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1. Introduction: A probability distribution specify the probabilities of the possible outcomes of a random variable. Here, well study the use of the uniform, binomial, normal, and lognormal probability distributions in investment analysis. Some examples of its use are:  The Black-Scholes-Merton option pricing model  The Binomial option pricing model  The Capital asset pricing model Monte Carlo Simulation: Is a computer- based tool for solving complex investment problems. To use it the analyst need to identify the risk factors associated with the problem and the corresponding probability distributions. 2. Discrete Random Variables: Has a countable number of possible values. It can be a limited or unlimited number of outcomes. The key is that they are countable. At the other end Continuous Random Variables are not countable; we cant even define the possible outcomes because outcomes not included in the list will always be possible. Ex. Consider a random variable Z with a list of items, z1, z2, zn; an outcome of the form (z1+z2)/2 is possible even though it is not in the list. In most practical cases the probability distribution is just a mathematical ideal, an aproximate model of the relative frecuency of the possible outcomes of the random variable. Most of the time we have the choice between which probability distribution is more efficient for the task we are facing. Ex. Stocks traded in NASDAQ and NYSE quote in ticks of $0.01, since we know all possible outcomes it is a discrete random variable; however we can model (aproximate) the stock price using a continuous probability function (LOGNORMAL), as well see later in the chapter. Example 5.1 Pending Every random variable is associated with a probability distribution that completely describes it. Probability function: Specifies the probability that a random value X takes on a specific value x: P(X=x). If the random variable is discrete the notation used is p(x). For a continuous variable the probability function is called probability density function (pdf), and the notation used is f(x). Key properties of probability functions:  0p(x)1  The sum of the probabilities of all possible distinct outcomes must equal 1 Cumulative distribution function: Gives the probability of a range of values less than or equal to a particular value x, P(X x). The notation is F(x). To get F(x) we sum up the values of the probability function p(x) or f(x) for all outcomes less than or equal to x. Note that the cdf is related to the cumulative relative frecuency discussed in the chapter on statistical concepts. 2.1. The Discrete Uniform Distribution: Is the simplest of all. In this context, uniform mean that the probability for any value is the same. So, if the possible outcomes are integers from 1 to 8, then p(x) = 1/8 for all value of X. Table 5-1 summarizes the distribution P(X7) : From third column of table 5-1 the value is 0.875 = 87.5% P(4X6): F(6)-F(3) = p(4) + p(5) +p(6) = 0.125*3 = 0.375 = 37.5% P(4<X 6): p(5) + p(6) = 0.125*2 = 0.25 = 25% | F(6) F(4) = 0.750 0.500 = 0.25 = 25%

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Table 5-1 Probability Function and Cumulative Distribution Function for a Discrete Uniform Random Variable
X=x 1 2 3 4 5 6 7 8
Probability Fnction p(x) = P(X =x) Cumulative Distribution Function F(x) = P(Xx)

0.125 0.125 0.125 0.125 0.125 0.125 0.125 0.125

0.125 0.250 0.375 0.500 0.625 0.750 0.875 1.000

2.2. Binomial Distribution: For dealing with binary outcomes of the type success or failure. Example. Options pricing model developed in 1979 by Cox, Ross, and Rubinstein based on binary moves, price up or price down, for the underlying asset. Very important in the development of the derivatives industry. It is also used in the decision making process. Bernoulli random variable: Is the building block of the binomial distribution. Suppose we have a bernoulli trial (one experiment with only two possible outcomes), and let Y equal 1 when the outcome is succes and Y = 0 when the outcome is failure. Under this circunstances the probability function of the Bernoulli random variable Y is: p(1) = P(Y=1) = p p(0) = P(Y=0) = 1-p where p is the probability that the trial is a success. Example 5-2 One-Period Stock Price Movement as Bernoulli Random Variable Suppose we describe stock price movement in the following way. Stock price today is S. Next period stock price can move up or down. The probability of an up move is p, and the probability of a down move is 1-p. Thus, stock price is a Bernoulli random variable with probability of success (an up move) equal to p. When the stock moves up, ending price is uS, with u equal to 1 plus the rate of return of if the stock moves up. For example, if the stock earns 0.01 or 1% on an up move, u=1.01. When the stock moves down, ending price is dS, with d equal to 1 plus the rate of return if the stock moves down. For example, if the stock earns -0.01 or -1% on a down move, d=0.99. Figure 5-1 shows a diagram of this model of stock price dynamics. Figure 5-1 One-Period Stock Price as a Bernoulli Random Variable
End of Period Stock Price
Probability = p

Stock Price Moves Up: Stock Price Equals uS Stock Price Moves Down:

Stock Price Today, S

Probaility = 1- p

Stock Price Equals dS

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Example 5-3 A Trading Desk Evaluates Block Brokers (1). You work in equities trading as an institutional money manager that regularly trades with a number of block brokers. Blocks are orders to sell or buy that are too large for the liquidity ordinarily available in dealer networks or stock exchanges. Your firm has known interest in certain kinds of stock. Block brokers call your trading desk when they want to sell blocks of stocks that they think your firm may be interested in buying. You know that this transactions have definite risks. For example, if the brokers client (the seller of the shares) has unfavorable information on the stock, or if the total number he is selling through all channels is not truthfully comunicated to you, you may see an inmediate loss on the trade. From time to time your firm audits the performance of block brokers. Your firm calculate the post-trade, market-risk-adjusted dollar returns on stocks purchased from block brokers. On that basis, you classify each trade as unprofitable or profitable. You have summarized the performance of the brokers in a spreadsheet, excerpted in table 5-2 for November 2003. (The broker names are coded BB001 and BB002). Table 5-1 Block Trading Gains and Losses November 2003
Profitable Trades Losing Trades

