CHAPTER ONE

RANDOM VARIABLES AND PROBABILITY DISTRIBUTION

1.1 Introduction
In this chapter we discuss probability distributions of random variables and these are
customary used to model some problems in various fields such as business, finance,
economics and in general life. To clearly understand this chapter, you need some basic
knowledge in probability fundamentals.

1.2 Definition of key Terms

1.2.1 A variable
It is an attribute that can take on different values or characteristics from one individual or
object to another. For example, number of items sold per day varies from one day to another,
then “number of items sold” is a variable.
1.2.2 Random Variable (R.V)
This is a variable whose numerical value is determined by the outcome of a random or
statistical experiment. Their values are determined by chance. In other words, this is the
variable that is subject to randomness and it can take on different values which make it
different from algebraic variable. Random variables also are normally used in econometrics to
determine relationships among one another. On the other hand, random experiment is an
experiment which results into at least two possible outcomes without a prior knowledge to
which one will occur. That is, an experiment whose outcome cannot be predicted in advance.
Most of these statistical experiments are described in words (e.g. an experiment of tossing a
fair coin, asking a sample of 10 people if they have ever been in the UK, etc), however, at one
point in time, the outcomes from these experiments are described more meaningful in terms
of numbers. But also, in real life, most of sample data are in explicated in terms numbers than
in words. Therefore, in short random variables are numerical values.

Traditionally random variables are denoted by capital letters, X, Y, Z or X1, X2, X3 etc.

[Link] Types of Random Variable

There are two types of random variable (R.V), these are discrete and continuous random
variables. A discrete random variable takes on only a finite/distinct/countable number of
values and these are integers. Examples of discrete random variables are; the number of cars
passing through the roadblock, an experiment of tossing one or more fair coins, number of
defective items in a sample, number of deaths by COVID-19 in year 2020, etc. On the other
hand, a continuous random variable is a random variable that can take on any value
within a range always real numbers; for example, interest rate can take any value within a
range (e.g. 15.25%, 15.2513%). Examples of continuous R.V are, height, weight, rainfall,
temperature etc.

General Examples of random variables in business context include among others;; the
unemployment rate, consumer price index, number of sales made in week, yearly profit of a
company, share prices, return on investments, money supply, GDP, wages, cash flows, interest
rates, etc.

1.3 Probability Distribution of Random Variable

Definition: A probability distribution is a Graph, Table or a Function that links each
outcome of a random experiment with its probability of occurrence. In other words, we may
say probability distribution is a function that can be used to derive probabilities of each
outcome of a random variable. That is the value taken by this random variable and their
associated probabilities.
1.3.1 Importance of probability distribution
• They can be used to model real world phenomena; that is probability distributions help
describe and model real-world data, like stock prices etc.
• Informs decision-making process, that is they provide a framework for making
predictions and estimating uncertainty
• Enables statistical analysis, that is crucial for hypothesis testing, confidence interval
estimation and regression analysis
1.3.2 Types of probability distribution
There are two types of probability distribution of a random variable (R.V), these are discrete
and continuous probability distribution. The following chart may help you understand the
branching of probability distribution

Figure 1: Branches of probability distribution

 [Link] Discrete Probability Distributions
If a random variable is a discrete variable its probability distributions is called a discrete
probability distribution. With a discrete probability distribution, each possible value of
the discrete random variable can be associated with a non-zero probability. Thus, a discrete
probability distribution can always be presented in Tabular form. The discrete Probability
Distribution is commonly known as Probability Mass Function (PMF). See Figure 1.

[Link] Probability Mass Function (PMF)

If X is a discrete random variable, the function denoted by 𝑓(𝑥) = 𝑃(𝑋 = 𝑥) for each 𝑥 within
the range of X is called Probability Mass Function of X. To capture clearly the meaning of the
probability distribution of a discrete random variable consider Example 1.1.

Example 1.1
Consider an experiment of tossing two fair coins simultaneously. Find the probability
distribution of obtaining a total number of heads.

Solution:
The following are the procedures for building probability distribution:

1. List a set of all possible events (outcomes)

2. Calculate probability of each event
3. Present these probabilities in a suitable table or diagram

Procedure 1
The list of all possible events can be obtained easily by using a structure of tree diagram as
shown below:

H
T

Start
H
T

TT
Figure 2: Tree Diagram
From a tree diagram as shown in Figure 2 the list of all possible outcomes of an experiment
(i.e. sample space, S) is as shown below:

𝑆 = {𝐻𝐻, 𝐻𝑇, 𝑇𝐻, 𝑇𝑇}

Procedure 2

From the sample space described above, a random variable (i.e. number of heads) takes on
three different values, 0, 1, 2 depending on whether zero head (no head), one head, or two
heads were obtained in the experiment of tossing two fair coins. That is

𝐻𝐻 → 2heads
𝐻𝑇 → 1 heads
𝑇𝐻 → 1 head
𝑇𝑇 → 0 head
Probability of an event can be obtained by employing traditional definition of probability, that
is:

n( E )
P( E ) =
n( S )

Let 𝑋 be a random variable (R.V) representing the number of observed heads, that is to say
𝑋 = {0,1,2}. The probabilities of the number of heads showing up are as indicated below and
the probability distribution is shown in Table 1.
𝑛(0) 1
𝑓(0) = 𝑃(𝑋 = 0) = =
𝑛(𝑠) 4
𝑛(1) 1
𝑓(1) = 𝑃(𝑋 = 1) = =
𝑛(𝑠) 2
𝑛(2) 1
𝑓(2) = 𝑃(𝑋 = 2) = =
𝑛(𝑠) 4

Procedure 3

Probability Distribution
Number of heads 𝒇(𝒙) = 𝑷(𝑿 = 𝒙)
(𝑿)
0 𝟏/𝟒

1 𝟏/𝟐
2 𝟏/𝟒
 Total 1.00
Properties of PMF
1. 𝑓(𝑥) ≥ 0 for each 𝑥 ∈ 𝑋
2. 0 ≤ 𝑓(𝑥) ≤ 1
3. ∑ 𝑓(𝑥) = 1
Example 1.2
An employment rate of a certain country A (𝑅𝐴 ) in percentage is assumed to be a discrete
random variable whose probability distribution is as shown below:
𝑅𝐴 -12 -10 -6 0 4 8 10 12
Prob. 0.10 0.15 0.10 0.15 0.1 0.15 0.1 0.15

Find
a) 𝑃(𝑅𝐴 ≥ 0)
b) 𝑃(𝑅𝐴 ≥ −10)

