Business Statistics

Basic Probability And

Probability Distributions
 Chapter Topics
• Basic Probability Concepts:
Sample Spaces and Events, Simple
Probability, and Joint Probability,
• Conditional Probability
• Bayes’ Theorem
• The Probability Distribution for a
Discrete Random Variable
 Chapter Topics

• Binomial and Poisson Distributions

• Covariance and its Applications in
Finance
• The Normal Distribution
• Assessing the Normality Assumption
 Sample Spaces
Collection of all Possible Outcomes
e.g. All 6 faces of a die:

e.g. All 52 cards of a bridge deck:

 Events
• Simple Event: Outcome from a Sample Space
with 1 Characteristic
e.g. A Red Card from a deck of cards.
• Joint Event: Involves 2 Outcomes
Simultaneously
e.g. An Ace which is also a Red Card from a
deck of cards.
 Visualizing Events
• Contingency Tables
Ace Not Ace Total
Black 2 24 26
Red 2 24 26
Total 4 48 52

• Tree Diagrams
 Simple Events
The Event of a Happy Face

There are 5 happy faces in this collection of 18 objects

 Joint Events
The Event of a Happy Face AND Light Colored

3 Happy Faces which are light in color

 Special Events

Null event Null Event

Club & diamond on

1 card draw

Complement of event
For event A,
'
All events not In A: A
 Dependent or
Independent Events
The Event of a Happy Face GIVEN it is Light Colored
E = Happy FaceLight Color

3 Items: 3 Happy Faces Given they are Light Colored

 Contingency Table
A Deck of 52 Cards
Red Ace
Not an Total
Ace
Ace
Red 2 24 26
Black 2 24 26
Total 4 48 52
Sample Space
 Contingency Table
2500 Employees of Company ABC

Agree Neutral Opposed | Total

MALE 900 200 400 | 1500

FEMALE 300 100 600 | 1000

1200 300 1000 | 2500

Total

Sample Space
 Tree Diagram
Event Possibilities Ace
Red
Cards Not an Ace
Full
Deck
Ace
of Cards
Black
Cards
Not an Ace
 Probability
•Probability is the numerical 1 Certain
measure of the likelihood
that the event will occur.
•Value is between 0 and 1. .5
•Sum of the probabilities of

all mutually exclusive and

0 Impossible
 Computing Probability
• The Probability of an Event, E:
Number of Event Outcomes
P(E) =
Total Number of Possible Outcomes in the Sample Space
X
= T e.g. P( ) = 2/36
(There are 2 ways to get one 6 and the other 4)

• Each of the Outcome in the Sample Space

equally likely to occur.
 Computing
Joint Probability
The Probability of a Joint Event, A and B:
P(A and B)
Number of Event Outcomes from both A and B
= Total Number of Possible Outcomes in Sample Space

e.g. P(Red Card and Ace)

2 Red Aces 1
= 
52 Total Number of Cards 26
 Joint Probability Using
Contingency Table

Event
Event B1 B2 Total
A1 P(A1 and B1) P(A1 and B2) P(A1)
A2 P(A2 and B1) P(A2 and B2) P(A2)

Total P(B1) P(B2) 1

Joint Probability Marginal (Simple) Probability

 Computing
Compound Probability
The Probability of a Compound Event, A or B:
Numer of Event Outcomes from Either A or B
P  A or B  
Total Outcomes in the Sample Space

e.g.
P(Red Card or Ace)
4 Aces + 26 Red Cards  2 Red Aces 28 7
  
52 Total Number of Cards 52 13
 Contingency Table
2500 Employees of Company ABC

Agree Neutral Opposed | Total

MALE 900 200 400 | 1500

FEMALE 300 100 600 | 1000

1200 300 1000 | 2500

Total

Sample Space
 The pervious table refers to 2500 employees of ABC Company, classified by gender
and by opinion on a company proposal to emphasize fringe benefits rather than wage
increases in an impending contract discussion

Calculate the probability that an employee selected (at random) from this group will be:
1. A female opposed to the proposal
 The pervious table refers to 2500 employees of ABC Company, classified by gender
and by opinion on a company proposal to emphasize fringe benefits rather than wage
increases in an impending contract discussion

Calculate the probability that an employee selected (at random) from this group will be:
1. A female opposed to the proposal 600/2500 = 0.24
 The pervious table refers to 2500 employees of ABC Company, classified by gender
and by opinion on a company proposal to emphasize fringe benefits rather than wage
increases in an impending contract discussion