BB001 BB002

3 5

9 3

Looking at each trade as a Bernoulli trial where the percentage of profitable trades is an estimate of p, the underlying probability of a profitable trade with each broker: BB001: 3/12 = 0.25 = 25% = the hat means it is an estimate BB002: 5/8 = 0.625 = 62.5% = Binomial random variable X: Is the number of successes in n Bernoulli trials. If the outcome of an individual trial is random, we can conclude that the total number of successes in n trials is also random; so, a binomial random variable is the sum of the Bernoulli random variables Yi , for i = 1,2,, n X = Y1+Y2++Yn where Yi is the outcome of the ith trial Assumptions of Binomial distribution:  The probability, p, of success is constant for all trials  The trials are independent So, a binomial random variable is completely described by two parameters: X ~ B(n,p) With this information we can now explore the probability that a binomial random variable shows x successes in n trials. Suppose we desire to model the dynamics of stocks price movements as a Bernoulli trial. If we make the time periods extremelly small we can model each time period as a bernoulli trial: With p = probability stock price moves up, 1-p the probability the price moves down, and x as the number of successes in n periods. That probability is given by the expresion: (5-1) P(X=x) = nCx px(1-p)n-x (See appendix I for derivation of formula) The binomial distribution is symmetric when the probability of success on a trial is 0.5, otherwise is asymmetric or skewed. Consider a random variable distributed B(n=5, p=0.50), the complete description of this random variable is given by table 5-3

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Table 5-3 Binomial Probabilities, p = 0.50 and n=5

Number of Up Moves, X 0 1 2 3 4 5 Number of Possible ways to Reach x Up Moves nCx 1 5 10 10 5 1 Probability of Each Way x n-x p (1-p) 0.500(1-0.50)5-0 = 0.03125 0.50 (1-0.50) = 0.03125 0.50 (1-0.50) = 0.03125 0.50 (1-0.50) = 0.03125 0.50 (1-0.50) = 0.03125 0.50 (1-0.50) = 0.03125
5 5-5 4 5-4 3 5-3 2 5-2 1 5-1

Probability P(X=x) x n-x nCx p (1-p) 0.03125 0.15625 0.31250 0.31250 0.15625 0.03125

F(X) = P(X x ) 0.03125 0.18750 0.50000 0.81250 0.96875 1.0000

What happens if we change the probabilities?

Number of Up Moves, X 0 1 2 3 4 5 Number of Possible ways to Reach x Up Moves nCx 1 5 10 10 5 1 Probability of Each Way x n-x p (1-p) x=0.10 0.100(1-0.10)5-0 = 0.59049 0.10 (1-0.10) = 0.06561 0.10 (1-0.10) = 0.00729 0.10 (1-0.10) = 0.00081 0.104(1-0.10)5-4= 0.00009 0.105(1-0.10)5-5= 0.00001
3 5-3 2 5-2 1 5-1

Probability of Each Way x n-x p (1-p) x=0.90 0.900(1-0.90)5-0 = 0.00001 0.90 (1-0.90) = 0.00009 0.90 (1-0.90) = 0.00081 0.90 (1-0.90) = 0.00729 0.904(1-0.90)5-4= 0.06561 0.905(1-0.90)5-5= 0.059049
3 5-3 2 5-2 1 5-1

Note that when the probability of success is lowered to 10%, 99.14% of the probabilities fall below x2. 1*0.59049 + 5*0.06561 + 10*0.00729 = 99.14%. So, the probability distribution is right skewed (long tail to the right).
At the other hand, if the probability of success is 90 (col 3) exactly the contrary occurs 99.14% of the values fall above x3.

Example 5-4 A Trading Desk Evaluates Brokers (2) You now want to evaluate the performance of the block brokers in example 5-3. You begin with two questions: 1. If you are paying a fair price in your trades with a broker, what should be the probability of a profitable trade. 2. Did each broker meet or miss that expectation on probability? You also realize that the brokers performance has to be evaluated in light of the sample size, and for that you need to use the binomial probability fn. You should address the following (referring to data in example 5-3): 3. Under the assumption that the prices of trades were fair: a. Calculate the probability of three or fewer profitable trades with broker BB001 b. Calculate the probability of five or more profitable trades with broker BB002. 1) Under a fair price I expect 50% of the trades to be profitable. 2) BB001 missed the mark, BB002 exceeded the mark. Solution 3: a) P(X3) = p(0) - p(1)-p(2)-p(3)

n=12

p=0.5 assumming a fair trade

P(X=0) = 12C0 (0.5)0(0.5)12-0 = 0.000244 P(X=1) = 12C1 (0.5)1(0.5)12-1 = 0.002930 P(X=2) = 12C2 (0.5)2(0.5)12-2 = 0.016113 P(X=3) = 12C3 (0.5)3(0.5)12-3 = 0.053711
P(X3) = 0.000244-0.002930-0.016113-0.053711 = 0.073

So, if you are receiving fair prices the probability of getting 3 or fewer profitable trades is only 7.3%

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b) P(X5) = 1-F(4) = p(5) + p(6)+p(7)+p(8)

P(X=5) = 8C5 (0.5) (0.5) = 0.21875 P(X=6) = 8C6 (0.5)6(0.5)8-6 = 0.10937 P(X=7) = 8C7 (0.5)7(0.5)8-7 = 0.03125 P(X=8) = 8C8 (0.5)8(0.5)8-8 = 0.00391
P(X5) = 0.21875 + 0.109375 + 0.03125 + 0.00391 = 0.363285