Solution:
a) 𝑃(𝑅𝐴 ≥ 0) = 𝑃(𝑅𝐴 = 0) + 𝑃(𝑅𝐴 = 4) + 𝑃(𝑅𝐴 = 8) + 𝑃(𝑅𝐴 = 10) + 𝑃(𝑅𝐴 = 12)
= 0.15 + 0.1 + 0.15 + 0.1 + 0.15
= 0.65
c) 𝑃(𝑅𝐴 ≥ −10) = 1 − 𝑃(𝑅𝐴 < −10)
= 1 − 𝑃(𝑅𝐴 = −12)
= 1 − 0.10
= 0.9

1.4 Cumulative Mass Function (CMF)

Definition: Cumulative Mass Function, 𝐹(𝑥) associated with Probability Mass Function,
𝑓(𝑥) of a discrete random variable 𝑋 is defined as follows:
𝐹(𝑥) = 𝑃(𝑋 ≤ 𝑥)

Where 𝑃(𝑋 ≤ 𝑥) means the probability that a random variable 𝑋 takes a value of less than or
equal to a specific value 𝑥, where 𝑥 is given. For example, 𝑃(𝑋 ≤ 2) means the probability that
the random variable 𝑋 takes the value less than of equal to 2.

Example 1.3

Find Probability Mass Function (PMF) and Cumulative Mass Function (CMF) of a total
number of heads obtained by tossing a fair coin three times.

Solution:
The following tree diagram is used to obtain the sample space 𝑆

H T

H
H
T T
Therefore 𝑺 = {𝐻𝐻𝐻, 𝐻𝐻𝑇, 𝐻𝑇𝐻, 𝐻𝑇𝑇, 𝑇𝐻𝐻, 𝑇𝐻𝑇, 𝑇𝑇𝐻, 𝑇𝑇𝑇 }
By letting 𝑋 =number of heads shown up, we find that 𝑋 can take values 0, 1, 2 or 3 and
hence the corresponding PMF will be obtained as indicated below:
1
𝑓(0) = 𝑃(𝑋 = 0) =
8
3
𝑓(1) = 𝑃(𝑋 = 1) =
8
3
𝑓(2) = 𝑃(𝑋 = 2) =
8
1
𝑓(3) = 𝑃(𝑋 = 3) =
8
In Tabula form:
𝑥 0 1 2 3
𝑓(𝑥) 1/8 3/8 3/8 1/8

It follows that, the Cumulative Mass Function (CMF) will be obtained as indicated here:
From:
𝐹(𝑥) = 𝑃(𝑋 ≤ 𝑥)
1
𝐹(0) = 𝑃(𝑋 ≤ 0) = 𝑃(𝑋 = 0) =
8
4
𝐹(1) = 𝑃(𝑋 ≤ 1) = 𝑃(𝑋 = 0) + 𝑃(𝑋 = 1) =
8
7
𝐹(2) = 𝑃(𝑋 ≤ 2) = 𝑃(𝑋 = 0) + 𝑃(𝑋 = 1) + 𝑃(𝑋 = 2) =
8
𝐹(3) = 𝑃(𝑋 ≤ 3) = 𝑃(𝑋 = 0) + 𝑃(𝑋 = 1) + 𝑃(𝑋 = 2) + 𝑃(𝑋 = 3) = 1
However, in plotting the CMF the following will be the ranges of :
 0 f or x0
1
 f or 0  x  1
8

4
F ( x) =  f or 1 x  2
8
7
8 f or 2 x3


1 f or 3 x

With reference to the previous example, it can be observed that, a CMF is merely an
accumulation of PMF for the values of 𝑋 less than or equal to a given 𝑥. That is,

𝐹(𝑥) = ∑ 𝑓(𝑥)
𝑥

Note: The results for both PMF and CMF can also be summarized in the following Table:
Number of
heads values of PMF values of CMF
𝑿 𝒙 𝒇(𝒙) 𝒙 𝑭(𝒙)
0 0≤𝑥<1 1/8 𝑥=0 1/8
1 1≤𝑥<2 3/8 𝑥≤1 4/8
2 2≤𝑥<3 3/8 𝑥≤2 7/8
3 3≤𝑥 1/8 𝑥≤3 1

1.5 Multivariate or Joint Probability Distribution

So far we have discussed discrete probability distributions for the case of single random
variable 𝑋 or univariate. However, the outcomes of numerous experiments can be described
by more than one random variables ([Link]), in which case we must find their probability
distribution. Such kind of probability distribution are called Multivariate or Joint
Probability Distribution, and the simplest is the bivariate or two-variables probability
distribution which we expected to discuss in here under. To summarize, a joint probability
distribution describes the probability of two or more random variables occurring together. It
tells you how probabilities are assigned to combinations of outcomes

1.5.1 Discrete Joint Probability Distribution

IF X and Y are two discrete random variables, the function given by 𝑓(𝑥, 𝑦) = 𝑃(𝑋 = 𝑥, 𝑌 =
𝑦) for each pair of values (𝑥, 𝑦) within the range of 𝑋 and 𝑌 is called the joint probability
distribution of 𝑋 and 𝑌. This represent the probability that 𝑋 takes value 𝑥 and 𝑌 takes value 𝑦
simultaneously
Key Properties of joint Probability Distribution

1. Non-negativity
𝑓(𝑥, 𝑦) ≥ 0
2. Total probability equals 1

 f ( x, y) = 1
x y

Example 1.4

Find the value of 𝑎 if the joint probability distribution is defined as

a( x 2 + y ) for x = 1, 2 and y = 2,3

f ( x, y ) = 
0 otherwise

Solution
Recall one of the conditions of joint probability distribution function, that is

 f ( x, y) = 1
x y

It implies that,
𝒇(𝟏, 𝟐) + 𝒇(𝟏, 𝟑) + 𝒇(𝟐, 𝟐) + 𝒇(𝟐, 𝟑) = 𝟏
𝟑𝒂 + 𝟒𝒂 + 𝟔𝒂 + 𝟕𝒂 = 𝟏
𝟐𝟎𝒂 = 𝟏
Therefore:
𝟏
𝒂=
𝟐𝟎
= 𝟎. 𝟎𝟓

1.5.2 Marginal Discrete Probability Distribution

These are probability that one random variable say X assumes a given value regardless of the
values taken by another variable say Y. This is obtained by summing up all probabilities of
other variable. More general, if X and Y are two discrete random variables and 𝑓(𝑥, 𝑦) is the
joint probability distribution at (𝑥, 𝑦) then the function given by

