Week 2 — Discrete Distributions ribution PMF MGF Mean Variance Binomial (pq (pe' +a)" — mp npq Geometric gp po 2 * Negative Binomial Cee (=e) 2 4 Poisson xe eel) a a Week 3 — Continuous Distributions Distribution PDF Mean Variance Uniform pe agb Gea? Exponential der d a Normal ge Putty o Lognormal oh te fe . ebthe? — e2uto? (eo? _ 1) Bayes’ Theorem Invented by an 18*"-century English mathemati © We know, from conditional probability, that , Thomas Bayes P(AN B) = P(A|B)P(B) = P(BIA)E(A) © Using the 2"4 equality, we can write P(A) P(A|B) = p(B|A) P(B) @ From this it should be clear that P(BIA) # P(A|B) unless P(A) © We write out P(B) explicitly if it is not known ) = P(B) P(B) = P(B|A)P(A) + P(B|A)P(A) P(A|B) = Then we obtain the expression for Bayes’ Theorem P(BIA)P(A) P(B\A)P(A) + P(B\A)P(A)Summary of Inequalities Covered So Far © Markov P(X >a) < EE @ © Chebyshev 2 PUX =| > a) < © Cantelli P(X — p20) <= Ane) S ore Pearson's Correlation For a pair of random variables (X,Y), Pearson's correlation is defined as Cov(X,¥) _ E[XY] —E[X]E[Y) oxoy /E(X7)— EXP EY?) - BYP AX) = If X and Y are independent, then (X,Y) = 0. But we've raised “| ane ‘these important questions: I : eget @ (X.Y) =0 does not ol necessarily imply that X and “| Y are independent. “| @ What is the assumption for « Pearson's correlation to be ak ae well-defined? lalaan S&P 500 Index vs. Dow Jones Technology Index Spearman's Correlation Coefficient For a pair of continuous random variables (X,Y), Spearman's correlation coefficient is defined as Pearson's p for the ranks of Fx(X) and Fy(Y), ie ps(X,¥) = p(Fx(X), Fy(¥)) E[Fx(X)F¥(¥)] — ElFx(X)IE[Fy(¥)] E[Fx (X)?] — E[Px (1)? VELFY (¥?] — E[Fy (¥)? Since the marginals Fx (X) and Fy (Y) are uniform random variables U,V € [0,1], respectively, we have E[UV]-3 @ = 12E(UV]-3 ps(X,¥) = p(U,V) =Spearman's Correlation Coefficient For estimation, we do 6G ps1 nae)" where d; = Rank(2:) — Rank(y.) is the difference between the ranks of corresponding values sr; and yi. Estimation of Kendall’s 7 Let (Xi, ¥;) and (X}, ¥;) be two arbitrary pairs of observations. If Xj — Xi and Yj — Yi have the same sign, we shall say that the pair is concordant. If they have opposite sign, we shall say that the pair is discordant. With a finite number of observations, Kendall's z can be approximated as TK where ne is the number of concordant pairs and na is the number of discordant pairs in a data set with n observations of (X,Y). In the event that we observe X; = X, and/or ¥i = Yj, then the pair i considered as neither concordant or discordant. In this case ne + ma no longer equals to the total number of pairs, and Kendall's r no longer span the range of [-1, +1] Random Stock Price & Expectation Pricing Suppose a client approaches an investment bank to purchase a forward Contract on a stock S, maturing at time T. When the forward contract, matures, the client will pay a cash amount (KX) in exchange for one stock (s'r).. The investment bank should set K’ to be K =E[Sr] for the forward contract to be worth par. To be able to evaluate the expectation, we need to first choose a probability measure. Suppose the bank's top analyst says that Sr = Soe*, where X ~ N(uT,o°T), then under this probability framework, the expectation is given by E[Sr] = E[Soe*]Asset-Or-Nothing Digital Option ‘Assume a stock price follows a lognormal process is given by the distribution Sp = Soexp [(« - 5) r+ovrx| , X~N(O,1). ‘An asset-or-nothing digital call option pays Sr, The value of this digital option is This can be evaluated as © ‘TE|Srisyon] =e 77 4 Cash-or-Nothing Digital Option ‘Similarly, assume a stock price follows a lognormal process with the following. distribution Si Soop [(-3 )reovTa| X~N(0,D). A cash-er-nothing digital call option pays teoxee{b 52K sok = Lo Spek ‘The value of this digital option is Vem eT Espn] We can evaluate the expectation as follow: One-Period Binomial Model Multiply the first equation (£1) with p* and the second (77) with q* = 1~ p*, adding them we get Xo +o [ 4° SH) +4°S:(0))— 5] = Liu +e) Choosing p” such that ie ; So = E'S) + 4°S1(T)). We arrive at the simple formula ro . Xo = EF VU) +0 H(T). Solving for p* and g*, we see that aGtdad punts)Martingales Consider the general binomial model with 0 Expected time to absorption Timid play vs. bold play Gambler's ruin Kelly's criterion