8-5

In a real life case you have also to consider the magnitude of the winning and losses
Tracking error: Is the total return on a portfolio(gross of fees) minus the total return on a benchmark index. Some managers use tracking error to describe what we later call tracking risk (the standard deviation of the differences between the portfolios and benchmarks returns) Example 5-5. Meeting Tracking Error Objective You work for a pension fund sponsor. You have assigned a new money manager to manage a $500 million portfolio indexed on the MSCI EAFE (Europe, Australasia, and Far East) Index, which is designed to measure developed-market equity performance excluding the United States and Canada. After research, you believe it is reasonable to expect that the manager will keep tracking error within a 75 basis points (bps) of the benchmarks return, on a quarterly basis. The manager meets the objective in six out of eight quarters. Of course, six out of eight quarters is 75% success rate. But how does a managers record precisely relate to your expectation of a 90% success rate and the sample size, 8 observations? So, you want to know the probability that, given a 90% success rate, you could get a performance as bad or worse than the one delivered and still be on track. P(X6) = F(6) = p(0) + p(1) + p(2) + p(3) + p(4) + p(5) + p(6) p(0) = 8C0 (0.90)0(0.10)8-0 = 0.00000001 p(1) = 8C1 (0.90)1(0.10)8-1 = 0.00000072 p(2) = 8C2 (0.90)2(0.10)8-2 = 0.00002268 p(3) = 8C3 (0.90)3(0.10)8-3 = 0.00040824 p(4) = 8C4 (0.90)4(0.10)8-4 = 0.00459270 p(5) = 8C5 (0.90)5(0.10)8-5 = 0.03306744 p(6) = 8C6 (0.90)6(0.10)8-6 = 0.14880348 P(X6) = 0.00000001 + 0.00000072 + 0.00002268 + 0.00040824 + 0.00459270 + 0.03306744 + 0.14880348 P(X6) = 0.186895 = 18.7% This result means there is a 18.7% probability that the manager is still able to meet the 75bps 90% of the time. Table 5-4 Mean and Variance of Binomial Random Variables
Mean Bernoulli, B(1,p) Binomial, B(n, p) p np Variance p(1-p) np(1-p)

A single bernoulli random variable have a value 1 with probability p, and a value 0 with probability (1-p). Its 2 2 2 weighted average value is p (p*1+(1-p)*0=p). Its variance can be calculated as: (Y)= E[(E-EY)] = p(1-p) + (12 p)(0-p) = p(1-p) A general binomial random variable, B(n,p), is the sum of n Bernoulli random variables, so its mean is np, and its variance is np(1-p) (assuming each trial is independent) Example: 2 B(n=5, p=0.5) = 5(0.5) = 2.5 = 5(0.5)(1-0.5) = 1.25 = 1.25 = 1.118

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= 5(0.1) = 0.5
2

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= 0.45 = 0.67

= 5(0.1)(1-0.1) = 0.45

Example 5-6. The Expected Number of Defaults in a Bond Portfolio Suppose as a bond analyst you are asked to estimate the number of bond issues expected to default over the next year in an unmanaged high yield bond portfolio with 25 U.S. issues from distint issuers. The credit ratings of the bonds in the portfolio are clustered arounf Moodys B2 / Standard & Poors B, meaning that the bonds are speculative with respect to the capacity tp pay interest and repay principal. The estimated annual default rate for B2/B rated bonds is 10.7% 1. Over the next year, what is the expected number of defaults in the portfolio, assuming a binomial model for defaults. 2. Estimate the estandard deviation of the number of defaults over the coming year. 3. Critique the use of the binomial probability model in this context. Solution 1: Lets define for each bond a Bernoulli random variable equal to 1 (the bond defaults during the year) and zero otherwise. With 25 bonds the expected number of defaults is: = np = 25*0.107) = 2.675 3 Solution 2: The variance is np(1-p) = (25)(.107) (1-0.107) = 2.3888, and the

= 2.3888

1/2

= 1.55

Solution 3: The binomial model assumes the trials are independent, in this context it means that the probabilities that a bond defaults are independent of the probabilities that any other bond defaults. Since issuing companies probably share the same economic environment that assumption is not entirely true but it is a good quick estimate. Consider stock price movement for 3 consecutive days, where each day is an independent trial. p is the constant probability the price move up. If the stock moves up, u is 1+ rate of return for an up move. The probability the stock moves down is 1-p, d is 1+ rate of return for a down move. Figure 5-2 is a binomial tree of the different scenarios for each of the 3 moves. Each node represent the potential value of the stock at a specific time.

Let the binomial random variable be the number of up moves. At node t=3 there is for possibilities for the price: uuuS, uudS, uddS, dddS. The probability that the stock price equals any of the possibilities is given by the binomial distribution. For example, to get to a final price of uud there is 3 routes: uud, duu, udu. Using the combination formula we get to the same result 3C2 = 3. The final probability is: p*p*(1-p)*S = p2(1-p). So P(S3 = uudS) = 3C2 p2(1-p) = 3 p2(1-p) where S3 is the sctock price after three moves. The final stock price is a function of the number of up moves, the initial stock price, and the size of the moves. The stock price itself might not be a binomial random variable but it is a function of the up moves, and up move is a binomial random variable. Check last paragraph

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3. Continuous Random Variables The totality of possible outcomes for a continuous random variable is never countable. Technically values can go from (-, +). You cant even tell the exact next number in the sequence. Here we focus in the normal and lognormal continuous distributions. 3.1. Continuous Uniform Distribution: (See appendix II for more info in this pdf) The pdf (probability density function)1 for a uniform random variable is:      

For example, with a=0, b=8, f(x) = 1/8. See the graph in figure 5-3. F(3) = P(0<X<3) = 3/8 = Example 5-7



