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2013, Study Session # 3, Reading # 9

COMMON PROBABILITY DISTRIBUTIONS

Probability Distribution Probability Function Discrete uniform All outcomes have


Describes the probabilities of Probability of a random random variable the same probability.
all possible outcomes for a variable being equal to a
random variable. specific value.
Uniform Probability Distribution

Sum of probabilities of all Properties:
possible outcomes is 1.
0 p(x) 1

p(x) = 1 Discrete Continuous

Has a finite number of
Defined over a range with
Discrete Continuous specified outcomes. parameters b (upper limit)

P(x)k. K is the & a (lower limit).
Finite (measurable) Infinite
Random Variable probability for k
cdf: It is linear over the
# of possible (immeasurable) # of
number of possible variables range.
outcomes. possible outcomes.
outcomes in a range.
Properties:

P(x) can be zero

P(x) cant be 0 if
cdf: F(xn) = n.p(x).
P ( x a) = 0 & P (x b) = 1
even if x can
x can occur.
occur.

We can find the
P( a < x < b)=
Distribution
We cant find the
probability of a
probability of a
specific point in
specific point in
time.
time.

Probability Density Cumulative Distribution Binomial Distribution Binomial Tree

Function (PDF) Function (CDF)
Shows all possible

It is used for continuous
Calculates the probability of Properties: combinations of up &
distribution. a random variable x taking
Two outcomes (success & down moves over a

Denoted by f(x). on the value less than or failure). number of successive
equal to a specific value of
n number of independent periods.
x. trials.
Node: Each of the

F(x) = P (X x)
Probability of success possible values along
remains constant. the tree.

p(x) =
U is up-move factor.

!
D is down-move factor
 (1 )

!. ! (1/U).

p is probability of up
move.

(1-p) is probability of
down move.

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2013, Study Session # 3, Reading # 9

Confidence Interval Roys Safety First Criterion

Range of values around the expected
Optimal portfolio minimizes the
value within which actual outcome is probability that the return of the portfolio
expected to be some specified falls below some minimum acceptable Shortfall Risk
percentage of time. level. Risk that portfolio value will

Minimize P(RP < RL). fall below some minimum

SFRatio = level at a future date.
Confidence Interval %age [ ) 

x 1s 68%
Choose the portfolio with greatest SFRatio.

x 1.65s 90%

x 1.96s 95%

x 2s 95.45%

x 2.58s 99%
Monte-Carlo Simulation
x 3s 99.73%
Repeated generation of one or more factors (e.g. risk) that
affect required value (e.g., stock price) in order to generate
a distribution of the values (stock price).
Compounded Rates
We have the flexibility of providing the data.
of Returns
Simulation Procedure for
Discrete Continuous Stock Option Valuation
Daily, annually,
ln(S1/S0) =
weekly, monthly ln(1+HPR)
Specify prob. Randomly Value the Calculate mean
compounding
These are additive
dist. of stock generate options for option value
for multiple
prices & values of each pair of performing
periods.
relevant stock prices risk factors. many

Effective annual
interest rate & interest iterations &
rate based on
as well as their rates. use it as
continuous
parameters. estimated
compounding is
option value.
given as:
Rcc
EAR = e -1

Uses Limitations

Valuing complex securities.
Complex procedure.

Simulating gains / losses from
Highly dependent on
Historical Simulation trading strategy. assumed distributions.

Based on actual values & actual
Estimating value at risk (VAR).
Based on a statistical rather
distribution of the factors i.e.,
Examining variability of the than an analytical method.
based on historical data. difference b/w assets & liabilities
of pension funds.
Limitation:

Valuing portfolio with non -

History does not repeat itself.
normal return distribution.

Historical data does not provide
flexibility.

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