BUAN 6312.

003 Applied Econometrics and Time Series Analysis

Assignment 1
Date: August 24th, 2020 Name: Swathi Vepachedu

P.4 In the U.S., the North and South are quite different. Below is the joint probability
distribution of political affiliation (R = Republican, I = Independent and D =
Democrat) for a Northern city and a Southern city.

Political Affiliation (PA)

R I D
Southern 0.24 0.04 0.12
Northern 0.18 0.12 0.30

(a) What is the probability of selecting a Republican given that we sample from the
Northern city? Show your calculation.
Conditional Probability: P(X = Republican | Y = Northern) = P(Republican, Northern)/P(Northern)
 0.18/0.60 = 0.3
Therefore, the probability of selecting a Republican given that we sample from the Northern city is 0.3

(b) Are political affiliation and region of residence statistically independent random
variables? Explain.
If political affiliation and region of residence are statistically independent then conditional pdf of PA and region of
residence will be the same as marginal pdf of PA alone for every pair of values of PA and region of residence,
f(x|y) = f(x,y)/fY(y) = fX(x) i.e., f(Republican | Southern) = f(Republican) and so on for all values
 For ex, lets consider X = Republican and Y = Southern,
f(Republican | Southern) = 0.24/0.40 = 0.6
f(Republican) = 0.24 + 0.18 = 0.42
 f(Republican | Southern) ≠ f(Republican)
Therefore, as f(Republican | Southern) is not equal to f(Republican), political affiliation and region of residence
are not statistically independence.

(c) Assign the values R = 0, I = 2 and D = 5 to political affiliation (PA). That is, if
a citizen is selected at random; the variable PA can take the values 0, 2 and 5. Find
the mathematical expectation of the random variable PA.
Expected Value of PA, E(PA) = R P(X = R) + I P(X = I) + D P(X = D)
With the assigned values of R = 0, I = 2 and D = 5,
E(PA) = (0 x 0.42) + (2 x 0.16) + (5 x 0.42) = 2.42
The mathematical expectation/expected value of the random variable PA is 2.42

(d) Find the expected value of X = 2PA + 2PA 2, where PA is the random variable
political affiliation.
E(X = 2PA + 2PA2) = E(2PA + 2PA2)

 2E(PA) + 2E(PA2) = 2 x 2.42 + 2[(R2 x P(R)) + (I2 x P(I)) + (D2 x P(D))]

4.84 + 2[(0 x 0.42) + (4 x 0.16) + (25 x 0.42)]
4.84 + 2(0 + 0.64 + 10.5) = 4.84 + (2 x 11.14)
 E(2PA + 2PA2) = 27.12

The expected value of 2PA + 2PA2 where PA is the random variable political affiliation is 27.12
P.12 Based on many years of experience, an instructor in econometrics has determined
that the probability distribution of X, the number of students absent on Mondays, is as
follows:

x 0 1 2 3 4 5 6 7
f(x) 0.02 0.03 0.26 0.34 0.22 0.08 0.04 0.01
P(Number of Students absent on Monday = x)

(a) Sketch the probability function of X.

Probability Function of X
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
0 1 2 3 4 5 6 7

Probability Function

(b) Find the probability that on a given Monday either 2, or 3 or 4 students will be
absent.
P(X = 2) + P(X = 3) + P(X = 4)
 0.26 + 0.34 + 0.22 = 0.82
The probability that on a given Monday either 2 or 3 or 4 students will be absent is 0.82

(c) Find the probability that on a given Monday more than 3 students are absent.
P(X > 3) = P(X = 4) + P( X = 5) + P(X = 6) + P(X = 7)
=> P(X >3) = 0.22 + 0.08 + 0.04 + 0.01 = 0.35
The probability that on a given Monday more than 3 students are absent is 0.35

