Mathematical Finance- Random

Variable, Distribution Functions

20.01.2020

1. Probability Distribution

2. Binomial Distribution

3. Normal Distribution

4. Brownian Motion

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1 Expectation,Variance, Covariance and Cor-
relation
Random variable is a function from Sample Space S into R.

Let X be a discrete r.v taking on values x1 , x2 , ..., xm

Expectation:
µ = E(X) = Σj xj P (X = xj ) which is also known as mean of X.

If h(X) is a function of X, E(h(X)) = Σj h(xj )P (X = xj )

E(X1 + X2 ) = E(X1 ) + E(X2 ), because

E(X1 + X2 ) = ΣΣ(xi + xj )p(xi , xj ) = Σi Σj xi p(xi , xj ) + Σj Σi xj p(xi , xj )

= E(X1 ) + E(X2 ) where p(xi , xj ) = P (X1 = xi , X2 = xj )

E(X1 ) = E(E(X1 |X2 )):

E(X1 ) = Σy (P (X2 = y)E(X1 ) (X1 |X2 = y)) = the expected value of
an expression of y, namely, E(X1 ) (X1 |X2 = y) which implies E(X1 ) =
E(X2 ) E(X1 ) (X1 |X2 )

Question: What is E(a) if a is a constant ?

Question: What is E(aX + bY ) where X and Y are r,v’s.

Question: E(X − µ) = ?

Variance:
V (X) = σ 2 = Σj (xj − µ)2 = E(X − µ)2 = E(X 2 ) − µ2

The positive value σ is standard deviation of X.

Question: V (X1 − X2 ) ?

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 Covariance:

X1 and X2 are independent if P (X1 ∈ A, X2 ∈ B) = P (X1 ∈ A)P (X2 ∈

B)

Let E(X1 ) = µ1 and E(X2 ) = µ2

Cov(X1 , X2 ) = E(X1 − µ1 )(X2 − µ2 )

E(X1 X2 ) = E(X1 )E(X2 ) if X1 ,X2 are independent

Show that Cov(X1 , X2 ) = 0 if X1 ,X2 are independent

V (X1 + X2 ) = V (X1 ) + V (X2 ), if X1 ,X2 are independent.

Correlation between X1 and X2 is ρ = √Cov(X1 ,X2 ) .

(V (X1 V (X2 ))

Using Cauchy-Schwarz inequality, (Cov(X1 , X2 ))2 ≤ V (X1 )V (X2 ), and

hence −1 ≤ ρ ≤ 1

If X1 is more likely to increase as X2 increases, then Cov(X1 , X2 ) is

positive and hence ρ is positive.

If X1 is more likely to decrease as X2 increases, then Cov(X1 , X2 ) is

negative and hence ρ is negative

Question: What happens to Cov. and Cor. when X1 decreases as X2

decreases ?

All the above results are true for any r.v’s, continuous or discrete.

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2 Probability Distribution
X is a r.v. Distribution function of X : F (x) = P (X ≤ x).

F (x) induces probability in the Sample Space R.

Question: What is P (x < X ≤ y) in terms of F (x) ?

For continuous r,v with density function is :f (x) = F ′ (x).

P (x ≤ X ≤ x + dx) = f (x)dx

Question: P (X = x) = ? if X is a continuous r.v.?

Tail distribution: Φ(x) = 1 − F (x)

∫∞ ∫∞
E(X) = 0 xf (x)dx = 0 Φ(x)dx for a nonnegative r.v. X.
√
Characteristif function (c.f) of X is f (t) = E(eitX ) where i = ( − 1)
(it)2
f (t) = 1 + (it)E(X) + 2!
E(X 2 + ...

c.f is unique foe each r.v.

c.f of aX1 + bX2 where the two r.v’s are independent, is the product of
their c.f’s. i.e f1 (at)f2 (bt).

Central Limit Theorem:

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Let Xi , i = 1, 2, ..., n are
√ n i.i.d variates with mean 0 and variance σ .
Let Let Yn = (ΣXi )/σ n.

If c.f of
√ Xn1 is f (t). Then c.f of Yn is:
f (t/σ n) = (1 − t /2n + o(t2 /n‘))n
2

nlog(f (t/n)) = nlog(1 − t2 /2n + o(t2 /n))− > −t2 /2

√
f (t/σ n)n − > e−t /2
2

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3 Normal Distribution
∫x 1
−(y−µ)2
1. F (x) = −∞ 2πσ
e 2σ 2 dy, E(X) = µ and V (X) = σ 2 .