𝑔(𝑥) = ∑ 𝑓(𝑥, 𝑦) = ∑ 𝑃(𝑋 = 𝑥, 𝑌 = 𝑦)

𝑦 𝑦

for each 𝑥 within the range of X is called marginal distribution of X. Similarly, the function

ℎ(𝑦) = ∑𝑥 𝑓(𝑥, 𝑦) = ∑𝑥 𝑃(𝑋 = 𝑥, 𝑌 = 𝑦) within the range of Y is called marginal distribution

of Y
1.5.3 Conditional Probability Distribution
If X and Y are two discrete random variables and 𝑓(𝑥, 𝑦) is the joint probability distribution at
(𝑥, 𝑦) then conditional probability of 𝑋 given 𝑌 is:

𝑃(𝑋 = 𝑥, 𝑌 = 𝑦)
𝑓(𝑥/𝑦) =
𝑃(𝑌 = 𝑦)

𝑇ℎ𝑒 𝑗𝑜𝑖𝑛𝑡 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑋 𝑎𝑛𝑑 𝑌

=
𝑇ℎ𝑒 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑌

Where 𝑃(𝑌 = 𝑦) = ℎ(𝑦) is the marginal probability of 𝑌 and 𝑓(𝑥/𝑦) stands for the conditional
probability of 𝑌 given 𝑋
Similarly, conditional probability of 𝑌 given 𝑋 is:
𝑃(𝑋 = 𝑥, 𝑌 = 𝑦)
𝑓(𝑦/𝑥) =
𝑃(𝑋 = 𝑥)

𝑇ℎ𝑒 𝑗𝑜𝑖𝑛𝑡 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑋 𝑎𝑛𝑑 𝑌

=
𝑇ℎ𝑒 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑌

Where 𝑃(𝑋 = 𝑥) = 𝑔(𝑥) is the marginal probability of 𝑋 and 𝑓(𝑥/𝑦) stands for the conditional
probability of 𝑋 given 𝑌
1.5.4 Independence of random variables

Two jointly distributed random variables are said to be linearly independent if and only if their
joint probability distribution can be expressed as the product of their individuals, or marginal,
for all combinations of 𝑋 and 𝑌 values. That is, symbolically:

𝑓(𝑥, 𝑦) = 𝑓(𝑥) × 𝑓(𝑦)

= 𝑃(𝑋 = 𝑥) × 𝑃(𝑌 = 𝑦)

Where 𝑓(𝑥) and 𝑓(𝑦) are marginal probability of 𝑋 and 𝑌 in this context
Similarly, as we will observe in some of the next sections, two random variables are pointed
out to be independent if their covariance is equal to zero. This means that the two random
variables do not have any kind of relationship. That is neither linear nor non-linear.
Example 1.5
Suppose we have the following joint probability distribution

𝑋/𝑌 0 1 𝐓𝐨𝐭𝐚𝐥
0 0.2 0.3 0.5
2 0.1 0.4 0.5
𝐓𝐨𝐭𝐚𝐥 0.3 0.7 1

a) Find 𝑃(𝑋 = 2, 𝑌 = 0)
 b) Find marginal probability of 𝑋 = 0
c) Find marginal probability of 𝑌 = 1
d) Check whether 𝑋 = 0, 𝑌 = 1 are independent
e) Find 𝑓(2/1)

1.6 Characteristics of Probability Distribution

Although a probability distribution shows the values taken by a random variable and their
corresponding probabilities, in most cases a researcher might be interested in deducing some
summary characteristics from such probability distribution. These summary characteristics
include among others; the expected value(population mean), variance, covariance,
correlations, etc.

1.6.1 Expected Value of a Discrete Probability Distribution

The average value of a random variable is called the expected value of the random variable,
and this is denoted by E (X ) .

Definition:
Let 𝑋 be a random variable with probability 𝑓(𝑥) = 𝑃(𝑋 = 𝑥) then the expected value 𝐸(𝑋) is
given by
𝐸(𝑋) = ∑ 𝑥𝑃(𝑋 = 𝑥) or
= ∑ 𝑥𝑓(𝑥)
=𝜇
In other words; if a discrete random variable 𝑋 has possible values 𝑥1 , 𝑥2 , 𝑥3 ⋯ 𝑥𝑛 with
corresponding probabilities 𝑃(𝑋 = 𝑥1 ), 𝑃(𝑋 = 𝑥2 ), 𝑃(𝑋 = 𝑥3 ), ⋯ , 𝑃(𝑋 = 𝑥𝑛 ) then expected
value is obtained by multiplying the value the random variable takes with the corresponding
probability of occurrence, i.e.

𝐸(𝑋) = 𝑥1 𝑃(𝑋 = 𝑥1 ) + 𝑥2 𝑃(𝑋 = 𝑥2 ) + 𝑥3 𝑃(𝑋 = 𝑥3 ) + ⋯ + 𝑥𝑛 𝑃(𝑋 = 𝑥𝑛 )

Therefore, Σ denotes summation notation whose properties are as indicated below:
Properties of summation notation
1. If 𝑘 is constant, then
𝑛

∑ 𝑘 = 𝑛𝑘
𝑖=1

2. If 𝑘 is constant, then
𝑛 𝑛

∑ 𝑘𝑋𝑖 = 𝑘 ∑ 𝑋𝑖
𝑖=1 𝑖=1

3. It both 𝑎 and 𝑏 are constants, then

 𝑛 𝑛

∑(𝑎 + 𝑏𝑋𝑖 ) = 𝑛𝑎 + 𝑏 ∑ 𝑋𝑖
𝑖=1 𝑖=1

Properties of Expected Value

1. The expected value of a constant is equal to the same constant. Hence if 𝑘is a constant,
𝐸(𝑘) = 𝑘
2. The expected value of the sum of two random variables is equal to sum of expected
value of the two random variables. That is for the random variables X and Y.
𝐸(𝑋 + 𝑌) = 𝐸(𝑋) + 𝐸(𝑌)

3. Also

𝐸(𝑋𝑌) ≠ 𝐸(𝑋)𝐸(𝑌)

That is, generally, the expected value of the product of two random variables is not
equal to product of the expected values of those random variables. However, there is
an exception to the rule, if X and Y are independent then:
𝐸(𝑋𝑌) = 𝐸(𝑋)𝐸(𝑌)
4. If 𝑘 is a constant, then
𝐸(𝑘𝑋) = 𝑘𝐸(𝑋)
That is to say, the expected value of a constant times a random variable X, is equal to
the constant times the expected value of the Random Variable
5. If 𝑎 and 𝑏 are constants, then
𝐸(𝑎𝑋 + 𝑏) = 𝐸(𝑎𝑋) + 𝐸(𝑏)
= 𝑎𝐸(𝑋) + 𝑏