3.2. The Normal Distribution Is probably the most extensively used probability distribution in quantitative analysis for modern portfolio theory and some risk management technologies. It was introduced by French Mathematician Abraham de Moivre in 1733. The normal standard distribution has the fllowing characteristics are: 1. Symmetrical and Bell shaped 2. Possible outcomes includes all real numbers (- to +). Tails extend limitless to the left and right 3. Described by 2 parameters: X~ N(, ) X follows a normal distribution with mean & stand dev. 4. Normal standard distribution has skewness of 0, and kurtosis of 3. 5. Excess kurtosis (kurtosis 3) is zero 6. Mean, median, and mode are all equal 7. Lineal combination of two or more normal random variables is also normally distributed Multivariate Normal Distribution: Specify the probabilities for a group of related random variables. This kind of distributions can be found in investment work. How? If you have a group of assets you can model the distribution of returns on each asset individually, or the distribution of returns on the assets as a group, taking into account all the statistical interrelationships among the return series. The multivariate normal distribution for the return on n stocks is defined by: 1. The mean returns of the individual assets 2. The variances of the securities 3. The pairwise correlations of the returns: n(n-1)/2 distint correlations

The Probability Density Function(PDF) of a continuous random variable is a function which can be integrated to obtain the probability that the random variable takes a value in a given interval

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Assume normally distributed returns: Portfolio returns are a weighted average of individual returns. A weighted average is a lineal combination. Thus, when returns are normally distributed it means individual assets returns are also normally distributed. Normal density function for one random variable:


5-3

Standard normal distribution: Have a = 0 and a =1. In such a case 5-3 simplifies to:

. Where z is the standarized

variable

In certain special circunstances the normal distribution can be considered and approximate model for returns. The normal distribution is a closer fit for quarterly and yearly holding period returns than it is for weekly and daily. Mainly, the problem is with fat tails (kurtosis>3), which means larger possibilities for extreme returns. Other case is skewness when dealing when dealing with portfolios heavy loaded in options. In general, normal distribution is less suited for asset prices than it is portfolio returns because prices have a lower limit of zero. Having stablished that the normal distribution is the right model for a variable under study the following probabilities apply: 1. About 50% of observations fall in the interval (2/3) 2. About 68% of observations fall in the interval 3. About 95% of observations fall in the interval 2 (exact is 1.96 ) 4. About 99% of observations fall in the interval 3 (exact is 2.58 ) Most of the time we have to rely on a sample thought to be representative of the population. So, we use the sample mean (   ) and sample standard deviation (s or ). Having stablished that the normal distribution is the right model for a variable under study the following probabilities apply: 1. 90% of observations for in the 90% confidence interval ( 1.65s) 2. 95% of observations for in the 95% confidence interval ( 1.96s) 3. 99% of observations for in the 99% confidence interval ( 2.58s) Example 5-8 Probabilities for a Common Stock Portfolio (1) You manage a U.S. core equity portfolio that is sector-neutral to the S&P 500 index (its industry sector weights approximately match the S&P 500s). Taking a weighted average of the projected mean returns on the holdings, you forecast a return of 12%. You estimate a standard deviation of annual return of 22%, close to the long figure for the SP500. For the year-ahead return on the portfolio, assuming normality for returns, you are asked the following: 1. Calculate and interpret a one standard deviation confidence interval for portfolio return return 2. Calculate and interpret a 90% confidence interval for portfolio return return 3. Calculate and interpret a 95% confidence interval for portfolio return return = 12%, s = 22% = 12 22 = [-10%, 34%] 1)  2)  1.65 = 12 1.65*22 = [-24.3%, 48.3%] 3)  1.96 = 12 1.96*22 = [-31.12%, 55.12%]

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So far we have dealt with specific confidence intervals to find the desired end points. However, we might be interested in others non standard intervals or we might want to know the probability of a specific return. Even though there exist as many standard distributions as pairs of means / standard deviations, and that we can answer any question regarding them if we have access to a spreadsheet or other statistical softwares, it would be nice to use a single normal distribution to answer any question about any mean / standard deviation pair. That can be achieved using the standard normal distribution. Standard Normal Distribution: Is a normal distribution with = 0 and =1. To use it we must first standarize our random variable. To standarize means to find to how many standard deviations is my observation from the mean. We call it Z; So,    For example, if we have a normal random variable , X, with = 5 and =1.5 [X~ N(, ) read X follows the 2 normal distribution with parameters and ], a value of 9.5 corresponds to a Z = (9.5-5)/1.5 = 3. This number means that the probability that we find a value as small or smaller than 9.5 for X~N(5,1.5) is exactly the same as the probability that well observe a value as small or smaller than 3 for Z~(0,1). How to compute in Excel: NORMSDIST(Z) NORMDIST(x, mean, standard_dev, cumulative)
2

cummulative = true, means cummulative area from left

Example 5-9. Probabilities for a Common Stock Portfolio (2) Recall that in example 5-8, the portfolio mena return estimate was 12% and the standard deviation of return estimate was 22% per year. Using these estimates, you want to calculate the following probabilities, assuming that a normal distribution describe returns. (You can use the excerpt from the table of normal probabilities to answer these questions). 1. What is the probability that portfolio return will exceed 20% 2. What is the probability that portfolio return will be between 12% and 20%? 3. You can buy a one-year T-bill that yields 5.5%. This yield is effectively a one year risk-free interest rate. What is the probability that your portfolios return will be equal to or less than the risk free rate? Solution 1: Let X be the portfolio return. 


P(Z>0.3636) P(Z>0.36) = 1- 0.6406 = 0.3594 36% Solution 2: Z12= (12-12)/22 = 0 Z20= (20-12)/22 = 0.36 P(Z12) = P(0) = 0.50% P(Z20) = P(0.36) = 0.6406 P(12%X20%) = 0.6406 0.50 = 0.1406 = 14.06% Solution 3: P(X5.5) ; Z5.5 = (5.5-12)/22 = -0.2955 = -0.30 P(Z -0.30 ) = 0.3821 38%

if normality assumption is accurate.

