Statistics for

Business and Economics

7th Edition

Chapter 5

Continuous Random Variables

and Probability Distributions
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-1
 Chapter Goals

After completing this chapter, you should be

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-2
 Chapter Goals
(continued)

After completing this chapter, you should be

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-3
 Probability Distributions
Probability
Distributions

Ch. 4 Discrete Continuous Ch. 5

Probability Probability
Distributions Distributions

Binomial Uniform

Hypergeometric Normal

Poisson Exponential

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-4
 5.1
Continuous Probability Distributions
 A continuous random variable is a variable that
can assume any value in an interval
 thickness of an item
 time required to complete a task
 temperature of a solution
 height, in inches

 These can potentially take on any value,

depending only on the ability to measure
accurately.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-5
 Cumulative Distribution Function
 The cumulative distribution function, F(x), for a
continuous random variable X expresses the
probability that X does not exceed the value of x

F(x)  P(X  x)
 Let a and b be two possible values of X, with
a < b. The probability that X lies between a
and b is

P(a  X  b)  F(b)  F(a)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-6
 Probability Density Function
The probability density function, f(x), of random variable X
has the following properties:

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

2. The area under the probability density function f(x) over
all values of the random variable X is equal to 1.0
3. The probability that X lies between two values is the
area under the density function graph between the two
values

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-7
 Probability Density Function
(continued)
The probability density function, f(x), of random variable X
has the following properties:

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

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

f(x 0 )   f(x)dx
xm

where xm is the minimum value of the random variable x

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-8
 Probability as an Area

Shaded area under the curve is the

probability that X is between a and b
f(x)
P (a ≤ x ≤ b)
= P (a < x < b)
(Note that the probability
of any individual value is
zero)

a b x

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-9
 The Uniform Distribution
Probability
Distributions

Continuous
Probability
Distributions

Uniform

Normal

Exponential

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-10
 The Uniform Distribution

 The uniform distribution is a probability

distribution that has equal probabilities for all
possible outcomes of the random variable

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

xmin xmax x

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-11
 The Uniform Distribution
(continued)

The Continuous Uniform Distribution:

1
if a  x  b
ba
f(x) =
0 otherwise

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-12
 Properties of the
Uniform Distribution
 The mean of a uniform distribution is

ab
μ
2
 The variance is
2
(b - a)
σ2 
12

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-13
 Uniform Distribution Example
Example: Uniform probability distribution
over the range 2 ≤ x ≤ 6:

1
f(x) = 6 - 2 = .25 for 2 ≤ x ≤ 6

f(x)
ab 26
μ  4
.25 2 2

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-14
 5.2 Expectations for Continuous
Random Variables

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

expected value of X

μX  E(X)

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

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

σ 2X  E[(X  μX )2 ]

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-15
 Linear Functions of Variables
 Let W = a + bX , where X has mean μX and
variance σX2 , and a and b are constants
 Then the mean of W is
μW  E(a  bX)  a  bμX
 the variance is
σ 2
W  Var(a  bX)  b σ 2 2
X

 the standard deviation of W is

σW  b σX
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-16
 Linear Functions of Variables
(continued)

 An important special case of the previous results is the

standardized random variable

X  μX
Z
σX
 which has a mean 0 and variance 1

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-17
 5.3
The Normal Distribution
Probability
Distributions

Continuous
Probability
Distributions

Uniform

Normal

Exponential

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-18
 The Normal Distribution
(continued)

‘Bell Shaped’
 Symmetrical
f(x)
 Mean, Median and Mode

are Equal
Location is determined by the σ
mean, μ x
μ
Spread is determined by the
standard deviation, σ
Mean
= Median
The random variable has an = Mode
infinite theoretical range:
+  to  
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-19
 The Normal Distribution
(continued)

 The normal distribution closely approximates the

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-20
 Many Normal Distributions

By varying the parameters μ and σ, we obtain

different normal distributions

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-21
 The Normal Distribution Shape
f(x) Changing μ shifts the
distribution left or right.

Changing σ increases
or decreases the
σ spread.

