FINA 6311: Mathematics for Finance

Chapter-2: Revision on Probability and Statistics

Hailegebriel Yirdaw(PhD)

Department of Economics

Addis Ababa University

School of Commerce

December 10, 2025

Mathematics for Finance Chapter 2 1 / 98

Chapter Overview
1 Introduction to Probability Theory Concepts

Sample Space and Events

Probability Axioms and Properties

Conditional Probability and Bayes' Formula

Random Variable

2 Discrete Distributions

The Bernoulli Distribution

The Binomial Distribution

The Geometric Distribution

The Poisson Distribution

3 Continuous Probability Distributions

The Uniform Distribution

The Exponential Distribution

The Gamma Distribution

The Normal Distribution

4 Expectation of a Random Variable

Expectation of a Discrete Random Variable

Expectation of Continuous Random Variable

5 Jointly Distributed Random Variables

6 Moment Generating Functions

7 Limit Theorems

Mathematics for Finance Chapter 2 2 / 98

Introduction to Probability Theory Concepts

Any realistic model of a real-world phenomenon must take

randomness into account.
Quantities of interest exhibit inherent variation and cannot
always be predicted deterministically.
This is usually accomplished by allowing the model to be
probabilistic in nature which requires probability theory
concepts.
Probability theory provides mathematical framework to model
such uncertainty.

Mathematics for Finance Chapter 2 3 / 98

Sample Space

Sample space (S) is the set of all possible outcomes of an

experiment.
Examples:
toss a coin: S = {H, T}, where H is the outcome of the toss
is a head and T is a tail .
Rolling a die: S = {1, 2, 3, 4, 5, 6}.
Toss two coins:S = {(H,H), (H,T), (T,H), (T,T)}
Lifetime of a car: S = [0,∞), here the sample space consists
of all nonnegative real number.

Mathematics for Finance Chapter 2 4 / 98

Events

An event (A) is any subset of the sample space (S).

Example: For tossing two coins, event (A =) "head appears on
rst coin"
A = {(H,H), (H,T)}.
For any two events A and B of a sample space S we dene the
new event using dierent Operations :
Union (A ∪ B),consisting of all outcomes which are both in A
and in B.
Intersection (A ∩ B),consisting of all outcomes which are both
in A and in B.
Complement (Ac = S \ A),consist of all outcomes in the
sample space S that are not in A.
Mutually exclusive if (A ∩ B = ∅).

Mathematics for Finance Chapter 2 5 / 98

Union and Intersection of n Events

Given events A1 , A2 , . . ., the union of these events is

∞
An = {ω | ω ∈ An for at least one n}
[

n=1

This means the union event consists of all outcomes that are in at
least one of the events An . Given events A1 , A2 , . . ., the
intersection of these events is
∞
An = {ω | ω ∈ An for all n}
\

n=1

This means the intersection event consists of all outcomes that are
in every one of the events An .

Mathematics for Finance Chapter 2 6 / 98

Exercise 1: Sample Space and Events

1 For an experiment of tossing two coins:

List the sample space (S).
Dene the event (B) = "at least one tail."
2 For rolling a die
List the sample space (S).
Dene the Event B : rolling even numbers
3 Tossing two coins:
List the sample space (S).
Event C : at least one head

Mathematics for Finance Chapter 2 7 / 98

Solution to Exercise 1

1 S = {(H,H), (H,T), (T,H), (T,T)}

Event (B =) "at least one tail" means: B = {(H,T), (T,H),
(T,T)}.
2 S = {1, 2, 3, 4, 5, 6},
Event B : rolling even numbers {2, 4, 6}
3 S = {HH, HT, T H, T T },
Event C : at least one head {HH, HT, T H}

Mathematics for Finance Chapter 2 8 / 98

Probabilities Dened on Events

A probability measure is a function P : A → R that assigns

a real number to each event A in the event space A, satisfying
the following axioms:



i) 0 ≤ P (A) ≤ 1
ii) P (S) = 1





iii) If A1 , A2 , . . . are mutually exclusive events, then
 P (S∞ A ) = P∞ P (A )

n=1 n n=1 n

Here, P (A) is called the probability of event A.

Mathematics for Finance Chapter 2 9 / 98

Example
Consider a fair six-sided die with equal likelihood for each outcome:
1, 2, 3, 4, 5, 6.
The event A = {2, 4, 6} represents getting an even number.
1 1 1 1
P (A) = P ({2}) + P ({4}) + P ({6}) = + + =
6 6 6 2
Complement Event
Let Ac be the complement of A, representing rolling an odd
number. Since A and Ac are mutually exclusive and exhaustive,
P (A ∪ Ac ) = P (S) = 1

By the axioms of probability,

P (A ∪ Ac ) = P (A) + P (Ac ) =⇒ 1 = P (A) + P (Ac )

Therefore, P (Ac ) = 1 − P (A) = 1 −

1
=
1
2 2
Mathematics for Finance Chapter 2 10 / 98
Example
Probability of a Union
For any two events (A) and (B),
P (A ∪ B) = P (A) + P (B) − P (A ∩ B).