3.3. Applications of The Normal Distribution According to modern portfolio theory (MPT) the value of investment opportunities can be adequately measured in terms of the mean return and the variance of the return. The proposition that returns are at least approximately normally distributed plays a key role in MPT. In economic theory mean-variance analysis2 (MVA - discussed Theory of combining risky assets so as to minimize the variance of return (i.e., risk) at any desired mean return. The locus of optimal mean-variance combinations is called the efficient frontier, on which all rational investors desire to be positioned. It Was developed by Harry W. Markowitz in the 1950 s.
2

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in chapter on portfolios) works pretty well for risk-averse investors3. MVA considers risk symmetrically because captures variability in both sides of the mean. One approach that considers only shortfall risk is safety-first rules. It considers only the risk that a portfolio value fall below some minimum acceptable level over x time horizon. Roys Safety-First Criterion: Stablish that the optimal portfolio is the one that minimizes the probability of the return RP falling below a treshold level RL, minimizes P(RP < RL). If we let SFRATIO = [ E(RP)-RL ] / P. and assume that portfolio returns are normally distributed then the SFRATIO is the number of s that RL lies below the expected portfolio return E(RP). Note that E(RP)-RL is the distance from the mean return to the shortfall level; when divided by P we are expressing this distance in terms of standard deviations. The result is an standarized value that can use with the standard normal distribution to find the P(RP < RL). To choose portfolios using Roys criterion (assuming normality):4 1. Calculate each portfolio SFRatio 2. Choose the portfolio with the highest SFRatio For a portfolio with a given SFRatio, the probability that its return will be less than RL is N(-SFRatio). For example : Portfolio A: 12% return, = 15% Portfolio B: 14%, = 16% RL = 2% SFRatioA = (12-2)/15 = 0.667 SFRatioB = (14-2)/16 = 0.750 We choose the protfolio with largest SFRatio, in this case portfolio B. N(-0.75) = 0.227 22.7% SFRatio vs Sharpe Ratio: Sharpe Ratio = (Rp Risk-Free-Rate) / SFRatio = (Rp RL) / Sharpe ratio use Risk Free Rate while SFRatio uses RL Example 5-10 The Safety-First Optimal Portfolio for a Client. You are researching asset allocations for a client with an $800,000 portfolio. Although her investment objective is long-term growth, at the end of a year she may want to liquidate $30,000 of the portfolio to fund educational expenses. If that need arises, she would like to be able to take out the $30,000 without invading the initial capital o $800,000. Table 5-6 shows three alternative alloations. Assume normality for parts 2 and 3. Table 5-6 Mean and Standard Deviation for three alloation (in %)
A Expected annual return Standard deviation of return 25 27 B 11 8 C 14 20

1. Given the clients desire not to invade the $800k principal, what is the shortfall level, RL? Use this shortfall level to answer part 2. 2. According to the safety-first criterion, which of the three allocations is the best? 3. What is the probability that the return on the safety-first optimal portfolio will be less than the short fall level? Solution 1: RL = 30,000 / 800,000 = 3.75%

Investors that choose investments to maximize satisfaction and when either (1)returns are normally distributed, or (2) investors have quadratic utility functions (Mathematical representations of attitudes toward risk and return). Mean-variance can still be usefull when either assumption (1) or (2) is violated. 4 If we can find an asset offering a risk-free return> RL over the time horizon being considered, then it is optimal to be fully invested in this risk-free asset because given the nature of the risk-free rate asset we have 100% assurance that RP > RL

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Solution 2: SFRatio1 = (25-3.75)/27 = 0.787 SFRatio2 = (11-3.75)/8 = 0.9062 SFRatio3 = (14-3.75)/20 = 0.512

Best option

Solution 3: P(RP<RL) = P(11 < 3.75) = N(-0.91) = 0.1841 = 18.4%

3.4. The Lognormal Distribution We used the normal distribution to model portfolio returns. The lognormal distribution is used to model share and other assets prices. As an example, the black-shole option pricing model use the lognormal distribution. How to know if a random variable follows a lognormal distribution: If the natural logarith of the RV is normally distributed then the variable is lognormal. To remenber use the log is normal. Characteristics of Lognormal distribution: Figure 5-8 1. Accurately describe the distribution of prices of many financial assets 2. Bounded by zero to the left size. Remenber stocks are low bounded by 0. 3. Skewed to the right 4. Described by the and of the associated normal distribution, the mean and variance of ln Y

5. You need to keep track of two sets of and . The ones for Y and the ones for ln Y 6. L = 7.
2 L

Applications of lognormal distribution: 1. If continuously compounded return of a stock is normally distributed, then future stock price is lognormallly distributed. 2. If continuously compounded return of a stock is not normally distributed, still stock prices may be well described by the lognormal distribution. Theoretical Fundations for Using Lognormal Distribution to Model Prices:  where (r0,T) is the continuously compounded return from t=0 to t=1. How did we get to this formula? Suppose we have a series of equally spaced stock prices: So, S1, S2, , ST. So , is the current stock price so it is nonrandom because we already know it, but S1, S2, , ST are random because we have no way to know its

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], that is equivalent to S1/S0 = 1+ R0,1

value in advance. For any holding period the return is given by [

where R0,1 is the holding period return from period t=0 to t=1. In a more general form: A-1 St+1 / St = 1 + Rt,t+1. Contrary to a bank account a stock return is continually compounding during the holding period. Consider a holding period return, HPR = ers 1, for continuous compounding5; ln(HPR+1) = ln(ers) rs = ln(HPR+1) = (S1/S0). rs is the equivalent continuous compounding for any given holding period return. Example: If So = $30 and S1 = $34.50, then S1/S0 = 34.50/30 = 1.15. Therefore R0,1 = 15%. The equivalent contunuous compounding would be ln(1.15) = 13.98% = ln(S1/S0). Note that the continuous compounding is always smaller because of the efect of compounding. In a more general form we can say that A-2 r0,T = ln (ST/ S0). Appliying e at both sides we end up with: Eq we began with.     