μ x

Given the mean μ and variance σ we define the normal

distribution using the notation
X ~ N(μ,σ 2 )
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-22
 The Normal Probability
Density Function

 The formula for the normal probability density

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

Where e = the mathematical constant approximated by 2.71828

π = the mathematical constant approximated by 3.14159
μ = the population mean
σ = the population standard deviation
x = any value of the continuous variable,  < x < 
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-23
 Cumulative Normal Distribution

 For a normal random variable X with mean μ and

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

F(x 0 )  P(X  x 0 )

f(x)

P(X  x 0 )

0 x0 x

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-24
 Finding Normal Probabilities

The probability for a range of values is

measured by the area under the curve

P(a  X  b)  F(b)  F(a)

a μ b x

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-25
 Finding Normal Probabilities
(continued)

F(b)  P(X  b)

a μ b x

F(a)  P(X  a)

a μ b x

P(a  X  b)  F(b)  F(a)

a μ b x
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-26
 The Standardized Normal
 Any normal distribution (with any mean and
variance combination) can be transformed into the
standardized normal distribution (Z), with mean 0
and variance 1
f(Z)

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

X μ
Z
σ
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-27
 Example
 If X is distributed normally with mean of 100
and standard deviation of 50, the Z value for
X = 200 is
X  μ 200  100
Z   2.0
σ 50
 This says that X = 200 is two standard
deviations (2 increments of 50 units) above
the mean of 100.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-28
 Comparing X and Z units

100 200 X (μ = 100, σ = 50)

0 2.0 Z ( μ = 0 , σ = 1)

Note that the distribution is the same, only the

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-29
 Finding Normal Probabilities
 a μ b μ
P(a  X  b)  P Z 
 σ σ 
f(x)  b μ  a μ
 F   F 
 σ   σ 

a µ b x
a μ b μ
0 Z
σ σ

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-30
 Probability as
Area Under the Curve
The total area under the curve is 1.0, and the curve is
symmetric, so half is above the mean, half is below

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

0.5 0.5

μ X
P(   X   )  1.0
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-31
 Appendix Table 1
 The Standardized Normal table in the textbook
(Appendix Table 1) shows values of the
cumulative normal distribution function

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

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

F(a)  P(Z  a)

0 a Z
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-32
 The Standardized Normal Table

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

any value a

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

0 2.00 Z

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-33
 The Standardized Normal Table
(continued)

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

distribution is symmetric to find the needed
probability:
.9772

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

-2.00 0 Z
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-34
 General Procedure for Finding
Probabilities

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

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

 Translate X-values to Z-values

 Use the Cumulative Normal Table

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-35
 Finding Normal Probabilities

 Suppose X is normal with mean 8.0 and

standard deviation 5.0
 Find P(X < 8.6)

X
8.0
8.6
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-36
 Finding Normal Probabilities
(continued)
 Suppose X is normal with mean 8.0 and
standard deviation 5.0. Find P(X < 8.6)
X  μ 8.6  8.0
Z   0.12
σ 5.0

μ=8 μ=0
σ = 10 σ=1

8 8.6 X 0 0.12 Z

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-37
 Solution: Finding P(Z < 0.12)

Standardized Normal Probability P(X < 8.6)

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

.11 .5438

.12 .5478
Z
0.00
.13 .5517
0.12

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-38
 Upper Tail Probabilities

 Suppose X is normal with mean 8.0 and

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

X
8.0
8.6
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-39
 Upper Tail Probabilities
(continued)
 Now Find P(X > 8.6)…
P(X > 8.6) = P(Z > 0.12) = 1.0 - P(Z ≤ 0.12)
= 1.0 - 0.5478 = 0.4522

0.5478
1.000 1.0 - 0.5478
= 0.4522

Z Z
0 0
0.12 0.12
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-40
 Finding the X value for a
Known Probability

 Steps to find the X value for a known

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

X  μ  Zσ

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-41
 Finding the X value for a
Known Probability
(continued)

Example:
 Suppose X is normal with mean 8.0 and

standard deviation 5.0.