Example
Tossing two coins with equally likely outcomes:
S = {(H, H), (H, T ), (T, H), (T, T )}.
Events: A is the rst coin falls head,B is the second coin falls head
A = {(H, H), (H, T )}, B = {(H, H), (T, H)},
Find P (A ∪ B).
1 1 1
P (A) = , P (B) = , P (A ∩ B) =
2 2 4
Then,
1 1 1 3
P (A ∪ B) = + − =
2 2 4 4
Mathematics for Finance Chapter 2 11 / 98
Probability of Union of Three Events

Inclusion-exclusion principle

The probability that any one of the three events A or B or C occurs may be calculated

as:

P (A ∪ B ∪ C) = P ((A ∪ B) ∪ C)
= P (A ∪ B) + P (C) − P ((A ∪ B) ∩ C)
= P (A) + P (B) − P (A ∩ B) + P (C) − P ((A ∩ C) ∪ (B ∩ C))
= P (A) + P (B) + P (C) − P (A ∩ B) − P (A ∩ C) − P (B ∩ C)
+ P (A ∩ B ∩ C)

This is known as the inclusion-exclusion principle for three events.

Mathematics for Finance Chapter 2 12 / 98

Conditional Probability
The probability of A occurring, given that B has occurred, is the
probability that both A and B occur, normalized by the probability
of B . Suppose A and B are two events with P (B) > 0.
Conditional probability of A given B :
P (A ∩ B)
P (A|B) =
P (B)

Example: Roll a fair six-sided die: - Event A: "Outcome is odd"

= {1, 3, 5} - Event B : "Outcome is ≤ 3" = {1, 2, 3}
Calculate P (A|B):

A ∩ B = {1, 3}

P (Outcome in {1, 3}) 2

6 2
P (A|B) = = =
P (Outcome in {1, 2, 3}) 3
6
3

Mathematics for Finance Chapter 2 13 / 98

Multiplication Rule and Law of Total Probability

The Multiplication Rule for two events A and B is:

(
P (A) · P (B | A)
P (A ∩ B) =
P (B) · P (A | B)

The Law of Total Probability for event A partitioned by B and

its complement B c is:

P (A) = P (A | B) · P (B) + P (A | B c ) · P (B c )

Mathematics for Finance Chapter 2 14 / 98

Multiplication Rule Example

Example
A box contains 12 pink balls and 6 blue balls. Two balls are drawn
one after the other without replacement.
Find the probability that both balls drawn are pink.

Mathematics for Finance Chapter 2 15 / 98

Multiplication Rule ...

Solution
Let event A be drawing a pink ball rst, and event B be drawing a
pink ball second. 12 2
P (A) = =
18 3
Since the rst ball is not replaced, there are now 11 pink balls left
out of 17 balls total. Therefore,
11
P (B|A) =
17
By the multiplication rule,
2 11 22
P (A ∩ B) = P (A) × P (B|A) = × = ≈ 0.4314
3 17 51
So, the probability that both drawn balls are pink is approximately
0.4314 or 43.14%.

Mathematics for Finance Chapter 2 16 / 98

Bank Credit Default case

Example
A hypothetical bank is considering extending credit to a new
customer. The bank wants to assess the probability that the
customer will default on the loan.
Based on historical data:
There is a 5% chance that a customer who has overdrawn an
account will default.
There is a 0.5% chance that a customer who has never
overdrawn will default.
The bank does not know whether the customer will overdraw her
account, but based on background checks, they estimate a 30%
chance she will overdraw.
Calculate the probability that the customer will default if credit is
extended.

Mathematics for Finance Chapter 2 17 / 98

Bank Credit Default Case
Solution
Given:
A = customer defaults on the loan
B = customer overdraws her account
P (A|B) = 0.05, probability defaults given overdraw
P (A|B c ) = 0.005, probability defaults given no overdraw
P (B) = 0.3, probability of overdraw
Using the Law of Total Probability:
P (A) = P (A|B) · P (B) + P (A|B c ) · P (B c )
= (0.05)(0.3) + (0.005)(1 − 0.3)
= 0.015 + 0.0035
= 0.0185
So, the probability that the customer will default if credit is
extended is approximately 0.0185 or 1.85%.
Mathematics for Finance Chapter 2 18 / 98
Bayes' Rule
Let A and B be events.
P (A ∩ B)
P (B | A) =
P (A)
We may express A as
A = (A ∩ B) ∪ (A ∩ B c )
Since A ∩ B and A ∩ B c are mutually exclusive, we have that
P (A) = P (A ∩ B) + P (A ∩ B c )
Using conditional probabilities,
P (A) = P (A | B)P (B) + P (A | B c )P (B c )
From the preceding two expressions, it follows that
P (A | B)P (B)
P (B | A) =
P (A | B)P (B) + P (A | B c )P (B c )
Mathematics for Finance Chapter 2 19 / 98
Example: Multiple Choice Test

Example
In answering a question on a multiple-choice test ,a student either
knows the answer or guesses. Let p be the probability that she
knows the answer and 1 − p be the probability that she guesses.
Assume that a student guessing will be correct with probability
1/m, where m is the number of alternatives.
What is the conditional probability that the student knew the
answer given that she answered correctly?

Mathematics for Finance Chapter 2 20 / 98

Solution: Multiple Choice Test
Solution
Dene events:
K = student knows the answer P (K) = p

G = student guesses P (G) = 1 − p

C = student answers correctly
Given: P (C|K) = 1, P (C|G) =
1
m
Total probability of answering correctly:
1−p
P (C) = P (C|K)P (K) + P (C|G)P (G) = p +
m
By Bayes' theorem, the conditional probability is:
P (C|K)P (K) p
P (K|C) = =
P (C) p + 1−p
m

Mathematics for Finance Chapter 2 21 / 98

Random Variable

The class of events F (called a σ -algebra or σ -eld) satises

closure properties such that usual set operations keep us within F :
(a) Ω ∈ F , where Ω is the sample space.
(b) If A ∈ F , then Ac ∈ F .
(c) If An ∈ F for all n = 1, 2, . . ., then ∞n=1 An ∈ F .
S

It follows that F is also closed under countable intersections,

complements of unions, etc.