Now, S1/S0 can also be expressed as the product of price relatives. ST/S0 = ST/ST-1 * ST-1 / ST-2 (S1 / S0) If we take natural logarithm at both sides Ln(ST / S0) = ln[ ST/ST-1 * ST-1 / ST-2 (S1 / S0) ] = ln(ST / ST-1) + ln(ST-1 / ST-2) + ln(S1 / S0)

Using Eq A-2

r0,T = rT-1,T + rT-2,T-1 + + r0,1

5-6

Earlier we learned to compute compounded returns multiplying (1+holding period) of smaller periods. What equation 5-6 means is that we can do the same adding continuously compounded returns of smaller periods.

3.5. s

Ln ers = rs

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Appendix I Introductory Mathematical Analysis Binomial Theorem: If n is a positive integer, then (a+b)n = nC0 an + nC1 an-1b + nC2 an-2b2 + + nCn bn . Where the coefficients of n are called binomial coefficients. This expression always result in n+1 terms. In terms of success / failure it can be re-written as: (q+p)n = nC0 qn + nC1 qn-1p + nC2 qn-2p2 + + nCn pn Bernoulli Trials: Trials in which we have only two possible outcomes (Success or Failure), and where the probability of success from trial to trial reains the same. Binomial Experiment: The distribution of the number of successes corresponds to the expansion of a power of a binomial. Binomial Distribution: Is the distribution of the number of successes in n trials of a binomial experiment, where any trial have a probability p of success and q of failure. If X is the number of successes then the distribution f for X is given by: f(x) = P(X=x) = nCxPxqn-x. 0 x n , q = 1-p, = np, and =

Example: Suppose you roll a fair die five times. What is the probability of exactly getting two 4 s? Solution: a) First, we have 5 independent trials. One outcome does not affect the next. b) The multiplication law can be used to obtain the probability of specific outcomes c) Consider a 4 as a success (S), and any other number as a failure(F). Suppose you get the secuence SSFFF; it can be considered as the interception of 5 independent events, and the probability can be obtained multiplicating the individual probabilities. For each success the probability is 1/6, for each failure it is 5/6 (=1-1/6). The probability of any sequence where I get 2 S s and 3 F s is (1/6)2(5/6)3. Now, in 5 trials I have 5C2 different combinations of 2 S s and 3F s, so the total probability is 5C2(1/6)2(5/6)3 Example 2: Suppose X is a binomial random variable with n=4 and p=1/3. Find the distribution of X. Solution: q = 1-p = 1-1/3 = 2/3

P(X=x) = nCx pxqn-x

for x = 0,1,2,3,4

P(X=0) = 4C0 (1/3)0(2/3)4-0 = 16/81 P(X=1) = 4C1 (1/3)1(2/3)4-1 = 32/81 P(X=2) = 4C2 (1/3)2(2/3)4-2 = 8/27 P(X=3) = 4C3 (1/3)3(2/3)4-3 = 8/81 P(X=4) = 4C4 (1/3)4(2/3)4-4 = 1/81 = np = 4(1/3) = 4/3 = (npq)1/2 = (2*1/3*2/3) = 0.94

32/81 8/27 16/81 8/81 1/81

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Determine the distribution f for the binomial random variable X if the number of trials is n, and p is the probability of success in any trial., also find and . P10.2-1 n=2 , p=1/4 P(X=0) = 2C0 (1/4)0(3/4)2-0 = 0.5625 P(X=1) = 2C1 (1/4)1(3/4)2-1 = 0.375 P(X=2) = 2C2 (1/4)2(3/4)0 = 0.0625 = np = 2(1/4) = 0.50 = (npq)1/2 = (2*1/4*3/4) = 0.6124 Determine the given probability if X is a binomial random variable, n is the number of trials, and p is the probability of success on any trial. P10.2-5 P(X=5), n=6, p=0.2 P(X=5) = 6C5 (0.2)5(0.8)1 = 0.001536 P10.2-10 P(X 2); n=6, p=2/3 P(X 2) = 1-P(X<2) = 1-P(X=0) P(X=1) P(X=0) = 6C0 (2/3)0(0.8)6-0 = 0.2621 P(X=1) = 6C1(2/3)1(1/3)6-1 = 0.165 P(X 2) = 1-0.2621-0.165 = 0.7214 P10.2-11 A fair coin is tossed 11 times. What is the probability that exactly 8 heads occurs? P(X=8), n=11, P=0.5 P(X=8) = 11C8 (0.5)8(0.5)11-8 = 0.0806 P10.2-13 An urn contains four red and six green marbles, and 4 marbles are randomly drawn in succession with replacement. Determine the probability that exactly one marble is green. Success: Green marble is selected P(X=1); n=4, p=6/10 P(X=1) = 4C1 (3/5)1(2/5)4-1 = 0.1536 P10.2-15 A manufacturer produces electrical switches, of which 2% are defective. From a production run of 50,000 switches, four are randomly selected and each is tested. Determine the probability that the sample contains exactly 2 defective switches. Round your answer to 3 decimal places. Assume that the four trials are independent and that the number of defective switches in the sample has a binomial distribution.