(d) Compute the expected value of the random variable X. Interpret this expected
value.
E(X) = (0 x 0.02) + (1 x 0.03) + (2 x 0.26) + (3 x 0.34) + (4 x 0.22) + (5 x 0.08) + (6 x 0.04) + (7 x 0.01)
E(X) = 0.03 + 0.52 + 1.02 + 0.88 + 0.4 + 0.24 + 0.07 = 3.16
The expected value of the random variable X is 3.16
Interpretation: When we observe the number of absences on Monday many times, the values x = 0, 1, 2, .. , 7 will
appear 2%, 3%, 26%, .. , 1% of the time respectively. The arithmetic mean of all these values will approach 3.16 as
the number of observations becomes large. Therefore, the expected value of the random variable X, i.e., number
of students absent on Mondays, is the average value that occurs in many repeated trials of an experiment.

(e) Compute the variance and standard deviation of the random variable X.
Var(X) = σ2x = E(X2) - µ2
E(X2) = (02 x 0.02) + (12 x 0.03) + (22 x 0.26) + (32 x 0.34) + (42 x 0.22) + (52 x 0.08) + (62 x 0.04) + (72 x 0.01)
 E(X2) = 0.03 + 0.96 + 3.06 + 3.52 + 2 + 1.44 + 0.49 = 11.5
µ = (3.16)2 = 9.9856
2

Therefore, variance, Var(X) = σ2x = 11.5 – 9.9856 = 1.5144 and standard deviation, σx = √1.5144 = 1.23
(f) Compute the expected value and variance of Y = 7X + 3.
E(aX + b) = aE(X) + b
Therefore, E(7X + 3) = 7E(X) + b
 (7 x 3.16) + 3 = 25.12
Therefore, the expected value of Y = 7X + 3 = 25.12
Var(aX + b) = a2var(X) +b
 72 (1.5144) + 3 = (49x1.5144) + 3 = 77.2
Therefore, the variance of Y = 7X + 3 = 77.2

P.13 Suppose a certain mutual fund has an annual rate of return that is approximately
normally distributed with mean (expected value) 5% and standard deviation 4%. Use
Table 1, the table of cumulative probabilities for the standard normal distribution, for
parts (a)–(c).
(a) Find the probability that your 1-year return will be negative.
Z = (X - µ)/σ
=> Z = (0 – 5)/4 = -1.25
Therefore, the probability that 1-year return will be negative i.e., P(Z < 1.25) = 0.8944

(b) Find the probability that your 1-year return will exceed 15%.
Z = (15 – 5)/4 = 2.5
P(Z > 15) = 1 – 0.9938 = 0.0062
Therefore, the probability that 1 year return will exceed 15% i.e., P(Z > 2.5) = 0.0062

(c) If the mutual fund managers modify the composition of its portfolio, they can
raise its mean annual return to 7%, but will also raise the standard deviation of
returns to 7%. Answer parts (a) and (b) in light of these decisions. Would you
advise the fund managers to make this portfolio change?
If the mean and standard deviation of the annual return rises to 7%,
i. The probability that 1-year return will be negative is,
Z = (0 – 7)/7 = -1
The probability that 1-year return will be negative i.e., P(Z < 1) = 0.8413
ii. The probability that 1-year return will exceed 15% is,
Z = (15 – 7)/7 = 1.14
The probability that 1-year return will exceed 15% i.e., P(Z > 1.14) = 1 – 0.8729 = 0.1271
Based on the above findings, wherein, the probability of returns being negative are lower and returns exceeding
15% are higher with the change in composition of portfolio, I would advise the fund managers to make this
change.

