If 500 applicants take the test, how many would you expect to score 590 or below?
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Solution:
Steps to find the probability value of a random variable which lies over an interval:
1. Calculate the appropriate z values
2. Find the areas (probabilities) in the table
3. Interpret your results
µ = 485 δ = 105 485≤X≤600
a) P (485≤X≤600) =?
X 
1. First convert X values in to Z-score using the formula Z 

Z485 = 0
600 485
Z600 = = +1.10
105
2. P(485≤X≤600) = P(0≤Z≤+1.10)
= P (0 to +1.10)
= 0.36433
b) P (X>650) =?
X 
1. First convert X values in to Z-score using the formula Z 

650 485
Z650 = = +1.57
105
2. P(X>650) = P(Z>+1.57)
= 0.5- P (0 to +1.57)
= 0.5-0.44179
= 0.05281
c) P (X<300) =?
X 
1. First convert X values in to Z-score using the formula Z 

300 485
Z300 = = -1.76
105
2. P(X<300) = P(Z<-1.76)
= 0.5- P (0 to -1.76)
= 0.5-0.46080
= 0.03920
d) P (350≤X≤550) =?
X 
1. First convert X values in to Z-score using the formula Z 

350 485
Z350 = = -1.29
105
550 485
Z550 = = +0.62
105

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2. P(350≤X≤550) = P (-1.29≤Z≤-1.29)
= P (0 to -1.29) + P (0 to 0.62)
= 0.40147 + 0.23237
= 0.63384
e) P (X<700) =?
X 
1. First convert X values in to Z-score using the formula Z 

700 485
Z700 = = +2.05
105
2. P(X<700) = P(Z<+2.05)
= P (X<485) + P (485≤X<700)
= 0.5+ P (0 to +2.05)
= 0.5 + 0.47982
= 0.97982
f) P(X=500) = 0. The probability of an exact/single value of a continuous random variable is zero.
Consequently, the probability of an interval is the same whether the end points are included or
not.
g) To find the expected number of applicants who score 590 or below, we first find P (X≤590) and
we multiply it by the number of applicants.
P (X≤590) =?
X 
1. First convert X values in to Z-score using the formula Z 

590 485
Z590 = = +1.00
105
2. P(X≤590) = P(Z≤+1.00)
= P (X<485) + P (485≤X<590)
= 0.5+ P (0 to +1.00)
= 0.5 + 0.34134
= 0.84134
If 500 applicants take the test, the number of students expected to score 590 or below is
500(0.84134) = 420.65 or 421 students.
2. The average selling price for a product is Br 30, and the standard deviation is Br 8.20. Assume
the selling price is normally distributed.
A. What is the probability a company will have a stock price of at least $40?
B. What is the probability a company will have a stock price no higher than $20?
Solution:
A) µ = 30 σ = 8.2 and X > 40

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X 
Z

Z = 40 – 30
8.2
Z = 1.22
P(Z=1.22) = 0.3888
P(X> 40) = 0.50 – 0.3888 = 0.1112

B) µ = 30 σ = 8.2 and X < 20

Z = 20 – 30
8.2
Z = -1.22
P(Z=1.22) = 0.3888
P(X< 20) = 0.50 – 0.3888 = 0.1112
3. The mean hourly pay rate for financial managers in the East region is $32.62, and the standard
deviation is $2.32. Assume that pay rates are normally distributed.
A) What is the probability a financial manager earns between $30 and $35 per hour?
B) For a randomly selected financial manager, what is the probability the manager earned
less than $28 per hour?
Answer: A) 0.7193 and B) 0.0233

4. The result of an exam score for a given class is normally distributed. If the mean score is 85
points and the standard deviation is equal to 20 points, find the cutoff passing grade such that
83.4% of those taking the test will pass.
Solution:
µ = 85 prob. Of passing = 83.4%
δ = 20 cutoff point =?
Since 83.4% is greater than 50%, the cutoff point should be less than the mean, and hence the Z-
value is negative. And this calls for the inverse use of the standard normal table.
(Z/P=0.334) = -0.97
X  485
-0.97 =
20
-19.4 = X-85
X = 65.6 Points – Minimum point to pass the test.

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