Chapter 5

Discrete Probability
Distributions

5-1
 Learning Objectives
In this chapter, you learn:
 The properties of a probability distribution

 To calculate the expected value and variance of a

probability distribution
 To calculate the covariance and understand its use
in finance
 To calculate probabilities from binomial and
Poisson distributions
 How to use the binomial and Poisson distributions
to solve business problems

5-2
 Definitions
Random Variables

 A random variable represents a possible

numerical value from an uncertain event.

 Discrete random variables produce outcomes

that come from a counting process (e.g. number
of classes you are taking).

 Continuous random variables produce

outcomes that come from a measurement (e.g.
your annual salary, or your weight).

5-3
 Definitions
Random Variables

Random
Variables

Ch. 5 Discrete Continuous Ch. 6

Random Variable Random Variable

5-4
 Discrete Random Variables
 Can only assume a countable number of values
Examples:

 Roll a die twice

Let X be the number of times 4 occurs
(then X could be 0, 1, or 2 times)

 Toss a coin 5 times.

Let X be the number of heads
(then X = 0, 1, 2, 3, 4, or 5)

5-5
 Probability Distribution For A
Discrete Random Variable
 A probability distribution for a discrete random
variable is a mutually exclusive listing of all
possible numerical outcomes for that variable and
a probability of occurrence associated with each
outcome.
Number of Classes Taken Probability
2 0.20
3 0.40
4 0.24
5 0.16

5-6
 Example of a Discrete Random
Variable Probability Distribution

Experiment: Toss 2 Coins. Let X = # heads.

4 possible outcomes
Probability Distribution
X Value Probability
T T
0 1/4 = 0.25

T H 1 2/4 = 0.50
2 1/4 = 0.25

H T
Probability

0.50

0.25
H H
0 1 2 X
5-7
 Discrete Random Variables
Expected Value (Measuring Center)
 Expected Value (or mean) of a discrete
random variable (Weighted Average)
N
  E(X)   Xi P( Xi )
i1

X P(X)
 Example: Toss 2 coins, 0 0.25
X = # of heads, 1 0.50

compute expected value of X: 2 0.25

E(X) = ((0)(0.25) + (1)(0.50) + (2)(0.25))

= 1.0

5-8
 Discrete Random Variables
Measuring Dispersion
 Variance of a discrete random variable
N
σ 2   [Xi  E(X)]2 P(Xi )
i1

 Standard Deviation of a discrete random variable

N
σ  σ2   i
[X
i1
 E(X)]2
P(Xi )

where:
E(X) = Expected value of the discrete random variable X
Xi = the ith outcome of X
P(Xi) = Probability of the ith occurrence of X

5-9
 Discrete Random Variables
Measuring Dispersion
(continued)

 Example: Toss 2 coins, X = # heads,

compute standard deviation (recall E(X) = 1)

σ  [X  E(X)] P(X )
i
2
i

σ  (0  1)2 (0.25)  (1 1)2 (0.50)  (2  1)2 (0.25)  0.50  0.707

Possible number of heads

= 0, 1, or 2

5-10
 Covariance

 The covariance measures the strength of the

linear relationship between two discrete random
variables X and Y.

 A positive covariance indicates a positive

relationship.

 A negative covariance indicates a negative

relationship.

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 The Covariance Formula

 The covariance formula:

N
σ XY   [ Xi  E( X)][(Yi  E( Y )] P( Xi Yi )
i1

where: X = discrete random variable X

Xi = the ith outcome of X
Y = discrete random variable Y
Yi = the ith outcome of Y
P(XiYi) = probability of occurrence of the
ith outcome of X and the ith outcome of Y

5-12
 Investment Returns
The Mean

Consider the return per $1000 for two types of

investments.
Investment
Economic Condition
Prob. Passive Fund X Aggressive Fund Y

0.2 Recession - $25 - $200

0.5 Stable Economy + $50 + $60

0.3 Expanding Economy + $100 + $350

5-13
 Investment Returns
The Mean

E(X) = μX = (-25)(.2) +(50)(.5) + (100)(.3) = 50

E(Y) = μY = (-200)(.2) +(60)(.5) + (350)(.3) = 95

Interpretation: Fund X is averaging a $50.00 return

and fund Y is averaging a $95.00 return per $1000
invested.

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 Investment Returns
Standard Deviation

σ X  (-25  50) 2 (.2)  (50  50) 2 (.5)  (100  50) 2 (.3)

 43.30

σ Y  (-200  95) 2 (.2)  (60  95) 2 (.5)  (350  95) 2 (.3)

 193.71

Interpretation: Even though fund Y has a higher

average return, it is subject to much more variability
and the probability of loss is higher.

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 Investment Returns
Covariance

σ XY  (-25  50)(-200  95)(.2)  (50  50)(60  95)(.5)

 (100  50)(350  95)(.3)
 8,250

Interpretation: Since the covariance is large and

positive, there is a positive relationship between the
two investment funds, meaning that they will likely
rise and fall together.