Mathematics for Finance Chapter 2 22 / 98

Denition of a Random Variable

A random variable is a mathematical function that assigns a

numerical value to each outcome in the sample space of a
random experiment.
It provides a way to quantify the outcomes of probabilistic
events.
Let X be a function from a probability space (Ω, F, P ) into
the real numbers R.
We say X is measurable (and call it a random variable) if for
each x ∈ R,
{ω : X(ω) ≤ x} ∈ F.
Since events in F have assigned probabilities, this allows us to
nd
P (X ≤ x)
for any x ∈ R.

Mathematics for Finance Chapter 2 23 / 98

Indicator Random Variable

An indicator random variable is a special type of random

variable used in probability theory to represent whether a
specic event occurs or not.
It takes the value 1 if the event [Link] takes the value 0 if
the event does not occur.
For an arbitrary set A ∈ F , dene the indicator random
variable IA (ω) by

1 if ω ∈ A,
(
IA (ω) =
0 otherwise.

This variable indicates membership of ω in A and is itself a

random variable.

Mathematics for Finance Chapter 2 24 / 98

Example 1

Tossing Two Fair Coins

Let X denote the number of heads appearing when tossing two fair
coins. Then X is a random variable taking values 0, 1, or 2 with
probabilities:
1
P (X = 0) = P (T,T) =
4
1
P (X = 1) = P (H,T or T,H) =
2
1
P (X = 2) = P (H,H) =
4

Mathematics for Finance Chapter 2 25 / 98

Example 2: Tossing a Coin Until First Head
Consider tossing a coin with probability p of heads, repeatedly until
the rst head appears.
Let X be the number of ips required. Then X can take values
1, 2, 3, . . . with probabilities:

P {X = 1} = P {H} = p

P {X = 2} = P {(T, H)} = (1 − p)p

P {X = 3} = P {(T, T, H)} = (1 − p)2 p
..
.
P {X = x} = P {(T, T..., T, H)} = (1 − p)x−1 p, x ≥ 1.
Check sum of probabilities:
∞ ∞
X X 1
P (X = x) = (1 − p)x−1 p = p · =1
1 − (1 − p)
x=1 x=1

Mathematics for Finance Chapter 2 26 / 98

Example 3: Indicator Random Variable for Battery Life

Suppose an experiment observes the lifetime of a battery.

Dene the random variable I by:

1, if battery life ≥ 2 years

(
I=
0, otherwise

Here, I is the indicator random variable for the event E : "battery

lasts at least two years".

Mathematics for Finance Chapter 2 27 / 98

Random variable...

In general functions of one or more random variables gives us

another random variable (provided that function is
measurable).
For example, if X1, X2 are random variables, so is X1+X2,
X1X2, min{X1,X2} .
The cumulative distribution function (or more simply the
distribution function) F (.) of a Random variable X is dened
to be the function
P (X ≤ x)
for any x ∈ R.
There are two types of distributions considered here, discrete
distributions and continuous ones.

Mathematics for Finance Chapter 2 28 / 98

Discrete Distributions
Discrete distributions are those whose cumulative distribution
function at any point x can be expressed as a nite or countable
sum of values. For example,
X
F (x) = pi
Xi ≤x

for some probabilities pi which sum to one.

The cumulative distribution in this case is piecewise constant, with
jumps at the values xi that the random variable can assume.
The values of those jumps are the individual probabilities pi .
For example, P (X = x) is equal to the size of the jump in the
graph of the cumulative distribution function at the point x.
We refer to the function
f (x) = P (X = x)

as the probability function of the distribution when the distribution

is discrete.
Mathematics for Finance Chapter 2 29 / 98
Example of CDF for Discrete Distribution

Suppose X has a probability mass function given by

1 1 1
p(1) = , p(2) = , p(3) = .
2 3 6
Then the cumulative distribution function F of X is



0, x<1
1,

1≤x<2
F (x) = 25


 6, 2≤x<3

1, x≥3

Mathematics for Finance Chapter 2 30 / 98

The Bernoulli Distribution

Consider an experiment with an outcome classied as either a

success or a failure.
Dene the random variable X by

1, if the outcome is a success

(
X=
0, if the outcome is a failure

The probability mass function of X is given by

p(0) = P (X = 0) = 1 − p, p(1) = P (X = 1) = p,

where 0 ≤ p ≤ 1 is the probability of success.

A random variable X with this PMF is said to be a Bernoulli
random variable.

Mathematics for Finance Chapter 2 31 / 98

The Binomial Distribution
Consider n independent trials, each resulting in a "success" with
probability p and a "failure" with probability 1 − p.
Let X be the number of successes in these n trials. Then X is a
binomial random variable with parameters (n, p).
The probability mass function of X is given by
 
n x
p(x) = P (X = x) = p (1 − p)n−x , x = 0, 1, 2, . . . , n,
x
where  
n n!
=
x x!(n − x)!
is the number of dierent groups of x successes from n trials.
This PMF gives the probability of exactly x successes occurring.
For example, if n = 3 and x = 2, then
 
3
= 3,
2
which counts the number of sequences with two successes and one
failure. Mathematics for Finance Chapter 2 32 / 98
Example: Binomial Probability Calculation
Suppose an item produced by a machine is defective with
probability 0.1, independently of others.
Let X be the number of defective items in a sample of 3 items.
Then X is a binomial random variable with parameters
(n = 3, p = 0.1).
We want the probability that at most one item is defective:
P (X ≤ 1) = P (X = 0) + P (X = 1).
Using the binomial PMF,
 