 Now find the X value so that only 20% of all

values are below this X

.2000

? 8.0 X
? 0 Z
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-42
 Find the Z value for
20% in the Lower Tail
1. Find the Z value for the known probability
Standardized Normal Probability  20% area in the lower
Table (Portion) tail is consistent with a
z F(z) Z value of -0.84
.82 .7939 .80
.20
.83 .7967

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-43
 Finding the X value

2. Convert to X units using the formula:

X  μ  Zσ

 8.0  ( 0.84)5.0

 3.80

So 20% of the values from a distribution

with mean 8.0 and standard deviation
5.0 are less than 3.80

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-44
 Assessing Normality

 Not all continuous random variables are

normally distributed

 It is important to evaluate how well the data is

approximated by a normal distribution

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-45
 The Normal Probability Plot

 Normal probability plot

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-46
 The Normal Probability Plot
(continued)

A normal probability plot for data

from a normal distribution will be
approximately linear:

100

Percent

0
Data

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-47
 The Normal Probability Plot
(continued)

Left-Skewed Right-Skewed
100 100
Percent

Percent
0 0
Data Data

Uniform
100 Nonlinear plots indicate
a deviation from
Percent

normality
0
Data
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-48
 5.4
Normal Distribution Approximation
for Binomial Distribution

 Recall the binomial distribution:

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

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

E(X)  μ  nP
Var(X)  σ  nP(1- P) 2

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-49
 Normal Distribution Approximation
for Binomial Distribution
(continued)

 The shape of the binomial distribution is

approximately normal if n is large

 The normal is a good approximation to the binomial

when nP(1 – P) > 5

 Standardize to Z from a binomial distribution:

X  E(X) X  np
Z 
Var(X) nP(1 P)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-50
 Normal Distribution Approximation
for Binomial Distribution
(continued)

 Let X be the number of successes from n independent

trials, each with probability of success P.

 If nP(1 - P) > 5,

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-51
 Binomial Approximation Example
 40% of all voters support ballot proposition A. What
is the probability that between 76 and 80 voters
indicate support in a sample of n = 200 ?
 E(X) = µ = nP = 200(0.40) = 80
 Var(X) = σ2 = nP(1 – P) = 200(0.40)(1 – 0.40) = 48
( note: nP(1 – P) = 48 > 5 )

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-52
 5.5
The Exponential Distribution
Probability
Distributions

Continuous
Probability
Distributions

Normal

Uniform

Exponential

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-53
 The Exponential Distribution

 Used to model the length of time between two

occurrences of an event (the time between
arrivals)

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-54
 The Exponential Distribution
(continued)

 The exponential random variable T (t>0) has a

probability density function

λt
f(t)  λ e for t  0
 Where
  is the mean number of occurrences per unit time
 t is the number of time units until the next occurrence
 e = 2.71828
 T is said to follow an exponential probability distribution

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-55
 The Exponential Distribution
 Defined by a single parameter, its mean  (lambda)

 The cumulative distribution function (the probability that

an arrival time is less than some specified time t) is

λt
F(t)  1 e

where e = mathematical constant approximated by 2.71828

 = the population mean number of arrivals per unit
t = any value of the continuous variable where t > 0

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-56
 Exponential Distribution
Example
Example: Customers arrive at the service counter at
the rate of 15 per hour. What is the probability that the
arrival time between consecutive customers is less
than three minutes?

 The mean number of arrivals per hour is 15, so  = 15

 Three minutes is .05 hours
 P(arrival time < .05) = 1 – e- X = 1 – e-(15)(.05) = 0.5276
 So there is a 52.76% probability that the arrival time
between successive customers is less than three
minutes
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-57
 5.6 Joint Cumulative Distribution
Functions

 Let X1, X2, . . .Xk be continuous random variables

 Their joint cumulative distribution function,

F(x1, x2, . . .xk)
defines the probability that simultaneously X1 is less
than x1, X2 is less than x2, and so on; that is

F(x1, x 2 , , x k )  P(X1  x1  X 2  x 2  Xk  x k )

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-58
 Joint Cumulative Distribution
Functions
(continued)
 The cumulative distribution functions
F(x1), F(x2), . . .,F(xk)
of the individual random variables are called their
marginal distribution functions

 The random variables are independent if and only if

F(x1, x 2 , , x k )  F(x1 )F(x 2 )F(x k )

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-59
 Covariance
 Let X and Y be continuous random variables, with
means μx and μy

 The expected value of (X - μx)(Y - μy) is called the

covariance between X and Y
Cov(X, Y)  E[(X  μx )(Y  μy )]
 An alternative but equivalent expression is
Cov(X, Y)  E(XY)  μxμy
 If the random variables X and Y are independent, then the
covariance between them is 0. However, the converse is not true.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-60
 Correlation

 Let X and Y be jointly distributed random variables.