P(X=2), n=4, p=0.02 p is probability of defective switch P(X=2) = 4C2 (0.02)2(0.98)4-2 = 0.002 P10.2-21 The probability of a certain baseball player gets a hit is 0.300. Find the probability that if he goes to bat four times, he will get at least one hit. P(X 1), n=4, p=0.300 P(X=0) = 4C0 (0.3)0(0.7)4-0 = 0.2401 P(X 1) = 1 P(X=0) = 1-0.2401 = 0.7599 P10.2-22 A financial advisor claims that 60% of the stocks he recommend for purchase increase in value. From a list of 200 recommended stocks, a client select 4 at random. Determine the probability, rounded to two decimal places, that at least two of the choosen stocks increase in value. Assume that the selections of the stocks are independent trials and that the number of stocks that increase in value has a binomial distribution. Success: Stock increase in value P(X=2), n=4, p=0.60 P(X 2) = 1 P(X<2) P(X=0) = 4C0(0.60)0(0.40)4-0 = 0.03 P(X=1) = 4C1(0.60)1(0.40)4-1 = 0.15 P(X 2) = 1 0.03 0.15 = 0.82 P10.2-26 In a production process, the probability of a defective unit is 0.07. Suppose a sample of 20 units is selected at random. Let X be the number of defectives. a. Find the expected number of defective units b. Find Var(X) c. Find P(X 1). Round your answer to two decimal places. a. = np = 20*0.07 = 1.4 1 b. 2 = npq = 20*0.07*0.93 = 1.30 c. P(X=0) = 20C0(0.07)0(0.93)20-0 = 0.23 P(X=1) = 20C1(0.07)1(0.93)20-1 = 0.35 P(X 1) = 0.23+0.35 = 0.58 Cross Reference Problems: CRP-1 Suppose you have a deck of 52 cards and you get two cards in succession (with replacement). What is the probability both cards are aces? Prove your answer using basic probabilities and binomial theorem. There is 4 aces in the deck of 52 cards. The probability the first card is and ace is 4/52, after I replace the card

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The probability the second card is an ace remains the same: 4/52. If you let A=probability first card is an ace, and B = probability second card is also and ace, then we need to find P(A B) = P(A|B) P(B). Since both A and B are independent events P(A|B) = P(A) and P(A B) = P(A)*P(B) = (4/52) * (4/52) = 0.005917. Using binomial theorem: P = probability we get and ace = 4/52 = 1/13 q = probability we get any other card = 48/52 = 4/13 P(X = 2) = 2C2p2q2-2 = p2 = (1/13)2 = 0.005917 CRP-2 A state lottery pays the jackpot to anyone who correctly picks 6 numbers out of 42. What s the probability a particular combination of 6 numbers hit at least twice in a period of 50 years if the draws are held twice a week. P(X 2) = ? P(X 2) = 1-p(X=0)-p(X=1) n = 50*2*52 = 5,200 p = 1 / 42C6 = 1/5,245,786 q = 5,245,785/5,245,786 p(X=0) = 5200C0p0q5200-0 = (5,245,785/5,245,786)5200 = 0.9990 p(X=1) = 5200C1p1q5200-1 = 5200(p)1(q)5199 = 0.00099 P(X 2) = 1-0.9990-0.00099 = 0.00001 Now suppose you want to express that probability as odds: P(E) = 0.00001 = 1/100,000 P(E ) = 1-P(E) = 1-0.00001 = 0.99999 = 99,999/100,000 Odds =  

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Appendix II: Continuous Random Variable p852 Introductory Mathematical Analysis: Continuous random variables usually represent data that can be measured, such as: heigths, weights, times, distances, etc. A continuos variable can assume an infinite number of values in any given interval, but the probability of a single specific value is zero, as we ll prove in a moment. For example, suppose the life of a computer battery is within [0,1000] hours. X, the battery life, is said to be a continuous random variable because it can assume any value within that interval, but the probability of any specific value, such as 785.2452 is extremely remote. Now, consider a continuous RV X that falls within [0,2]. If we carry an experiment, what is the probability that X falls within [0,1]? Since [0,1] is half the length of [0,2] we can logically predict the probability is (50%). We can also say that the probability of falling within [0,1/2] is 25%, and so on, since each probability is just the length of the interval divided by the original interval [0,2]. This time consider a different escenario, make the original interval length equals 1 [0,1]. The probability, then, is just the length of the interval because anything divided by one remains equal. If you take the interval [0.2, 0.5], the probability is 0.3/1 = 0.3, for the interval [0.2, 0.20001] the probability is 0.0001, and so on. As you make the interval shorter the probability becomes smaller. If you take the limit of the interval [0.2, 0.2 + x] as x 0, at the limit, you will have the probability of a single point, and that probability is practically zero. So, in general, the probability that a continuous random variable assumes a single point is zero. As a conclusion the probability that X lies in any interval is not affected by whether or not we include any of the end points. Ex: P(X 4) = P(X<4) + P(X=4) P(X<4) + 0 = P(X<4) Figure A: Probability density function Figure A represents the probability that X assumes a value between a and b. P(a X b) = shaded area. The function f is called the probability density

function of X. So, we can define that: If X is a continuous RV, then a function y = f(x) is called a probability density function of X if and only if it has the following caracteristics: 1. f(x) 0 All area under the curve, between a and b, must be positive 2. 3. Figure B: Uniform density function The uniform density function is the simplest density function, one that is constant. Suppose that over the range [a,b]
     

P(a X b) =

We are dealing with probabilities total area has to be = 1  Any probability is the area between two points

The area under the curve is: p(c X d) = p(2<x<3) =   

Example: Suppose x is uniformly distributed over the interval [1,4] and we need to find p(2<x<3). a = 1, b=4, c=2, d=3



. So, for any range [c,d] in [a,b]