1.6.2 Variance and standard deviation of a Discrete Probability Distribution

[Link] Variance and standard deviation

Variance indicates how individual values are spread, dispersed or distributed around the mean
value. But also, the statistical concept of variance is a useful measure of risk of any kind.
Generally, if X is a discrete random variable, then its variance is given by:
2
𝑉𝑎𝑟(𝑋) = 𝐸(𝑋 − 𝐸(𝑋))
= 𝐸(𝑋 2 ) − (𝐸(𝑋))2
= 𝐸(𝑋 2 ) − 𝜇2
= 𝜎2
Where 𝐸(𝑋 2 ) = ∑ 𝑥 2 𝑓(𝑥)
The standard deviation of X is therefore given by
𝑆𝐷(𝑋) = √Var(𝑋)
 =𝜎
Example 1.6
A company estimates the net profit for a new product to be launched with its corresponding
probabilities under different market conditions as follows;

Market Condition Good Fair Poor

Net Profit (in million TZS.) 30 10 -3
Probability , 𝑷(𝑿 = 𝒙) 0.15 0.25 0.60

Required:
a) Calculate the expected value of the net profit for the Company
b) What is standard deviation of the net profit

Solution:
a) We know that

𝐸(𝑋) = ∑ 𝑥𝑃(𝑋 = 𝑥)
𝑖=1

Market Condition Net Profit (in million Probability 𝒇(𝒙) 𝒙𝒇(𝒙)

TZS) (𝒙)
Good 30 0.15 4.5
Fair 10 0.25 2.5
Poor -3 0.6 -1.8
Total 5.2
𝑛

𝐸(𝑋) = ∑ 𝑥𝑃(𝑋 = 𝑥) = 30 × 0.15 + 10 × 0.25 − 3 × 0.6 = 5.2

𝑖=1

Therefore, the expected value of the net profit for the company under all three given market
conditions is 5.2 million TZS.

b) The variance is given by

𝑛 𝑛 2
2
𝑉𝑎𝑟(𝑋) = ∑ 𝑥 𝑓(𝑥) − [∑ 𝑥𝑓(𝑥)]
𝑖=1 𝑖=1

Market Net Profit (in million TZS) Probability 𝑥𝑓(𝑥) 𝑥 2 𝑓(𝑥)

Condition (𝑥) 𝑓(𝑥)
Good 30 0.15 4.5 135
 Fair 10 0.25 2.5 25
Poor -3 0.6 -1.8 5.4
Total 5.2 165.4

𝑉𝑎𝑟(𝑋) = 165.4 − 5.22 = 138.36

The Standard Deviation is given by:

𝜎𝑥 = √𝑉𝑎𝑟(𝑋) = √138.36 = 11.76

Therefore, the standard deviation of the net profit for the company under all three given
market conditions is 11.76 million TZS. This tells us how much the net profit deviates from the
expected value of 5.2 million TZS. Thus, we may say that although the expected net profit is
about 5.2 million TZS, it may go above or below this value by 11.76 million TZS. You may
calculate the confidence interval to estimate the interval on which the expected net profit will
fall.

Example 1.7

A return of certain investment B (𝑅𝐵 ) in percentage is a discrete random variable whose

probability distribution is as shown below:
𝑅𝐵 -10 -6 0 4 8 12
Prob. 0.15 0.2 0.15 0.1 0.15 0.25

Find the expected value and the standard deviation of 𝑅𝐵

Solution
Let 𝑋 be a random variable representing return of investment. Required to find 𝐸(𝑋) and
𝑆𝐷(𝑋)
Hint: For the purpose of simplification, we can summarise the sums as indicated in the Table
below:

𝑥 𝑓(𝑥) 𝑥𝑓(𝑥) 𝑥 2 𝑓(𝑥)

-10 0.15 -1.5 15
-6 0.2 -1.2 7.2
0 0.15 0 0
4 0.1 0.4 1.6
8 0.15 1.2 9.6
12 0.25 3 36
TOTAL 1.9 69.4
Hence:
𝐸(𝑋) = ∑ 𝑥𝑓(𝑥)

= 1.9
2
𝑉𝑎𝑟(𝑋) = 𝐸(𝑋 2 ) − (𝐸(𝑋))
= ∑ 𝑥 2 𝑓(𝑥) − (∑ 𝑥𝑓(𝑥))2
= 69.4 − 1.92
= 65.79

𝑆𝐷(𝑋) = √𝑉𝑎𝑟(𝑋)
= √65.79
= 8.11

Example 1.8

A monthly income of workers in millions of TZS from a certain sector with their associated
probabilities are as indicated in the following probability distribution

Income 1.4 3.5 2.0 0.9 3.0

Probability 0.25 0.2 0.15 0.1 0.3
Find the expected income and standard deviation of all workers
Solution:
Let 𝑋 be a random variable representing monthly income of worker. Required to find 𝐸(𝑋)
and 𝑆𝐷(𝑋
Hint: For the purpose of simplification, we can summarize the sums as indicated in the Table
below:

𝑥 𝑓(𝑥) 𝑥𝑓(𝑥) 𝑥 2 𝑓(𝑥)

1.4 0.25 0.35 0.49
3.5 0.2 0.7 2.45
2 0.15 0.3 0.6
0.9 0.1 0.09 0.081
3 0.3 0.9 2.7
TOTAL 2.34 6.321
Hence:

𝐸(𝑋) = ∑ 𝑥𝑓(𝑥)

= 2.34
2
𝑉𝑎𝑟(𝑋) = 𝐸(𝑋 2 ) − (𝐸(𝑋))
= ∑ 𝑥 2 𝑓(𝑥) − (∑ 𝑥𝑓(𝑥))2
= 6.321 − 2.342
 = 0.8454

𝑆𝐷(𝑋) = √𝑉𝑎𝑟(𝑋)
= √0.8454
= 0.9194

Properties of variance

1. The variance of a constant is zero. That is to say, if 𝑎 is a constant, then

Var(𝑎) = 0

2. If X and Y are two independent random variables, then

𝑉𝑎𝑟(𝑋 + 𝑌) = 𝑉𝑎𝑟(𝑋) + 𝑉𝑎𝑟(𝑌) and

𝑉𝑎𝑟(𝑋 − 𝑌) = 𝑉𝑎𝑟(𝑋) + 𝑉𝑎𝑟(𝑌)