Calculate the probability that an employee selected (at random) from this group will be:
1. A female opposed to the proposal 600/2500 = 0.24
2. Neutral
 The pervious table refers to 2500 employees of ABC Company, classified by gender
and by opinion on a company proposal to emphasize fringe benefits rather than wage
increases in an impending contract discussion

Calculate the probability that an employee selected (at random) from this group will be:
1. A female opposed to the proposal 600/2500 = 0.24
2. Neutral 300/2500 = 0.12
 The pervious table refers to 2500 employees of ABC Company, classified by gender
and by opinion on a company proposal to emphasize fringe benefits rather than wage
increases in an impending contract discussion

Calculate the probability that an employee selected (at random) from this group will be:
1. A female opposed to the proposal 600/2500 = 0.24
2. Neutral 300/2500 = 0.12
3. Opposed to the proposal, GIVEN that
the employee selected is a female
 The pervious table refers to 2500 employees of ABC Company, classified by gender
and by opinion on a company proposal to emphasize fringe benefits rather than wage
increases in an impending contract discussion

Calculate the probability that an employee selected (at random) from this group will be:
1. A female opposed to the proposal 600/2500 = 0.24
2. Neutral 300/2500 = 0.12
3. Opposed to the proposal, GIVEN that
the employee selected is a female 600/1000 = 0.60
 The pervious table refers to 2500 employees of ABC Company, classified by gender
and by opinion on a company proposal to emphasize fringe benefits rather than wage
increases in an impending contract discussion

Calculate the probability that an employee selected (at random) from this group will be:
1. A female opposed to the proposal 600/2500 = 0.24
2. Neutral 300/2500 = 0.12
3. Opposed to the proposal, GIVEN that
the employee selected is a female 600/1000 = 0.60
4. Either a female or opposed to the
proposal
 The pervious table refers to 2500 employees of ABC Company, classified by gender
and by opinion on a company proposal to emphasize fringe benefits rather than wage
increases in an impending contract discussion

Calculate the probability that an employee selected (at random) from this group will be:
1. A female opposed to the proposal 600/2500 = 0.24
2. Neutral 300/2500 = 0.12
3. Opposed to the proposal, GIVEN that
the employee selected is a female 600/1000 = 0.60
4. Either a female or opposed to the
proposal ……….. 1000/2500 + 1000/2500 - 600/2500 =
1400/2500 = 0.56
 The pervious table refers to 2500 employees of ABC Company, classified by gender
and by opinion on a company proposal to emphasize fringe benefits rather than wage
increases in an impending contract discussion

Calculate the probability that an employee selected (at random) from this group will be:
1. A female opposed to the proposal 600/2500 = 0.24
2. Neutral 300/2500 = 0.12
3. Opposed to the proposal, GIVEN that
the employee selected is a female 600/1000 = 0.60
4. Either a female or opposed to the
proposal ……….. 1000/2500 + 1000/2500 - 600/2500 =
1400/2500 = 0.56

5. Are Gender and Opinion (statistically) independent?

 The pervious table refers to 2500 employees of ABC Company, classified by gender
and by opinion on a company proposal to emphasize fringe benefits rather than wage
increases in an impending contract discussion

Calculate the probability that an employee selected (at random) from this group will be:
1. A female opposed to the proposal 600/2500 = 0.24
2. Neutral 300/2500 = 0.12
3. Opposed to the proposal, GIVEN that
the employee selected is a female 600/1000 = 0.60
4. Either a female or opposed to the
proposal ……….. 1000/2500 + 1000/2500 - 600/2500 =
1400/2500 = 0.56

5. Are Gender and Opinion (statistically) independent?

For Opinion and Gender to be independent, the joint probability of each pair of
A events (GENDER) and B events (OPINION) should equal the product of the
respective unconditional probabilities….clearly this does not hold…..check, e.g.,
the prob. Of MALE and IN FAVOR against the prob. of MALE times the prob.
of IN FAVOR …they are not equal….900/2500 does not equal 1500/2500 *
1200/2500
 Compound Probability
Addition Rule
P(A1 or B1 ) = P(A1) +P(B1) - P(A1 and B1)
Event
Event B1 B2 Total
A1 P(A1 and B1) P(A1 and B2) P(A1)
A2 P(A2 and B1) P(A2 and B2) P(A2)