3
P (X = 0) = (0.1)0 (0.9)3 = (1)(1)(0.729) = 0.729,
0
 
3
P (X = 1) = (0.1)1 (0.9)2 = (3)(0.1)(0.81) = 0.243.
1
Therefore,
P (X ≤ 1) = 0.729 + 0.243 = 0.972.
Note: If X is binomial with parameters (n, p), we say X has a
binomial distribution B(n, p).
Mathematics for Finance Chapter 2 33 / 98
The Geometric Distribution
Consider independent trials, each with probability p of success,
performed until the rst success occurs.
Dene the random variable X as the number of trials required until
the rst success.
Then X is a geometric random variable with parameter p.
The probability mass function of X is given by
p(x) = P (X = x) = (1 − p)x−1 p, x = 1, 2, 3, . . .

This follows because for X = x, the rst x − 1 trials must be

failures and the x-th trial a success, assuming independence.
To verify that p(x) is a valid probability mass function:
∞ ∞ ∞
X X X 1
p(x) = (1 − p)x−1 p = p (1 − p)x = p · = 1.
1 − (1 − p)
x=1 x=1 x=0

Mathematics for Finance Chapter 2 34 / 98

The Poisson Distribution
A random variable X taking values 0, 1, 2, . . . is said to be Poisson
distributed with parameter λ > 0, if its probability mass function is
e−λ λx
p(x) = P (X = x) = , x = 0, 1, 2, . . .
x!
This PMF satises
∞ ∞
X X λx
p(x) = e−λ = e−λ eλ = 1.
x!
x=0 x=0
An important property of the Poisson distribution is that it can
approximate a binomial distribution with parameters (n, p) when n
is large and p is small.
Let X be binomial with parameters (n, p), and let λ = np. Then,
e−λ λx
 
n x
P (X = x) = p (1 − p)n−x ≈
x x!
for large n and small p.
This follows from approximations:
λ n!
(1 − )n → e−λ , and → 1 as n → ∞.
n (n − x)!nx
Mathematics for Finance Chapter 2 35 / 98
Example: Radioactive Decay and Poisson Distribution
Consider counting the number of α-particles emitted in one second
by one gram of radioactive material.
If the average number of α-particles emitted is λ = 3.2, then the
number of emitted particles X is a Poisson random variable with
parameter λ.
We want the probability that no more than two α-particles will
appear:
P (X ≤ 2) = P (X = 0) + P (X = 1) + P (X = 2).

Using the Poisson PMF:

e−λ λx
P (X = x) = ,
x!
we calculate:
3.2 3.22
 
−3.2
P (X ≤ 2) = e 1+ + ≈ 0.38.
1! 2!

Mathematics for Finance Chapter 2 36 / 98

Continuous Probability Distributions
A random variable X whose set of possible values is uncountable is
called a continuous random variable.
There exists a nonnegative function f (x), dened for all real
x ∈ (−∞, ∞), called the probability density function (PDF) of
X , such that for any set B ⊂ R, Z
P (X ∈ B) = f (x) dx.
B
Since X must assume some value, the PDF satises the
normalization condition Z ∞
f (x) dx = 1.
−∞

If B = [a, b], then

Z b
P (a ≤ X ≤ b) = f (x) dx.
a
If a = b, then Z a
P (X = a) = f (x) dx = 0.
a
Mathematics for Finance Chapter 2 37 / 98
Cumulative Distribution Function (CDF)

The cumulative distribution function F (x) of continuous X is

dened by Z x
F (x) = P (X ≤ x) = f (u) du.
−∞

Dierentiating the CDF yields the PDF,

d
F (x) = f (x).
dx
Intuitively, for small ε > 0,
 ε ε
P a− ≤X ≤a+ ≈ εf (a).
2 2
Thus, f (a) measures how likely X is near a.

Mathematics for Finance Chapter 2 38 / 98

The Uniform Distribution

A random variable X is said to be uniformly distributed over the

interval (a, b) if its probability density function (pdf) is

if a < x < b,
(
1
f (x) = b−a ,
0, otherwise.
For any a < c < d < b, the probability that X lies in the interval
[c, d] is
d
d−c
Z
1
P (c ≤ X ≤ d) = dx = .
c b−a b−a

Mathematics for Finance Chapter 2 39 / 98

CDF of Uniform Distribution

For a random variable X uniformly distributed over (a, b), the

cumulative distribution function F (x) is:


Z x 0,
 x ≤ a,
F (x) = P (X ≤ x) = f (u) du = x−a
, a < x < b,
−∞  b−a
1, x ≥ b.


Mathematics for Finance Chapter 2 40 / 98

The Exponential Distribution

A continuous random variable X with parameter λ > 0 is said to

have an exponential distribution if its probability density function
(pdf) is (
λe−λx , x ≥ 0,
f (x) =
0, x < 0.
The cumulative distribution function F is
Z x
F (x) = P (X ≤ x) = λe−λu du = 1 − e−λx , x ≥ 0.
0

Note that Z ∞
λe−λx dx = 1.
0

Mathematics for Finance Chapter 2 41 / 98

The Gamma Distribution

A continuous random variable X with parameters a > 0 and λ > 0

is said to have a Gamma distribution if its probability density
function (pdf) is:
λa a−1 −λx
(
Γ(a) x e , x ≥ 0,
f (x) =
0, x < 0,

where Γ(a) is the Gamma function dened by

Z ∞
Γ(a) = e−x xa−1 dx.
0

The Gamma function generalizes the factorial function with the

property Γ(n) = (n − 1)! for positive integers n.