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Appendix III: The Normal Distribution Datamyte handbook Introductory Mathematical Analysis How It All Began: Began in 1798 when Witney won a contract to produce 10,000 muskets for the U.S. Gov for world war I. The conventional way to do a musket was custom made by a skilled craftsman. If a part was broken another has to be custom made. In need for fast supply Witney wanted a mass production process of interchangeable parts. It is believed that from the first run of 700 parts only 14 guns could be assembled. Dr. Walter A Shewhart: A physicist from Bell Labs that used its statistical knowledge to design a process for producing 100,000 radio headsets for army troops. He followed the following procedure: 1. Measured the head size of 10,000 troops 2. Built a frecuency histogram 3. Discovered the distribution of bars followed what is now known as a Bell shaped curve 4. He published a book and developed the Shewhart Control Chart (    What Shewhart discovered: 1. Variability to a manufacturing process is as normal as it is to the movement of particles in a fluid 2. No two things are exactly alike in nature and no two things can be ever made exactly alike by man 3. The key is to understand the causes of variability and have a method that is able to recognize them 4. There is two causes of variability: common causes and assignable causes Common Causes of Variability: Are those that occurs purely by chance. For example, consider the experiment of flipping a coin. In the short run the probability of a head or tail can be different than 50% but over the long run the statistic will meet the probability. It is an equal frequency distribution. At the other hand if we toos a pair of dies and observe the sum of the outcome we will observe that some sums occurs frequently than others. It is an example of an unequal frecuency distribution. For both cases we know are certain of the probability of the outcomes over the long run, that is what we know as a constant cause system. If we let a process run undisturbed it will behave as a constant/cause system. Assignable Causes of Variability: Causes of variation that are not the natural common causes, such as: change in materials, excessive tool wear, new operators. When we know the assignable causes of anything we can reduce the variability, improve quality, reduce costs, and increase return on investment. Dr W. E. Deming: Helped the war department implement statistical control for its suppliers. Postwar, little interest was shown by americans and Deming took his knowledge to japan where they listened and implemented them becoming a manufacturing superpower. The Normal Distribution: Can be entirely described by its mean and normal deviation as seen in figure A.

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Figure A: Normal Distribution 

Why is the Normal Distribution Important: We can compare a histogram of a process to it and draw conclusions about the capability of the process. However, before doing that we must be sure the process is stable over time. That prove stability can be achieved by: 1. Taking small groups of samples at selected intervals. 2. Measure and plot their avgs / ranges on a control chart The control chart provides indication of whether we have stable variation (constant-cause system), or a lack of stability due to assignable cuases. The reason why it works has to do with central limit theorem. (Chapter 2 Datamyte handbook). Central Limit Theorem: Shewhart found that the normal distribution curve appears when we plot the averages of subgroups from a constantcause system in form of histogram. Said another way: If I have a constant-cause system and take samples at different intervals, calculate the average of each sample, and plot them, what I will see is that the points fall along the edges or inside a bell shaped curve (always that the sample size is reasonably large, for most distributions, a normal distribution is approached very quickly as N increases). It doesn t matter if the system itself is not normally distributed. How Shewhart Proved it: 1. He put numbered chips in bowls. Chips on one bowl had normal distribution, other rectangular & last triangular 2. Took each chip out of a bowl, 1 at a time, recorded the number, put it back, mixed it, took another one and so on 3. Averaged every fourth 4. The points he plotted fell within or along the edges of the Bell shaped curve. This means a process can be monitored over time by measuring and averaging a standard group of parts. Subgroup size can be 2,4, 20 and frequency can be once a day, once an hour, depending on the process. This frequent checking of the averages allows me to detect when special causes of variation appears and keep the process in statistical control. Chating of ranges also helps monitoring of stability.

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Appendix IV Refreshing Math Fundamentals Introductory Mathematical Analysis Positive Integers: 1, 2, 3, Integers: -3, -2, -1, 0, 1, 2, 3 Rational Numbers: Can be written as ratio of two integers. Every integer is a rational with denominator equal 1 Irrational Numbers: Real Numbers: Non-repeating, non-terminatinating decimals that can t be written as ratio of integers. Ex: Rationals + irrationals

Equation: Statement that two expressions that are equal. The two expressions are called its sides. Functions: A function is a rule that exactly assigns to each input number one output number. The set of all input numbers to which the rule applies is called the domain of the function. The set of all output numbers is called the range. Lets leave Interest = 100(0.06)t, where t=time; the domain is t 0 because negative time makes no sense. A function doesn t have to be restricted to numbers (numeric functions). We can have a list of states and their capitals where each state has assigned exactly one capital. Independent Variables: Variable that represent input numbers for a function. Dependent Variables: Variable that represent output numbers. Its value dependeds in the independent variable, so it is a function of the independent variable. Not all mathematical relations adjust to the definition of a function. Ex. Y2 = X leads to two values for every X; if we let X=9, then Y = 3. So, even though there is a mathematical relation between X and Y we can t say that this relation is a function. Some equations in two variables can define either variable as a function of the other. Ex. Y= 2X can also be expressed as X = Y/2. Either way meets the definition of a function. Special Functions: Constant Function: function of the form h(x) = C, where C is a constant. Polynomial Function: f(x) = CnXn + Cn-1Xn-1 + + C1X + Co where Cn, Cn-1, , Co are 0. The number n is the degree of the polynomial; n has to be greater than 0. So, Y = X-1 is not a polynomial function. Lineal Functions: Are polynomial functions of degree 1 Quadratic Functions: Are polynomial functions of degree 2 Rational Functions: A function resultng from the quotient of two polynomial functions. Ex.

Compound Functions: The rule that specifies it includes more than one expression The domain is -1 s 8.





Exponential Functions: Are functions defined by f(x) = bx, where b >0 and 1, and x is any real number.

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Logarithmic Functions: Are functions defined by Y = logbx if and only if by = x where b >0 and 1. The domain consist of all positive integers (0, ) and the range consist of all real numbers (- , + ). Logarithmic and exponential functions are the inverse of each other. Properties of Logarithims: 1. Logb(mn) = logbm+ logbn 2. Logb(m/n) = logbm - logbn 3. Logbmr = r logbm 4. Logb(1/m) = - logbm 5. Logb 1 = 0 6. Logb(b) = 1 7. Logb(b)r = r 8. b Logbm = m 10logx = x 9. loge x = ln x

e lnx = x