2. A Normal variate Z with mean = 0 and s.d = 1 is called a standard

Normal variate
(X−µ)
3. σ
is a standardized Normal variate.

4. If X1 and X2 are Normal with means µ1 and µ2 respectively, and vari-

ances, σ12 and σ22 . Then aX1 + bX2 is Normal with mean aµ1 + bµ2 and
variance, a2 σ12 + b2 σ22
1 2 2
c.f of Normal variate is: f (t) = eitµ− 2 t σ

A positive r.v X for which log(X) is a Normal Variate is called lognor-

mal r.v.

Question: Prove the Central Limit Theorem item[] Z a standard Nor-

mal variate.
P (−1 ≤ Z ≤ 1) = .6826
P (−2 ≤ Z ≤ 2) = .9544
P (−3 ≤ Z ≤ 3) = .9974

Question: IQ examination scores for people in a region are normally

distributed with mean 100 and s.d 14.2. What is the probabilty that a
person from the region chosen at random has score greater than 130?

4 Binomial Distribution
The c.f of X taking on values 1 and 0 with probability p and q is:
f (t) = q + eit p

c.f of a Binomial variate with parameters n and p is:

(q + peit )n = ΣCrn pr eitr q n−r = E(eitX ).

E(X) = np
V (X) = npq

(X − np)/sqrtnpq is a standard Normal variate for large n

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 Question: A fair coin is tossed 100 times. What is the probability that
head appears fewer than 40 times ?

5 Stochastic Process
1. Stochastic Process:
A collction of r.v’s X(t) where t is a time parameter and any subset of
r.v’s X(ti ), i = 1, 2, ..., n has a joint probability distribution
is a stochastic process.

Process with independent increments:

For any two non-overlapping intervals of time, say, [t1 , t2 ] and [τ1 , τ2 ],
the r.v’s X(t2 ) − X(t1 )
and X(τ2 ) − X(τ1 ) are independent.

Examples are Poisson Process and Brownian Motion

5.1 Poisson Process

Events take place in the interval of time [0, t] at different time poins.
item[] X(t) is the number of events in [0, t] item[] X(t) is a Poisson r.v.

P (X(t) = n) = e−λt λtn /n!, n = 0, 1, ..., ∞

In a small interval of length dt, there cannot occur more than one event,

P (X(dt) = 0) = e−λdt (dt)0 /0! ∼

= (1 − λdt)
P (X(dt) = 1) = e−λdt (dt)/1! ∼
= (1 − λdt)dt ∼
= dt

Divide [0, t] into small intervals of size dt = t/n

Observe the process in the intervals, [0, dt], [dt, 2dt], ..., [(n − 1)dt, t].

In each interval event occurs or not is a Binomial r.v. Probability that

an event occurs is dt

Suppose starting from time 0, the first event occurs at time τ

Let the no. of dt’s in [0, τ ] be m which increses as n increases and dt

becomes smaller.

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 Probabilty of such a first event is (1 − λdt)m−1 dt = (1 − λτ
m
)m−1 λdt− >
−λτ
e λdt dt can be replaced by dτ both denoting a very small length of
interval. dτ = τ /m.

The first occurance time of an event is exponentially distrubuted with

parameter λ.

The inter-occurance time of events is exponentially distributed.

5.2 Brownian Motion

1.

Xy+t − Xy has the same distribution as Xt − X0 .

X(t), t ≥ 0 is a Normal r.v with mean µt and variance σ 2 t.
µ is called drift parameter and σ is known as volatility.
Divide the time interval [0, t] into n small intervals of length
∆ = t/n each. √
Consider a Binomial√ r.v which takes on value σ ∆ with
p =√(1/2)(1 + µ ∆) and
−σ ∆ with probabilty 1 − p √
The mean and variance of the above r.v, are (2p − 1)σ ∆ and (1 − (2p −
1)2 )σ 2 ∆. If Xi i.i.d binomial r.v’s as defined above, then Sn is distributed as
a Normal r.v with
mean µt and V (Sn ) = σ 2 t(1 − (2p − 1)2 ).
As n− > ∞, ∆− > 0 and hence Sn = X(n∆) = X(t) is a Normal r.v with
mean µt and variance σ 2 t.