Mathematics for Finance Chapter 2 42 / 98

The Normal Distribution
A random variable X is said to be normally distributed with
parameters µ (mean) and σ 2 (variance) if its probability density
function is given by
 2 !
1 1 x−µ
f (x) = √ exp − , −∞ < x < ∞.
σ 2π 2 σ
An important property is that if X ∼ N (µ, σ 2 ), then for constants
a > 0 and b, the random variable
Y = aX + b
is also normally distributed with parameters
Y ∼ N (aµ + b, a2 σ 2 ).
The cumulative distribution function (CDF) of Y is related to that
of X by
   
y−b y−b
FY (y) = P (Y ≤ y) = P X ≤ = FX .
a a
Mathematics for Finance Chapter 2 43 / 98
Expectation: Denition

Expectation (or mean) of a random variable X is the average

or long-run value.
For discrete X :
X X
E(X) = xP (X = x) = xp(x)
x x

For continuous X with pdf f (x):

Z ∞
E(X) = xf (x)dx
−∞

Mathematics for Finance Chapter 2 44 / 98

Properties of Expectation

E(a) = a for constant a.

Linearity: For random variables X, Y and constants a, b,
E(aX + bY ) = aE(X) + bE(Y )

If X and Y are independent, E(XY ) = E(X)E(Y ).

Independence: p(x, y) = pX (x) · pY (y)

XX
E(XY ) = xy · pX (x)pY (y)
x y

ypY (y) (separate sums)

X X
= xpX (x)
x y

= E(X) · E(Y )

Mathematics for Finance Chapter 2 45 / 98

Variance

Measures spread of X :
V ar(X) = E (X − E(X))2 = E(X 2 ) − [E(X)]2

Properties:
V ar(aX + b) = a2 V ar(X)

Mathematics for Finance Chapter 2 46 / 98

Expectation of a Discrete Random Variable

For a discrete random variable X with probability mass

function p(x), the expected value (or mean) is dened as
X
E(X) = x p(x).
{x:p(x)>0}

Example: Suppose X is the outcome of rolling a fair six-sided

die. Then
1
p(1) = p(2) = . . . = p(6) = .
6
The expectation is
6
X 1 1 21
E(X) = x· = (1 + 2 + 3 + 4 + 5 + 6) = = 3.5.
6 6 6
x=1

Mathematics for Finance Chapter 2 47 / 98

Expected Value of a Binomial ...
Rewrite the sum indices using k = x − 1:
n−1
X 
n−1 k
E(X) = np p (1 − p)(n−1)−k .
k
k=0

By the Binomial Theorem,

n−1
X 
n−1 k
p (1 − p)n−1−k = (p + (1 − p))n−1 = 1.
k
k=0

Therefore,
E(X) = np × 1 = np.
Hence, the expected value of a binomial random variable is

E(X) = np .

Mathematics for Finance Chapter 2 48 / 98

Expected Value of a Geometric Random Variable
Let X be a geometric random variable with parameter p, i.e.,
P (X = x) = p(1 − p)x−1 for x = 1, 2, . . ..
The expected value E(X) is∞dened as
X
E(X) = xp(1 − p)x−1 .
x=1
Set q = 1 − p. Then, ∞
X
E(X) = p xq x−1 .
x=1
Note∞that ∞
!  
X
x−1 d X
x d q 1
xq = q = = .
dq dq 1−q (1 − q)2
x=1 x=1
Therefore, 1 1 1
E(X) = p · 2
=p· 2 = .
(1 − q) p p
Hence, the expected number of trials until the rst success is
1
E(X) = .
p
Mathematics for Finance Chapter 2 49 / 98
Expected Value of a Poisson Random Variable
Let X be a Poisson random variable with parameter λ > 0,
with probability mass function
λx
P (X = x) = e−λ , x = 0, 1, 2, . . . .
x!
The expected value E(X) is
∞
X λx
E(X) = xe−λ .
x!
x=0
Since the term for x = 0 is zero, we start the sum from x = 1:
∞ ∞
X λx X λx−1
E(X) = e−λ x = e−λ λ .
x! (x − 1)!
x=1 x=1
Let k = x − 1, then
∞
X λk
E(X) = λe−λ = λe−λ eλ = λ.
k!
k=0
E(X) = λ .
Mathematics for Finance Chapter 2 50 / 98
Expectation of Continuous Random Variable

X is a continuous random variable if it takes values over

intervals of R.
Probability density function (pdf) f (x) satises:
Z ∞
f (x) ≥ 0, f (x)dx = 1.
−∞

Probability that X lies in interval A:

Z
P (X ∈ A) = f (x)dx.
A

Cumulative distribution function (cdf):

Z x
F (x) = P (X ≤ x) = f (t)dt.
−∞

Mathematics for Finance Chapter 2 51 / 98

Expectation of Uniform Distribution

Continuous uniform on [a, b], a < b.

Pdf:
1
f (x) = , a ≤ x ≤ b.
b−a
Expectation and variance:
a+b
E(X) = ,
2
(b − a)2
V ar(X) = .
12

Mathematics for Finance Chapter 2 52 / 98

Continuous Uniform Distribution Example
Example
Suppose X is the time (in minutes) to travel from home to
university, uniformly distributed on [10, 40].
PDF: f (x) = 1
40−10 = 30 ,
1
10 ≤ x ≤ 40
Expectation:
10 + 40
E(X) = = 25 minutes
2
(Average travel time)
Variance:
(40 − 10)2 302
V ar(X) = = = 75
12 12
√
Standard deviation: 75 ≈ 8.66 minutes
Interpretation
On average, expect 25-minute travel with typical variation of ±8.66
minutes.
Mathematics for Finance Chapter 2 53 / 98
Expectation of Exponential Distribution

Models waiting time between events in Poisson process.