Total P(B1) P(B2) 1

For Mutually Exclusive Events: P(A or B) = P(A) + P(B)

 Computing
Conditional Probability
The Probability of Event A given that Event B
has occurred:
P  A and B 
P(A B) =
P  B
e.g.
2 Red Aces 1
P(Red Card given that it is an Ace) = 
4 Aces 2
 Conditional Probability
Using Contingency Table
Conditional Event: Draw 1 Card. Note Kind & Color

Color
Type Red Black Total Revised
Sample
Ace 2 2 4 Space
Non-Ace 24 24 48
Total 26 26 52
P(Ace AND Red) 2 / 52 2
P(Ace | Red) =  
P(Red) 26 / 52 26
 Conditional Probability and
Statistical Independence
Conditional Probability:
P ( A and B )
P(AB) =
P( B )

Multiplication Rule:
P(A and B) = P(A B) • P(B)
= P(B ) • P(A)
 Conditional Probability and
Statistical Independence (continued)
Events are Independent:
P(A  B) = P(A)
Or, P(B  A) = P(B)
Or, P(A and B) = P(A) • P(B)

Events A and B are Independent when the

probability of one event, A is not affected by
another event, B.
 Bayes’ Theorem
P ( A Bi )  P ( Bi )
P(Bi A) =
P ( A B1 )  P ( B1 )      P ( A Bk )  P ( Bk )

P ( Bi and A )
 Adding up
P( A ) the parts
of A in all
Same
the B’s
Event
 A manufacturer of VCRs purchases a particular microchip, called the LS-24, from three suppliers: Hall
Electronics, Spec Sales, and Crown Components. Thirty percent of the LS-24 chips are purchased
from Hall, 20% from Spec, and the remaining 50% from Crown. The manufacturer has extensive past
records for the three suppliers and knows that there is a 3% chance that the chips from Hall are
defective, a 5% chance that chips from Spec are defective and a 4% chance that chips from Crown are
defective. When LS-24 chips arrive at the manufacturer, they are placed directly into a bin and not
inspected or otherwise identified as to supplier. A worker selects a chip at random.
 
   

What is the probability that the chip is defective?

 
 
 
 
 
  A worker selects a chip at random for installation into a VCR and finds it is defective. What is the
probability that the chip was supplied by Spec Sales?

 
 
 Bayes’ Theorem: Contingency Table
What are the chances of repaying a loan,
given a college education?
Loan Status
Education Repay Default Prob.
College .2 .05 .25
No College ? ? ?
Prob. ? ? 1

P(College and Repay)

P(RepayCollege) =
P(College and Repay) + P(College and Default)
= .20
.25 = .80
 Discrete Random Variable
• Random Variable: outcomes of an
experiment expressed numerically
e.g.
Throw a die twice: Count the number of times 4
comes up (0, 1, or 2 times)
 Discrete Random Variable
•Discrete Random Variable:
• Obtained by Counting (0, 1, 2, 3, etc.)
• Usually finite by number of different
values
e.g.
Toss a coin 5 times. Count the number of
tails. (0, 1, 2, 3, 4, or 5 times)
 Discrete Probability
Distribution Example
Event: Toss 2 Coins. Count # Tails.
Probability distribution
Values probability
T 0 1/4 = .25
1 2/4 = .50
T
2 1/4 = .25
T T
 Discrete
Probability Distribution
• List of all possible [ xi, p(xi) ] pairs
Xi = value of random variable
P(xi) = probability associated with value
• Mutually exclusive (nothing in common)
• Collectively exhaustive (nothing left out)
0  p(xi)  1
 P(xi) = 1
 Discrete Random Variable
Summary Measures
Expected value (The mean)
Weighted average of the probability distribution
 = E(X) = xi p(xi)

E.G. Toss 2 coins, count tails, compute expected value:

= 0  .25 + 1 .50 + 2  .25 = 1

Number of Tails
 Discrete Random Variable
Summary Measures
Variance
Weighted average squared deviation about mean
 = E [ (xi -  )2]= (xi -  )2p(xi)

E.G. Toss 2 coins, count tails, compute variance:

 = (0 - 1)2(.25) + (1 - 1)2(.50) + (2 - 1)2(.25)
= .50
Important Discrete Probability
Distribution Models