3. If 𝑏 is a constant, then
𝑉𝑎𝑟(𝑏 + 𝑋) = 𝑉𝑎𝑟(𝑋)

4. If 𝑎 is a constant, then
𝑉𝑎𝑟(𝑎𝑋) = 𝑎2 𝑉𝑎𝑟(𝑋)

5. If X and Y are independent random variables and 𝑎 and 𝑏 are constants, then
𝑉𝑎𝑟(𝑎𝑋 + 𝑏𝑌) = 𝑎2 𝑉𝑎𝑟(𝑋) + 𝑏 2 𝑉𝑎𝑟(𝑌)

1.6.3 Covariance and Correlation

[Link] Covariance
Covariance is a measure of how two random variables change together. If the two variables
either increases or decreases simultaneously we get a positive covariance. However, if they
vary inversely or move in opposite direction, they give negative covariance. Let X and Y be two
random variables, then covariance between the two variables is defined as:

𝐶𝑜𝑣(𝑋, 𝑌) = 𝐸[(𝑋 − 𝐸(𝑋))(𝑌 − 𝐸(𝑌)]

= 𝐸(𝑋𝑌) − 𝐸(𝑋)𝐸(𝑌)

= 𝐸(𝑋𝑌) − 𝜇𝑥 𝜇𝑦

Where 𝜇𝑥 = 𝐸(𝑋) and 𝜇𝑦 = 𝐸(𝑌)

To compute the covariance as defined in the above Equations, we now use the following
formula
 𝐶𝑜𝑣(𝑋, 𝑌) =  ( X − 
x y
x )(Y −  y ) 𝑓(𝑥, 𝑦)

= ∑ ∑ 𝑥𝑦𝑓(𝑥, 𝑦) − 𝜇𝑥 𝜇𝑦
𝑥 𝑦

Where 𝑓(𝑥, 𝑦) is the joint probability distribution function of the two random variables X and
Y. The double summation sign in this expression indicates that covariance requires the
summation of both variables over the range of their values.

Properties of Covariance

1. If X and Y are independent random variables, their covariance is zero. This can be
verified as indicated here. Recall that if two random variables are independent, then

𝐸(𝑋𝑌) = 𝐸(𝑋)𝐸(𝑌) = 𝜇𝑥 𝑢𝑦

Substituting the above expression into equation (...), we see at once that the covariance
of two independent random variable is zero

2. If 𝑎, 𝑏, 𝑐 and 𝑑 are constants, then

𝐶𝑜𝑣(𝑎 + 𝑏𝑋, 𝑐 + 𝑑𝑌) = 𝑏𝑑𝐶𝑜𝑣(𝑋, 𝑌)

3. 𝐶𝑜𝑣(𝑋, 𝑋) = 𝑉𝑎𝑟(𝑋) that is covariance of a random variable with itself is simply a

variance of such variable.

[Link] Correlation
Correlation coefficient is a numerical value which measures the strength of relationships
between two random variables. IF X and Y are two random variables, their correlation
coefficient denoted by 𝐶𝑜𝑟𝑟(𝑋, 𝑌)or 𝜌 is given by
𝐶𝑜𝑣(𝑋, 𝑌)
𝜌=
𝜎𝑥 𝜎𝑦
Properties of Correlation Coefficient
Like covariance, 𝜌 can be either positive or negative
The correlation coefficient always lies between −1 and +1. Symbolically
−1 ≤ 𝜌 ≤ 1

If the correlation coefficient is +1, it means that the two variables are perfectly positive
correlated, whereas if the correlation coefficient is −1, it means that they are perfectly negative
correlated. If 0, it means no relationship at all. However, if 0.8 ≤ 𝜌 < 1 then this indicates a
very strong linear relationship, it is just strong when 0.6 ≤ 𝜌 < 0.8. Furthermore if 𝜌 ≤ 0.3
then it indicates weak linear relationship

Example 1.8

The following Table gives the joint PDF of two random variables X and Y, where X represent
the first-year rate of return (%) expected from investment A, and Y stands for the first-year
rate of return expected from investment B.

X(%)

-10 0 20 30

20 0.27 0.08 0.16 0.00

Y(%)
50 0.00 0.04 0.1 0.35

a) Find the marginal distribution of X and hence the expected rate of return and standard
deviation
b) Find the marginal distribution of Y and hence the expected rate of return and standard
deviation
c) Compute the covariance, correlation coefficient between these cash flows and
comment on the results
d) Are X and Y linearly independent?

Solution:
The marginal distribution of 𝑋 is given below:

𝑥 -10 0 20 30
Prob. 0.27 0.12 0.26 0.35

The corresponding sums are summarised below:

𝑥 ℎ(𝑥) 𝑥ℎ(𝑥) 𝑥 2 ℎ(𝑥)

-10 0.27 -2.7 27
0 0.12 0 0
20 0.26 5.2 104
30 0.35 10.5 315
TOTAL 13 446

Hence:

𝐸(𝑋) = ∑ 𝑥ℎ(𝑥)
 = 13
2
𝑉𝑎𝑟(𝑋) = 𝐸(𝑋 2 ) − (𝐸(𝑋))
= ∑ 𝑥 2 ℎ(𝑥) − (∑ 𝑥ℎ(𝑥))2
= 446 − 132
= 277
𝑆𝐷(𝑋) = √𝑉𝑎𝑟(𝑋)
= √277
= 16.64
The marginal distribution of 𝑌 is given below:
y 20 50
g(y) 0.51 0.49

From above distribution:

𝐸(𝑌) = ∑ 𝑦𝑔(𝑦)

= 20(0.51) + 50(0.49)
= 10.2 + 24.5
= 34.7
2
𝑉𝑎𝑟(𝑌) = 𝐸(𝑌 2 ) − (𝐸(𝑌))
= ∑ 𝑦 2 𝑔(𝑦) − (∑ 𝑦𝑔(𝑦))2
= 202 (0.51) + 502 (0.49) − 34.72
= 204 + 1225 − 1204.09
= 224.91
𝑆𝐷(𝑌) = √𝑉𝑎𝑟(𝑌)
= √224.91
= 14.99
Example 1.9:

Suppose a certain investor has decided to invest into two different stocks, A and B and it is
expected that returns from the stocks depend on the following three states of economy, which
are equally likely to happen:

State of Return on Stock A (%) Return on Stock B (%)