Pdf:
f (x) = λe−λx , x ≥ 0, λ > 0.
Cdf:
F (x) = 1 − e−λx , x ≥ 0.
Expectation and variance:
1 1
E(X) = , V ar(X) = .
λ λ2

Example
Bus arrivals: λ = 0.2/min =⇒ E(X) = 5 min, V ar(X) = 25

Mathematics for Finance Chapter 2 54 / 98

Expectation of Gamma Distribution

Generalization of exponential distribution.

Pdf: r λ
f (x) = xr−1 e−λx , x ≥ 0, r, λ > 0,
Γ(r)
where Γ(r) is the gamma function.
Expectation and variance:
r r
E(X) = , V ar(X) = .
λ λ2

Mathematics for Finance Chapter 2 55 / 98

Expectation of Normal (Gaussian) Distribution

Pdf:
(x − µ)2
 
1
f (x) = √ exp − , x∈R
2πσ 2 2σ 2
Parameters: mean µ, variance σ 2 .
Expectation and variance:
E(X) = µ, V ar(X) = σ 2 .

Standard normal: µ = 0, σ 2 = 1.

Mathematics for Finance Chapter 2 56 / 98

Exercise:
Discrete Expectation
Let X be a discrete RV with pmf:

0.2 x = 1

p(x) = 0.3 x = 2

0.5 x = 3


Calculate E(X) and V ar(X).

Uniform Expectation
Let X ∼ U (0, 2) uniform. Find E(X) and V ar(X).

Exponetial Expectation
Suppose X is exponentially distributed with parameter λ = 0.5.
Calculate: E(X) and V ar(X).
Mathematics for Finance Chapter 2 57 / 98
Joint Distribution Functions

We are often interested in probability statements concerning

two or more random variable
For two random variables (X) and (Y), the joint distribution
species probabilities for pairs ((X=x, Y=y)).
Joint pmf for discrete random variables:
p(x, y) = P (X = x, Y = y).

Joint pdf for continuous random variables:

Z ∞ Z ∞
f (x, y) ≥ 0, f (x, y)dxdy = 1.
−∞ −∞

Mathematics for Finance Chapter 2 58 / 98

Marginal Distributions

Marginal pmf (discrete):

X X
pX (x) = p(x, y), pY (y) = p(x, y).
y x

Marginal pdf (continuous):

Z Z
fX (x) = f (x, y)dy, fY (y) = f (x, y)dx.

Mathematics for Finance Chapter 2 59 / 98

Example: Joint Probability Distribution

The random variable X and Y have the following joint

probability distribution:
x\y 0 1 2
0 0.2 0.1 0.2
1 0.0 0.2 0.1
2 0.1 0.0 0.1
a Calculate the marginal distribution of X and Y
b What is the expected value of X?
c What is the expected value of Y?

Mathematics for Finance Chapter 2 60 / 98

Marginal Distribution of X

P (X = 0) = 0.2 + 0.1 + 0.2 = 0.5

P (X = 1) = 0.0 + 0.2 + 0.1 = 0.3
P (X = 2) = 0.1 + 0.0 + 0.1 = 0.2

Mathematics for Finance Chapter 2 61 / 98

Marginal Distribution of Y

P (Y = 0) = 0.2 + 0.0 + 0.1 = 0.3

P (Y = 1) = 0.1 + 0.2 + 0.0 = 0.3
P (Y = 2) = 0.2 + 0.1 + 0.1 = 0.4

Mathematics for Finance Chapter 2 62 / 98

Expected Values

E[X] = 0 · 0.5 + 1 · 0.3 + 2 · 0.2 = 0.7

E[Y ] = 0 · 0.3 + 1 · 0.3 + 2 · 0.4 = 1.1

Mathematics for Finance Chapter 2 63 / 98

Independent Random Variables
The random variables X and Y are said to be independent if,
for all x, y ,
P (X ≤ x, Y ≤ y) = P (X ≤ x) P (Y ≤ y) (1)
In terms of the joint distribution function F of X and Y , we
have that X and Y are independent if
F (x, y) = FX (x)FY (y), for all x and y.
When X and Y are discrete, the condition of independence
becomes
P (X = x, Y = y) = P (X = x)P (Y = y)
for all x, y in the support. When X and Y are continuous
random variables with joint PDF fX,Y (x, y) and marginal
PDFs fX (x), fY (y), they are independent if
fX,Y (x, y) = fX (x)fY (y)
for all x, y . This means the joint density factors into the
product of the marginal densities.
Mathematics for Finance Chapter 2 64 / 98
Exercise 1: Joint pmf

Given the joint pmf:

(
1
8, (x, y) ∈ {(0, 0), (0, 1), (1, 0), (1, 1)}
p(x, y) =
0, otherwise

Find the marginal pmfs pX (x) and pY (y).

Are X and Y independent?

Mathematics for Finance Chapter 2 65 / 98

Solution: Marginal pmfs

Marginal pmfs:
1 1 1 1
pX (0) = p(0, 0) + p(0, 1) = + = , pX (1) =
8 8 4 4

1 1
pY (0) = p(0, 0) + p(1, 0) = , pY (1) =
4 4

Mathematics for Finance Chapter 2 66 / 98

Solution: Independence Check

Check independence: p(x, y) =? pX (x)pY (y)

Counterexample: p(0, 0) = 81 ̸= pX (0)pY (0) = 41 · 14 = 1
16
X and Y are NOT independent.