P.14 An investor holding a portfolio consisting of two stocks, invests 25% of assets in Stock A
and 75% into Stock B. The return RA from Stock A has a mean of 4% and a standard
deviation of σA = 8%. Stock B has an expected return E(RB) = 8% with a standard
deviation of σB = 12%. The portfolio return is P = 0.25R A +0.75RB.
(a) Compute the expected return on the portfolio.
E(Portfolio) = E(0.25 RA + 0.75 RB) = 0.25 E(RA) + 0.75 E(RB)
E(Portfolio) = (0.25 x 4) + (0.75 x 8) = 1 + 6 = 7
Therefore, the expected return on the portfolio is 7%

(b) Compute the standard deviation of the returns on the portfolio assuming that the
two stocks’ returns are perfectly positively correlated.
Let us first calculate covariance,
Cov(RA, RB) = [correlation(RA, RB)] x (σRA) x (σRB)
  Since we are assuming that correlation is perfectly positive,
Cov(RA, RB) = 1 x 8 x 12 = 96
Now, we will calculate variance of portfolio,
Var(P) = Var[(0.25RA) + (0.75RB)]
Since Var(X+Y) = Var(X) + Var(Y) + 2cov(X,Y) and var(aX) = a 2Var(X),
Var(P) = (0.25)2 x 82 + (0.75)2 x 122 + 2 x 0.25 x 0.75 x 96
Var(P) = 4 + 81 + 36 = 121
Var(P) = σ2 = 121
 Standard deviation of portfolio = σ = √121 = 11
Therefore, assuming that the two stocks’ return are perfectly positively correlated, the standard deviation of the
portfolio is 11%

(c) Compute the standard deviation of the returns on the portfolio assuming that the
two stocks’ returns have a correlation of 0.5.
Cov(RA, RB) = 0.5 x 8 x 12 = 48
Var(P) = Var[(0.25RA) + (0.75RB)]
Since Var(X+Y) = Var(X) + Var(Y) + 2cov(X,Y) and var(aX) = a 2Var(X),
Var(P) = (0.25)2 x 82 + (0.75)2 x 122 + 2 x 0.25 x 0.75 x 48
Var(P) = 4 + 81 + 18 = 103
Var(P) = σ2 = 103
 Standard deviation of portfolio = σ = √103 = 10.15
Therefore, assuming that the two stocks’ return have a correlation of 0.5, the standard deviation of the portfolio
is 10.15%

(d) Compute the standard deviation of the returns on the portfolio assuming that the
two stocks’ returns are uncorrelated.
Cov(RA, RB) = 0 x 8 x 12 = 0
Var(P) = Var[(0.25RA) + (0.75RB)]
Since Var(X+Y) = Var(X) + Var(Y) + 2cov(X,Y) and var(aX) = a 2Var(X),
Var(P) = (0.25)2 x 82 + (0.75)2 x 122 + 2 x 0.25 x 0.75 x 0
Var(P) = 4 + 81 + 0 = 85
Var(P) = σ2 = 85
 Standard deviation of portfolio = σ = √85 = 9.22
Therefore, assuming that the two stocks’ return are uncorrelated, the standard deviation of the portfolio is
9.22%

P.18 Let X take 4 values x1 = 1; x2 = 3; x3 = 5; x4 = 3.

(a) Calculate the arithmetic average
Arithmetic average = x1 + x2 + x3 + x4 /4
 (1 + 3 + 5+ 3)/4 = 12/4 = 3
Therefore, arithmetic average = 3

(b) (x1 – average) + (x2 – average) + (x3 – average) + (x4 – average)

 (1-3) + (3-3) + ( 5-3) + ( 3-3) = -2 + 0 + 0 + 2 = 0

(c) (x1 – average)2 + (x2 – average) 2 + (x3 – average) 2 + (x4 – average) 2

 (1-3) 2 + (3-3) 2 + ( 5-3) 2 + ( 3-3) 2
 4+0+4+0=8

(d)(x1) 2 +(x2) 2 + (x3) 2+ (x4) 2 - n(average)2

 [(1)2 + (3)2 + (5)2 + (3)2] – 4 x (3)2
 (1 + 9 + 25 + 9) – 36
  44 – 36 = 8

P.18 (e) and P.19 in below picture