Economy
Good 7.3 −4.7
Normal 11.5 5.4
Best 16.6 24.3
 a) Calculate the expected return of each stock.
b) Calculate the standard deviation of returns of each stock.
c) Calculate the covariance and correlation between the two stocks and comment on the
results.
d) Are the stock returns, A and B independent?
Solution:
Let 𝑋 represent return on stock A and 𝑌 return on stock B and since the three states of
economy are equally likely to happen, then each state has a probability:
1
𝑓(𝑥) = 𝑓(𝑦) = 𝑃𝑖 = 3: Recall: ∑𝑥 𝑓(𝑥) = 1

Where: 𝑃𝑖 =Probability of state 𝑖

State of the
Economy 𝑥 𝑦 𝑃𝑖 𝑥𝑃𝑖 𝑦𝑃𝑖 𝑥 2 𝑃𝑖 𝑦 2 𝑃𝑖
Good 7.3 -4.7 1/3 2.433 -1.567 17.763 7.363
Normal 11.5 5.4 1/3 3.833 1.800 44.083 9.72
Best 16.6 24.3 1/3 5.533 8.100 91.853 196.83
Total 11.80 8.33 153.7 213.913

From the Table Above:

(a) The expected return of each stock is given by:
𝐸(𝑋) = ∑ 𝑥𝑃𝑖 = 11.80

𝐸(𝑌) = ∑ 𝑦𝑃𝑖 = 8.33

(b) Standard deviation of returns of each stock is given by:

𝑉𝑎𝑟(𝑋) = 𝐸(𝑋 2 ) − (𝐸(𝑋))2
𝑛 𝑛 2

= ∑ 𝑥 2 𝑓(𝑥) − [∑ 𝑥𝑓(𝑥)]
𝑖=1 𝑖=1
2
= 153.7 − 11.8
= 𝟏𝟒. 𝟒𝟔
𝑆𝐷(𝑋) = √𝑉𝑎𝑟(𝑋)
= √14.46
= 𝟑. 𝟖𝟎𝟑
𝑉𝑎𝑟(𝑌) = 𝐸(𝑌 2 ) − (𝐸(𝑌))2
𝑛 𝑛 2

= ∑ 𝑦 2 𝑓(𝑦) − [∑ 𝑦𝑓(𝑦)]
𝑖=1 𝑖=1

= 213.913 − 8.332
 = 𝟏𝟒𝟒. 𝟓𝟐𝟒𝟏
𝑆𝐷(𝑌) = √𝑉𝑎𝑟(𝑌)
= √144.5241
= 𝟏𝟐. 𝟎𝟐𝟏𝟖
(c) Covariance and correlation between the two stocks is given by:
𝐶𝑜𝑣(𝑋, 𝑌) = 𝐸[(𝑋 − 𝐸(𝑋))(𝑌 − 𝐸(𝑌))]

= ∑ ∑(𝑋 − 𝐸(𝑋)(𝑌 − 𝐸(𝑌)𝑓(𝑥, 𝑦)

𝑥 𝑦

Where 𝑓(𝑥, 𝑦) = 𝑃(𝑋 = 𝑥 and 𝑌 = 𝑦) is the joint probability distribution function of

the two discrete random variables X and Y:
Recall:
𝐸(𝑋) = 11.80

𝐸(𝑌) = 8.33
The following Table of gives some summary characteristics:
State of
the
Economy 𝑥 𝑦 𝑓(𝑥, 𝑦) 𝐸 − 𝐸(𝑋) 𝐸 − 𝐸(𝑌) (𝐸 − 𝐸(𝑋)(𝐸 − 𝐸(𝑌)𝑓(𝑥, 𝑦)
Good 7.3 -4.7 1/3 -4.5 -13.033 19.55
Normal 11.5 5.4 1/3 -0.3 -2.933 0.293
Best 16.6 24.3 1/3 4.8 15.967 25.547
Total 45.39
From the Table above:
𝐶𝑜𝑣(𝑋, 𝑌) = 𝐸[(𝑋 − 𝐸(𝑋))(𝑌 − 𝐸(𝑌))]

= ∑ ∑(𝑋 − 𝐸(𝑋)(𝑌 − 𝐸(𝑌)𝑓(𝑥, 𝑦)

𝑥 𝑦

= 𝟒𝟓. 𝟑𝟗
𝐶𝑜𝑣(𝑋, 𝑌)
𝐶𝑜𝑟𝑟(𝑋, 𝑌) =
𝑆𝐷(𝑋)𝑆𝐷(𝑌)
45.39
=
3.803 × 12.0218
= 𝟎. 𝟗𝟗𝟑
Interpretation:
𝜌 = 0.993 indicates strong positive relationship between the two stock returns
(d) Since 𝐶𝑜𝑣(𝑋, 𝑌) ≠ 0 hence the two stock returns are NOT linearly independent.
1.7 Relationship Between Population and Sample

So, we have seen on how to compute numerous characteristics of PDF of discrete random
variables such as expected value, variance, standard deviation, covariance, and correlation
coefficient. All these are population variables. In reality when conducting quantitative
research, it is somehow difficult to deal with the whole population, unless otherwise if the
population is finite. But in most cases , we normally use a sample which is subset of the
population to draw conclusion about the properties of a given population. This is the basis of
the so-called inference statistics that will be discussed in later sections. But mean while the
sample counterpart together with their corresponding population variables are summarized
in the following Table.

Population variable Sample counterpart (Raw Data)

𝑛
𝐸(𝑋) = ∑ 𝑥𝑓(𝑥) = 𝜇𝑥 𝑋𝑖
𝑋̅ = ∑
𝑥 𝑛
𝑖=1
2 𝑛
𝑉𝑎𝑟(𝑋) = 𝐸(𝑋 − 𝐸(𝑋)) (𝑋𝑖 − 𝑋̅)2
𝑆𝑥2 =∑
= 𝐸(𝑋 − 𝜇𝑋 )2 𝑛−1
𝑖=1
= 𝛿2

𝑆𝐷(𝑋) = √𝑉𝑎𝑟(𝑋) = 𝛿 𝑆𝐷(𝑋) = √𝑉𝑎𝑟(𝑋) = 𝑆𝑥

𝐶𝑜𝑣(𝑋, 𝑌) = 𝐸[(𝑋 − 𝜇𝑥 )(𝑌 − 𝜇𝑦 )] ∑(𝑋𝑖 − 𝑋̅)(𝑌𝑖 − 𝑌̅)

sample 𝐶𝑜𝑣(𝑋, 𝑌) =
= 𝐸(𝑋𝑌) − 𝜇𝑥 𝜇𝑦 𝑛−1

𝐶𝑜𝑣(𝑋, 𝑌) sample 𝐶𝑜𝑣(𝑋, 𝑌)