 The correlation between X and Y is

Cov(X, Y)
ρ  Corr(X, Y) 
σ Xσ Y

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-61
 Sums of Random Variables
Let X1, X2, . . .Xk be k random variables with
means μ1, μ2,. . . μk and variances
σ12, σ22,. . ., σk2. Then:

 The mean of their sum is the sum of their

means
E(X1  X 2    Xk )  μ1  μ2    μk

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-62
 Sums of Random Variables
(continued)
Let X1, X2, . . .Xk be k random variables with means μ1,
μ2,. . . μk and variances σ12, σ22,. . ., σk2. Then:
 If the covariance between every pair of these random
variables is 0, then the variance of their sum is the
sum of their variances
Var(X 1  X 2    Xk )  σ12  σ 22    σ k2

 However, if the covariances between pairs of random

variables are not 0, the variance of their sum is
K 1 K
Var(X 1  X 2    Xk )  σ12  σ 22    σ k2  2  Cov(X i , X j )
i1 ji1

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-63
 Differences Between Two
Random Variables
For two random variables, X and Y
 The mean of their difference is the difference of their
means; that is
E(X  Y)  μX  μY
 If the covariance between X and Y is 0, then the
variance of their difference is
Var(X  Y)  σ 2X  σ 2Y
 If the covariance between X and Y is not 0, then the
variance of their difference is
Var(X  Y)  σ 2X  σ 2Y  2Cov(X, Y)
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-64
 Linear Combinations of
Random Variables
 A linear combination of two random variables, X and Y,
(where a and b are constants) is

W  aX  bY

 The mean of W is

μW  E[W]  E[aX  bY]  aμX  bμY

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-65
 Linear Combinations of
Random Variables
(continued)

 The variance of W is

σ 2W  a 2σ 2X  b 2σ 2Y  2abCov(X, Y)

 Or using the correlation,

σ 2W  a 2σ 2X  b 2σ 2Y  2abCorr(X, Y)σ Xσ Y

 If both X and Y are joint normally distributed random

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-66
 Example

 Two tasks must be performed by the same worker.

 X = minutes to complete task 1; μ = 20, σ = 5
x x

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

 X and Y are normally distributed and independent

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

complete both tasks?

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-67
 Example
(continued)
 X = minutes to complete task 1; μx = 20, σx = 5
 Y = minutes to complete task 2; μy = 30, σy = 8

 What are the mean and standard deviation for the time to complete
both tasks?
W  XY
μW  μX  μY  20  30  50
 Since X and Y are independent, Cov(X,Y) = 0, so
σ 2W  σ 2X  σ 2Y  2Cov(X, Y)  (5)2  (8)2  89
 The standard deviation is
σ W  89  9.434
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 Portfolio Analysis

 A financial portfolio can be viewed as a linear

combination of separate financial instruments

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

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-69
 Portfolio Analysis Example

 Consider two stocks, A and B

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-70
 Portfolio Analysis Example
(continued)

 The mean and variance of this stock portfolio

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

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

σ 2W  10 2 σ 2A  30 2 σ B2  (2)(10)(30)Corr(A,B)σ A σ B
 10 2 (4)2  30 2 (16)2  (2)(10)(30)(.50)(4)(16)
 251,200

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-71
 Portfolio Analysis Example
(continued)

 What is the probability that your portfolio value is

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

 P(Z < -0.44) = 0.3300

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

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-72
 Chapter Summary
 Defined continuous random variables
 Presented key continuous probability distributions and
their properties
 uniform, normal, exponential
 Found probabilities using formulas and tables
 Interpreted normal probability plots
 Examined when to apply different distributions
 Applied the normal approximation to the binomial
distribution
 Reviewed properties of jointly distributed continuous
random variables
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 5-73