Mathematics for Finance Chapter 2 67 / 98

Exercise 2: Joint pmf

Given joint pmf:



0.1 (0, 0)

0.2 (0, 1)



p(x, y) = 0.3 (1, 0)

0.4

 (1, 1)

otherwise

0


Find marginal pmfs pX (x) and pY (y)

Mathematics for Finance Chapter 2 68 / 98

Solution Exercise2:Marginal pmfs

pX (0) = p(0, 0)+p(0, 1) = 0.1+0.2 = 0.3, pX (1) = 0.3+0.4 = 0.7

pY (0) = p(0, 0)+p(1, 0) = 0.1+0.3 = 0.4, pY (1) = 0.2+0.4 = 0.6

Mathematics for Finance Chapter 2 69 / 98

Conditional Distributions
Denition
p(x, y) f (x, y)
pX|Y (x|y) = , fX|Y (x|y) = .
pY (y) fY (y)

Example
Given joint pmf:


0.1 (0, 0)

0.2 (0, 1)



p(x, y) = 0.3 (1, 0)

0.4 (1, 1)




otherwise

0


compute: pX|Y (x|1).

and pX|Y (y|1).
Mathematics for Finance Chapter 2 70 / 98
Joint Distribution Table

x\y 0 1
0 0.1 0.2
1 0.3 0.4
What is Marginal P (Y = 1)
What is Marginal P (X = 1)

Mathematics for Finance Chapter 2 71 / 98

Marginal P (Y = 1)

P (Y = 1) = p(0, 1) + p(1, 1) = 0.2 + 0.4 = 0.6

Mathematics for Finance Chapter 2 72 / 98

Conditional pX|Y (x|1)

p(x, 1) p(x, 1)
pX|Y (x|1) = =
P (Y = 1) 0.6

0.2 1
pX|Y (0|1) = 0.6 = 3 ≈ 0.333
0.4 2
pX|Y (1|1) = 0.6 = ≈ 0.667
3

1
3
 x=0
pX|Y (x|1) = 23 x=1
otherwise

0


Mathematics for Finance Chapter 2 73 / 98

Conditional pY |X (y|1)
First compute marginal P (X = 1):
P (X = 1) = p(1, 0) + p(1, 1) = 0.3 + 0.4 = 0.7

Conditional distribution:
p(1, y) p(1, y)
pY |X (y|1) = =
P (X = 1) 0.7

0.3
pY |X (0|1) = 0.7 ≈ 0.429
0.4
pY |X (1|1) = 0.7 ≈ 0.571

3
7
 y=0
pY |X (y|1) = 4
y=1
7
0 otherwise


Mathematics for Finance Chapter 2 74 / 98

Covariance of Random Variables

The covariance of any two random variables X and Y ,

denoted by cov(X, Y ), is dened by
cov(X, Y ) = E[(X − E(X))(Y − E(Y ))]

Expanding gives:
cov(X, Y ) = E[XY ] − E(X)E(Y )

Note that if X and Y are independent, then cov(X, Y ) = 0.

Mathematics for Finance Chapter 2 75 / 98

Properties of Covariance

For any random variables X, Y, Z and constant c,

1 cov(X, X) = var(X)
2 cov(X, Y ) = cov(Y, X)
3 cov(cX, Y ) = c · cov(X, Y )
4 cov(X, Y + Z) = cov(X, Y ) + cov(X, Z)
The rst three properties are immediate. The nal one is proven as
follows:

Mathematics for Finance Chapter 2 76 / 98

Proof of Additivity

cov(X, Y + Z) = E[X(Y + Z)] − E(X)E(Y + Z)

= E[XY + XZ] − E(X)[E(Y ) + E(Z)]

= [E(XY ) − E(X)E(Y )] + [E(XZ) − E(X)E(Z)]

= cov(X, Y ) + cov(X, Z)

Mathematics for Finance Chapter 2 77 / 98

Exercise 3: Covariance

Given the joint pmf:



0.1 (0, 0)

0.2 (0, 1)



p(x, y) = 0.3 (1, 0)

0.4 (1, 1)




otherwise

0


Calculate E(X), E(Y ).

Calculate E(XY ).
Find cov(X, Y ).

Mathematics for Finance Chapter 2 78 / 98

Exercise 3: Covariance - Solution

x\y 0 1
Joint pmf table: 0 0.1 0.2
1 0.3 0.4

Mathematics for Finance Chapter 2 79 / 98

Marginals

P (X = 0) = 0.1 + 0.2 = 0.3, P (X = 1) = 0.3 + 0.4 = 0.7

P (Y = 0) = 0.1 + 0.3 = 0.4, P (Y = 1) = 0.2 + 0.4 = 0.6

Mathematics for Finance Chapter 2 80 / 98

Expected Values

E(X) = 0 · 0.3 + 1 · 0.7 = 0.7

E(Y ) = 0 · 0.4 + 1 · 0.6 = 0.6
E(XY ) = 0 · 0 · 0.1 + 0 · 1 · 0.2 + 1 · 0 · 0.3 + 1 · 1 · 0.4 = 0.4

Mathematics for Finance Chapter 2 81 / 98

Covariance

cov(X, Y ) = E(XY ) − E(X)E(Y ) = 0.4 − 0.7 · 0.6 = −0.02

Negative covariance indicates inverse relationship.

Mathematics for Finance Chapter 2 82 / 98

What is a Statistical Moment?