𝐶𝑂𝑅𝑅(𝑋, 𝑌) = =𝜌 𝐶𝑂𝑅𝑅(𝑋, 𝑌) = =𝑟
𝛿𝑥 𝛿𝑦 𝑆𝐷(𝑋)𝑆𝐷(𝑌)

Example 1.10
Returns (in millions of shillings) from two samples of investments projects X and Y were
recorded as follows;
X 3 4 6 8 7

Y 2 5 7 8 10

(a) Compute the mean return and standard deviation for each Project.
(b) Compute the correlation between the returns and comment on your results.
Hint: Let the students find the solution of the above problem

1.8 Linear Combination of Random Variables

In this subsection we expect to discuss the concept of linear combination of two or more
random variables. We also anticipate to discuss issues related to expected value and variance
of such random variables. Mathematically, if 𝑋1 , 𝑋2 , ⋯ , 𝑋𝑛 are random variables, and
𝑎1 , 𝑎2 , ⋯ , 𝑎𝑛 are constants, then

𝑌 = 𝑎1 𝑋1 + 𝑎2 𝑋2 + ⋯ + 𝑎𝑛 𝑋𝑛 = ∑ 𝑎𝑖 𝑋𝑖 = 𝑎́ 𝑿
𝑖=1

is a linear combination of random variables. Where 𝑎́ is a row vector (a row matrix) and 𝑿
is a column vector (column matrix). That is to say a linear combination of random variables
can also be expressed in terms of matrix notation.

1.8.1 Properties of Linear Combination of Random Variables

If 𝑋1 , 𝑋2 , ⋯ , 𝑋𝑛 are random variables with a linear combination such that
𝑛

𝑌 = 𝑎1 𝑋1 + 𝑎2 𝑋2 + ⋯ + 𝑎𝑛 𝑋𝑛 = ∑ 𝑎𝑖 𝑋𝑖
𝑖=1
Then
𝑛

𝐸(𝑌) = 𝑎1 𝐸(𝑋1 ) + 𝑎2 𝐸(𝑋2 ) + ⋯ + 𝑎𝑛 𝐸(𝑋𝑛 ) = ∑ 𝑎𝑖 𝐸(𝑋𝑖 )

𝑖=1

𝐸(𝑌) = 𝑎1 𝜇1 + 𝑎2 𝜇2 + ⋯ + 𝑎𝑛 𝜇𝑛 = ∑ 𝑎𝑖 𝜇𝑖 = 𝑎𝒖́
𝑖=1
where 𝑎1 , 𝑎2 , ⋯ , 𝑎𝑛 are constants

If 𝑋1 , 𝑋2 , ⋯ , 𝑋𝑛 are random variables with a linear combination

𝑛

𝑉𝑎𝑟(𝑌) = ∑ 𝑎𝑖2 𝑉𝑎𝑟(𝑋𝑖 ) + 2 ∑ ∑ 𝑎𝑖 𝑎𝑗 𝐶𝑜𝑣(𝑋𝑖 , 𝑋𝑗 )

𝑖=1

and if 𝑋1 , 𝑋2 , ⋯ , 𝑋𝑛 are independent random variables, then

𝑛

𝑉𝑎𝑟(𝑌) = ∑ 𝑎𝑖2 𝑉𝑎𝑟(𝑋𝑖 )

𝑖=1

By considering two random variables as indicated below:

𝑍 = 𝑎𝑋 + 𝑏𝑌
Then
𝐸(𝑍) = 𝑎𝐸(𝑋) + 𝑏𝐸(𝑌)
 𝑉𝑎𝑟(𝑍) = 𝑎2 𝑉𝑎𝑟(𝑋) + 𝑏 2 𝑉𝑎𝑟(𝑌) + 2𝑎𝑏𝐶𝑜𝑣(𝑋, 𝑌)
For three random variables as indicated below:
𝑌 = 𝑎1 𝑋1 + 𝑎2 𝑋2 + 𝑎3 𝑋3
𝐸(𝑌) = 𝑎1 𝐸(𝑋1 ) + 𝑎2 𝐸(𝑋2 ) + 𝑎3 𝐸(𝑋3 )
𝑉𝑎𝑟(𝑌) = 𝑎12 𝑉𝑎𝑟(𝑋1 ) + 𝑎22 𝑉𝑎𝑟(𝑋2 ) + 𝑎32 𝑉𝑎𝑟(𝑋2 ) + 2𝑎1 𝑎2 𝐶𝑜𝑣(𝑋1 , 𝑋2 ) + 2𝑎1 𝑎3 𝐶𝑜𝑣(𝑋1 , 𝑋3 )
+ 2𝑎2 𝑎3 𝐶𝑜𝑣(𝑋2 , 𝑋3 )
If we have three or more random variables, it is more convenient to use matrix approach to
compute mean and variance of linear combination.

Note: Linear combinations are widely used in:

❖ Portfolio analysis
❖ Forecasting
❖ Finance and Economics

Example 1.11: Application in Portfolio Analysis:

Eighty percent of a portfolio is invested by in TBL stock and the remaining 20% is invested in
UTT stock. TBL stock has expected return of 6% and the expected standard deviation of return
of 9%. UTT stock has expected return of 20% and an expected standard deviation of 30%. The
coefficient of correlation between of the two securities is expected to be 0.4. Determine the
following:

a) the expected return of portfolio

b) the expected variance of the portfolio
c) the expected standard deviation of a portfolio
d) the expected variance of the portfolio if the two securities are independent

Solution:
Let 𝑋 be a random variable representing return from the amount invested in TBL, 𝑌 denote
a random variable representing return of the amount invested in UTT, and 𝑊 denotes the
corresponding weights such that ∑𝑛𝑖=1 𝑊𝑖 = 1 (this is special for portfolio)
Let also 𝑅𝑝 be a random variable representing return of corresponding portfolio then:
𝑅𝑝 = 𝑊𝑥 𝑋 + 𝑊𝑦 𝑌
That is to say, portfolio return is a linear combination of returns from the two types of
investments:
Data Given:
𝑊𝑥 = 80%, 𝑊𝑦 = 20%, 𝐸(𝑋) = 6%, 𝐸(𝑌) = 20%, 𝑆𝐷(𝑋) = 30%, 𝑆𝐷(𝑌) = 30% 𝜌𝑥𝑦 = 0.4
 a) 𝐸(𝑅𝑝 ) = 𝑊𝑥 𝐸(𝑋) + 𝑊𝑦 𝐸(𝑌)