Discrete Probability
Distributions

Binomial Poisson
 Binomial Distributions

• ‘N’ identical trials

 E.G. 15 tosses of a coin, 10 light bulbs
taken from a warehouse
• 2 mutually exclusive outcomes on each
trial
 E.G. Heads or tails in each toss of a coin,
defective or not defective light bulbs
 Binomial Distributions
• Constant Probability for each Trial
• e.g. Probability of getting a tail is the same
each time we toss the coin and each light bulb
has the same probability of being defective
• 2 Sampling Methods:
• Infinite Population Without Replacement
• Finite Population With Replacement
• Trials are Independent:
• The Outcome of One Trial Does Not Affect the
Outcome of Another
 Binomial Probability
Distribution Function
n! X nX
P(X)  p (1  p )
X ! (n  X)!
P(X) = probability that X successes given a knowledge of n
and p
Tails in 2 Tosses of Coin
X = number of ‘successes’ in
X P(X)
sample, (X = 0, 1, 2, ..., n) 0 1/4 = .25
p = probability of each ‘success’ 1 2/4 = .50
n = sample size 2 1/4 = .25
 Binomial Distribution
Characteristics

Mean .6
P(X) n = 5 p = 0.1
  E ( X )  np .4
.2
e.g.  = 5 (.1) = .5 0 X
0 1 2 3 4 5
Standard Deviation
 
P(X) n = 5 p = 0.5
np (1  p ) .6
.4
.2
e.g.  = 5(.5)(1 - .5) 0 X
0 1 2 3 4 5
= 1.118
 Poisson Distribution
Poisson process:
• Discrete events in an ‘interval’ P( X  x | 
- x
The probability of one success in
e 


an interval is stable
The probability of more than one


success in this interval is 0

x!
• Probability of success is
Independent from interval to
Interval
E.G. # Customers arriving in 15 min
# Defects per case of light
bulbs
 Poisson Distribution
Function
 X
P (X )  e 
X!
P(X ) = probability of X successes given 
 = expected (mean) number of ‘successes’
e = 2.71828 (base of natural logs)
X = number of ‘successes’ per unit
e.g. Find the probability of 4 -3.6 4
customers arriving in 3 P(X) = e 3.6 = .1912
4!
minutes when the mean is 3.6.
 Poisson Distribution
Characteristics
Mean P(X) = 0.5
  E (X )   .6
.4
N .2
  Xi P( Xi ) 0 X
0 1 2 3 4 5
i 1

.6
P(X) = 6
Standard Deviation .4

   .2
0 X
0 2 4 6 8 10
 Covariance
N
 XY    X i  E ( X )   Y i  E ( Y )   P ( X iY i )
i 1

X = discrete random variable X

Xi = value of the ith outcome of X
P(xiyi) = probability of occurrence of the
ith outcome of X and ith outcome of Y
Y = discrete random variable Y
Yi = value of the ith outcome of Y
I = 1, 2, …, N
 Computing the Mean for
Investment Returns
Return per $1,000 for two types of
investments Investment
P(XiYi) Economic condition Dow Jones fund X Growth Stock Y
.2 Recession -$100 -$200
.5 Stable Economy + 100 + 50
.3 Expanding Economy + 250 + 350

E(X) = X = (-100)(.2) + (100)(.5) + (250)(.3) = $105

E(Y) = Y = (-200)(.2) + (50)(.5) + (350)(.3) = $90
 Computing the Variance for
Investment Returns
Investment
P(XiYi) Economic condition Dow Jones fund X Growth Stock Y
.2 Recession -$100 -$200
.5 Stable Economy + 100 + 50
.3 Expanding Economy + 250 + 350

Var(X) =  X = (.2)(-100 -105)2 + (.5)(100 - 105)2 + (.3)(250 - 105)2

2

= 14,725, X = 121.35
Var(Y) = 
2
Y= (.2)(-200 - 90)2 + (.5)(50 - 90)2 + (.3)(350 - 90)2
= 37,900, Y = 194.68
 Computing the Covariance for
Investment Returns
Investment
P(XiYi) Economic condition Dow Jones fund X Growth Stock Y
.2 Recession -$100 -$200
.5 Stable Economy + 100 + 50
.3 Expanding Economy + 250 + 350

XY = (.2)(-100 - 105)(-200 - 90) + (.5)(100 - 105)(50 - 90)

+ (.3)(250 -105)(350 - 90) = 23,300
The Covariance of 23,000 indicates that the two investments are
positively related and will vary together in the same direction.
 The Normal Distribution
• ‘Bell Shaped’
• Symmetrical f(X)