Moment = Expected value of powers of random variable

1st raw moment: E[X] (mean, center of mass)
2nd raw moment: E[X 2 ]
3rd raw moment: E[X 3 ]
nth raw moment: E[X n ]
Central moments (around mean):
1st central: E[X − µ] = 0
2nd central: E[(X − µ)2 ] = Var(X)
3rd central: E[(X − µ)3 ] = skewness

Mathematics for Finance Chapter 2 83 / 98

Moment Generating Functions

The moment generating function (MGF) MX (t) of X is

dened by

discrete
(P
etx p(x),
MX (t) = E[etX ] = R ∞x tx
−∞ e f (x) dx, continuous

MX (t) generates all moments by dierentiation

Mathematics for Finance Chapter 2 84 / 98

Moments from MGF

First derivative:
′ d ′
MX (t) = E[etX ] = E[XetX ] =⇒ MX (0) = E[X]
dt
Second derivative:
′′ ′′
MX (t) = E[X 2 etX ] =⇒ MX (0) = E[X 2 ]

nth derivative: MX (0) = E[X n ], n ≥ 1

(n)

Mathematics for Finance Chapter 2 85 / 98

Moment Generating Function Example




0.7 x = 1

0.2 x = 2
Given PMF: f (x) =

0.1 x = 3
otherwise


0
MGF: MX (t) = E[etX ] = x etx f (x)
P

Mathematics for Finance Chapter 2 86 / 98

MGF Calculation

MX (t) = et·1 · 0.7 + et·2 · 0.2 + et·3 · 0.1

MX (t) = 0.7et + 0.2e2t + 0.1e3t

Verication: MX (0) = 0.7 + 0.2 + 0.1 = 1

Mathematics for Finance Chapter 2 87 / 98

Moments from MGF

′ (0)
E[X] = MX

′
MX (t) = 0.7et + 0.4e2t + 0.3e3t

′
MX (0) = 0.7 + 0.4 + 0.3 = 1.4

Mathematics for Finance Chapter 2 88 / 98

Higher Moments: E(X 2 ) and E(X 3 )

Given MX (t) = 0.7et + 0.2e2t + 0.1e3t

Second moment E(X 2 ) = MX′′ (0):
′
MX (t) = 0.7et + 0.4e2t + 0.3e3t
′′
MX (t) = 0.7et + 0.8e2t + 0.9e3t
′′
E(X 2 ) = MX (0) = 0.7 + 0.8 + 0.9 = 2.4

Mathematics for Finance Chapter 2 89 / 98

Third Moment E(X 3 )

′′′
MX (t) = 0.7et + 1.6e2t + 2.7e3t
′′′
E(X 3 ) = MX (0) = 0.7 + 1.6 + 2.7 = 5.0
Verication (direct method):
E(X 2 ) = 12 · 0.7 + 22 · 0.2 + 32 · 0.1 = 0.7 + 0.8 + 0.9 = 2.4
E(X 3 ) = 13 · 0.7 + 23 · 0.2 + 33 · 0.1 = 0.7 + 1.6 + 2.7 = 5.0

Mathematics for Finance Chapter 2 90 / 98

Example:Bernoulli Distribution

Suppose that Bernoulli X ∼ Bern(0.5)

This means:
X takes values {0, 1} only (binary outcome)
P (X = 1) = 0.5 (success probability)
P (X = 0) = 1 − 0.5 = 0.5 (failure probability)

Mathematics for Finance Chapter 2 91 / 98

MGF Derivation: MX (t) = 0.5 + 0.5et

X
MX (t) = E[etX ] = etx P (X = x)
x

When X = 0: et·0 · P (X = 0) = 1 · 0.5 = 0.5

When X = 1: et·1 · P (X = 1) = et · 0.5 = 0.5et

MX (t) = 0.5 + 0.5et = 0.5(1 + et )

Mathematics for Finance Chapter 2 92 / 98

Example: Bernoulli X ∼ Bern(0.5)

MX (t) = 0.5 + 0.5et

′ ′
MX (t) = 0.5et =⇒ MX (0) = 0.5 = E[X]
′′ ′′
MX (t) = 0.5et =⇒ MX (0) = 0.5 = E[X 2 ]
Var(X) = 0.5 − (0.5)2 = 0.25

Mathematics for Finance Chapter 2 93 / 98

Markov's Inequality

For a non-negative random variable X ≥ 0 and a > 0,

E(X)
P (X ≥ a) ≤ .
a
Useful for bounds without knowing full distribution.

Mathematics for Finance Chapter 2 94 / 98

Chebyshev's Inequality

For any random variable with nite variance,

V ar(X)
P (|X − E(X)| ≥ k) ≤ .
k2
Shows probability of deviation decreases as variance decreases.

Mathematics for Finance Chapter 2 95 / 98

Example

Example
Suppose the number of items produced in a factory during a week
is a r.v. with mean 500.
a) What is the probability that this week's production will be at
least 1000?

Solution
Let X be the number of items produced. By Markov's inequality,
E(X) 500 1
P (X ≥ 1000) ≤ = =
1000 1000 2

Mathematics for Finance Chapter 2 96 / 98

Example continued

Example
b) If the variance of a week's production is 100, what is the
probability that production will be between 400 and 600?

Solution
By Chebyshev's inequality,
σ2 100 1
P (|X − 500| ≥ 100) ≤ 2
= =
100 10000 100
Hence,
1 99
P (|X − 500| ≤ 100) ≥ 1 − = = 0.99
100 100
So the probability is at least 0.99.

Mathematics for Finance Chapter 2 97 / 98