= (0.8 × 0.06)+(0.2 × 0.2)

= 0.048 + 0.04
= 0.088
= 8.8%

b) 𝑉𝑎𝑟(𝑅𝑝 ) = 𝑊𝑥2 𝑉𝑎𝑟(𝑋) + 𝑊𝑦2 𝑉𝑎𝑟(𝑌) + 2𝑊𝑥 𝑊𝑦 𝐶𝑜𝑣(𝑋, 𝑌)

Where:
𝐶𝑜𝑣(𝑋, 𝑌) = 𝜌𝑥𝑦 𝑆𝐷(𝑋)𝑆𝐷(𝑌)

Therefore:

𝑉𝑎𝑟(𝑅𝑝 ) = 𝑊𝑥2 𝑉𝑎𝑟(𝑋) + 𝑊𝑦2 𝑉𝑎𝑟(𝑌) + 2𝑊𝑥 𝑊𝑦 𝜌𝑥𝑦 𝑆𝐷(𝑋)𝑆𝐷(𝑌)

= [0.82 × 0.092 ] + [0.22 × 0.32 ]+[2 × 0.8 × 0.2 × 0.4 × 0.09 × 0.3]
= 0.00514 + 0.0036 + 0.003456
= 0.012196

c) 𝑆𝐷(𝑅𝑝 ) = √𝑉𝑎𝑟(𝑅𝑝 )

= √0.012196
= 0.11043
d) If the two securities are independent, then 𝐶𝑜𝑣(𝑋, 𝑌) = 0
Therefore:

𝑉𝑎𝑟(𝑅𝑝 ) = 𝑊𝑥2 𝑉𝑎𝑟(𝑋) + 𝑊𝑦2 𝑉𝑎𝑟(𝑌)

= [0.82 × 0.092 ] + [0.22 × 0.32 ]

= 0.00874
Example 1.12
An investment return labelled (X) of a certain investment (in thousands of dollars) is assumed
to be a discrete random variable with the following probability distribution;

𝑥 -10 -4 0 20 25
𝑓(𝑥) 0.10 0.15 0.25 0.30 0.20

(a) Determine the expected value and standard deviation of the return.
(b) Suppose that a net present value (NPV) depends on X above, compute an expected
value and variance of NPV given that:

𝑋
𝑁𝑃𝑉 = −10 + 1.5
 (c) Three equally weighted and independent returns 𝑅𝑖 for 𝑖 = 1,2,3 constitute a portfolio
return 𝑅𝑃 . Suppose that the following information is available:
𝐸(𝑅1 ) = 9, 𝐸(𝑅2 ) = 10, 𝐸(𝑅3 ) = 7, 𝑉𝑎𝑟(𝑅1 ) = 6, 𝑉𝑎𝑟(𝑅2 ) = 12 and 𝑉𝑎𝑟(𝑅3 ) = 9.
Compute the expected return and standard deviation for the entire portfolio.

Solutions:
(a) Determine the expected value and standard deviation of the investment return.

Consider the following Table of values:

𝑥 𝑓(𝑥) 𝑥𝑓(𝑥) 𝑥 2 𝑓(𝑥)

-10 0.1 -1 10
-4 0.15 -0.6 2.4
0 0.25 0 0
20 0.3 6 120
25 0.2 5 125
Total 9.4 257.4

From the Table above:

∑ 𝑥𝑓(𝑥) = 9.4

∑ 𝑥 2 𝑓(𝑥) = 257.4

𝐸(𝑋) = ∑ 𝑥𝑓(𝑥) = 𝟗. 𝟒

𝑉𝑎𝑟(𝑋) = 𝐸(𝑋 2 ) − (𝐸(𝑋))2

𝑛 𝑛 2
2
= ∑ 𝑥 𝑓(𝑥) − [∑ 𝑥𝑓(𝑥)]
𝑖=1 𝑖=1
2
= 257.4 − 9.4
= 𝟏𝟔𝟗. 𝟎𝟒
(b) Compute an expected value and variance of NPV

From
𝑋
𝑁𝑃𝑉 = −10 +
1.5
𝑋
𝐸(𝑁𝑃𝑉) = 𝐸 (−10 + )
1.5
𝐸(𝑋)
= 𝐸(−10) +
1.5
9.4
= −10 +
1.5
 = −𝟑. 𝟕𝟑𝟑
𝑋
𝑉𝑎𝑟(𝑁𝑃𝑉) = 𝑉𝑎𝑟 (−10 + )
1.5
𝑉𝑎𝑟(𝑋)
= 𝑉𝑎𝑟(−10) +
1.52
169.04
=0+
2.25
= 𝟕𝟓. 𝟏𝟐𝟗
(c) Compute the expected return and standard deviation for the entire portfolio.

Let 𝑎1 , 𝑎2 𝑎𝑛𝑑 𝑎3 be the weights of the three independent returns, then:

𝑅𝑝 = 𝑎1 𝑅1 + 𝑎2 𝑅2 + 𝑎3 𝑅3

Where:
1
𝑎1 = 𝑎2 = 𝑎3 = 3 since ∑ 𝑎𝑖 = 1

𝐸(𝑅𝑝 ) = 𝑎1 𝐸(𝑅1 ) + 𝑎2 𝐸(𝑅2 ) + 𝑎3 𝐸(𝑅3 )

9 10 7
= + +
3 3 3
= 𝟖. 𝟔𝟕

𝑉𝑎𝑟(𝑅𝑝 ) = 𝑎12 𝑉𝑎𝑟(𝑅1 ) + 𝑎22 𝑉𝑎𝑟(𝑅2 ) + 𝑎32 𝑉𝑎𝑟(𝑅2 ) + 2𝑎1 𝑎2 𝐶𝑜𝑣(𝑅1 , 𝑅2 ) + 2𝑎1 𝑎3 𝐶𝑜𝑣(𝑅1 , 𝑅3 )
+ 2𝑎2 𝑎3 𝐶𝑜𝑣(𝑅2 , 𝑅3 )

But since returns are independent then 𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑗 ) = 0 for 𝑖 < 𝑗

Therefore:

𝑉𝑎𝑟(𝑅𝑝 ) = 𝑎12 𝑉𝑎𝑟(𝑅1 ) + 𝑎22 𝑉𝑎𝑟(𝑅2 ) + 𝑎32 𝑉𝑎𝑟(𝑅2 )

6 12 9
= + +
9 9 9
=3

𝑆𝐷(𝑅𝑝 ) = √𝑉𝑎𝑟(𝑅𝑝 )

= √3
= 1.73