• Mean, Median and

Mode are Equal X

• ‘Middle Spread’
Mean
Equals 1.33  Median
• Random Variable has Mode

Infinite Range
The Mathematical Model
1
1   X    2

f X 

2
e
2 2

f(X) = frequency of random variable X

 = 3.14159; e = 2.71828
 = population standard deviation
X = value of random variable (- < X < )
 = population mean
Many Normal Distributions

There are
an Infinite
Number

Varying the Parameters  and , we obtain

Different Normal Distributions.
 Normal Distribution:
Finding Probabilities
Probability is the
area under the
curve! P (c  X  d ) ?
f(X)

X
c d
 Which Table?

Each distribution
has its own table?

Infinitely Many Normal Distributions Means

Infinitely Many Tables to Look Up!
 Solution (I): The Standardized
Normal Distribution
Standardized Normal Distribution
Table (Portion)  Z = 0 and Z = 1
.0478
Z .00 .01 .02
0.0 .0000 .0040 .0080 Shaded Area
Exaggerated

0.1 .0398 .0438 .0478

0.2 .0793 .0832 .0871
Z = 0.12
0.3 .0179 .0217 .0255 Probabilities

Only One Table is Needed

 Solution (II): The Cumulative
Standardized Normal Distribution
Cumulative Standardized Normal
Distribution Table (Portion)
   0 and    1 .5478
Z .00 .01 .02
0.0 .5000 .5040 .5080 Shaded Area
Exaggerated
0.1 .5398 .5438 .5478
0.2 .5793 .5832 .5871
Z = 0.12
0.3 .5179 .5217 .5255 Probabilities
Only One Table is Needed
 Standardizing Example
X   6 .2  5
Z   0 . 12
 10
Normal Standardized
Distribution Normal Distribution

 = 10 Z = 1

 = 5 6.2 X  = 0 .12 Z
Shaded Area Exaggerated
 Example:
P(2.9 < X < 7.1) = .1664
x   2 .9  5
z    . 21
 10
Normal x   7 .1  5 Standardized
z    . 21
Distribution  10 Normal Distribution
 = 10 Z = 1
.1664

.0832 .0832

2.9 5 7.1 X -.21 0 .21 Z

Shaded Area Exaggerated
 Example: P(X  8) = .3821
x  85
z   .. 30
 10
Normal Standardized
Distribution Normal Distribution

 = 10  =1
.5000

.3821
.1179

 =5 8 X  = 0 .30 Z
Shaded Area Exaggerated
 Finding Z Values
for Known Probabilities
What Is Z Given Standardized Normal
Probability = 0.1217? Probability Table (Portion)

 =1 Z .00 .01 0.2

.1217
0.0 .0000 .0040 .0080

0.1 .0398 .0438 .0478

 = 0 .31 Z 0.2 .0793 .0832 .0871

Shaded Area 0.3 .1179 .1217 .1255

Exaggerated
 Recovering X Values
for Known Probabilities
Normal Distribution Standardized Normal Distribution

 = 10  =1
.1217 .1217

 =5 ? X  = 0 .31 Z

X  Z= 5 + (0.31)(10) = 8.1

Shaded Area Exaggerated
 Assessing Normality
Compare Data Characteristics to
Properties of Normal Distribution
• Put Data into Ordered Array
• Find Corresponding Standard Normal
Quantile Values
• Plot Pairs of Points
• Assess by Line Shape
Assessing Normality
Normal Probability Plot for
Normal Distribution
90
X 60
30 Z
-2 -1 0 1 2

Look for Straight Line!

 Normal Probability Plots
Left-Skewed Right-Skewed
90 90
X 60 X 60
30 Z 30 Z
-2 -1 0 1 2 -2 -1 0 1 2

Rectangular U-Shaped
90 90
X 60 X 60
30 Z 30 Z
-2 -1 0 1 2 -2 -1 0 1 2
 Chapter Summary
• Discussed Basic Probability Concepts:
Sample Spaces and Events, Simple
Probability, and Joint Probability
• Defined Conditional Probability
• Discussed Bayes’ Theorem
• Addressed the Probability of a Discrete
Random Variable
 Summary
• Discussed Binomial and Poisson
Distributions
• Addressed Covariance and its
Applications in Finance
• Covered Normal Distribution
• Discussed Assessing the Normality
Assumption