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 The Sum of
Two Random Variables
 Expected Value of the sum of two random variables:

E(X  Y)  E( X)  E( Y )

 Variance of the sum of two random variables:

Var(X  Y)  σ 2X Y  σ 2X  σ 2Y  2σ XY

 Standard deviation of the sum of two random variables:

σ X Y  σ 2X Y
5-17
 Portfolio Expected Return and
Expected Risk

 Investment portfolios usually contain several

different funds (random variables)

 The expected return and standard deviation of

two funds together can now be calculated.

 Investment Objective: Maximize return (mean)

while minimizing risk (standard deviation).

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 Portfolio Expected Return
and Portfolio Risk

 Portfolio expected return (weighted average

return):
E(P)  w E( X)  (1  w ) E( Y )

 Portfolio risk (weighted variability)

σP  w 2σ 2X  (1 w )2 σ 2Y  2w(1 - w)σ XY

Where w = proportion of portfolio value in asset X

(1 - w) = proportion of portfolio value in asset Y

5-19
 Portfolio Example
Investment X: μX = 50 σX = 43.30
Investment Y: μY = 95 σY = 193.21
σXY = 8250

Suppose 40% of the portfolio is in Investment X and

60% is in Investment Y:
E(P)  0.4 (50)  (0.6) (95)  77

σ P  (0.4)2 (43.30)2  (0.6)2 (193.71)2  2(0.4)(0.6)(8,250)

 133.30

The portfolio return and portfolio variability are between the values
for investments X and Y considered individually
5-20
 Probability Distributions
Probability
Distributions

Ch. 5 Discrete Continuous Ch. 6

Probability Probability
Distributions Distributions

Binomial Normal

Poisson Uniform

Hypergeometric Exponential

5-21
 Binomial Probability Distribution
 A fixed number of observations, n
 e.g., 15 tosses of a coin; ten light bulbs taken from a warehouse
 Each observation is categorized as to whether or not the
“event of interest” occurred
 e.g., head or tail in each toss of a coin; defective or not defective
light bulb
 Since these two categories are mutually exclusive and
collectively exhaustive
 When the probability of the event of interest is represented as π,
then the probability of the event of interest not occurring is 1 - π
 Constant probability for the event of interest occurring
(π) for each observation
 Probability of getting a tail is the same each time we toss the
coin
5-22
 Binomial Probability Distribution
(continued)

 Observations are independent

 The outcome of one observation does not affect the
outcome of the other
 Two sampling methods deliver independence
 Infinite population without replacement
 Finite population with replacement

5-23
 Possible Applications for the
Binomial Distribution

 A manufacturing plant labels items as

either defective or acceptable
 A firm bidding for contracts will either get a
contract or not
 A marketing research firm receives survey
responses of “yes I will buy” or “no I will
not”
 New job applicants either accept the offer
or reject it
5-24
 Airlines may know from old data that 2% of
booked tickets are always either cancelled or
rescheduled. Here we can apply Binomial
distribution. So if 175 tickets are booked ,
n=175, p=0.02 and we can then find for any
value of X, what is the probability.

5-25
 The Binomial Distribution
Counting Techniques

 Suppose the event of interest is obtaining heads on the

toss of a fair coin. You are to toss the coin three times.
In how many ways can you get two heads?

 Possible ways: HHT, HTH, THH, so there are three

ways you can get two heads.

 This situation is fairly simple. We need to be able to

count the number of ways for more complicated
situations.

5-26
 Counting Techniques
Rule of Combinations

 The number of combinations of selecting X

objects out of n objects is

n!
n Cx 
X! (n  X)!
where:
n! =(n)(n - 1)(n - 2) . . . (2)(1)
X! = (X)(X - 1)(X - 2) . . . (2)(1)
0! = 1 (by definition)

5-27
 Counting Techniques
Rule of Combinations

 How many possible 3 scoop combinations could you

create at an ice cream parlor if you have 31 flavors to
select from?
 The total choices is n = 31, and we select X = 3.

31! 31! 31 30  29  28!

31 C 3     31 5  29  4,495
3!(31 3)! 3!28! 3  2  1  28!

5-28
 Binomial Distribution Formula

n! x nx
P(X=x |n,π)  π (1-π)
x! (n  x )!

P(X=x|n,π) = probability of x events of interest

in n trials, with the probability of an
“event of interest” being π for Example: Flip a coin four
each trial times, let x = # heads:
n=4
x = number of “events of interest” in sample,
(x = 0, 1, 2, ..., n) π = 0.5

n = sample size (number of trials 1 - π = (1 - 0.5) = 0.5

or observations) X = 0, 1, 2, 3, 4
π = probability of “event of interest”

5-29
 Example:
Calculating a Binomial Probability
What is the probability of one success in five
observations if the probability of an event of
interest is 0.1?
x = 1, n = 5, and π = 0.1

n!
P(X  1 | 5,0.1)   x (1   ) n  x
x! (n  x)!
5!
 (0.1)1 (1  0.1)51
1!(5  1)!
 (5)(0.1)(0.9)4
 0.32805

5-30
 The Binomial Distribution
Example
Suppose the probability of purchasing a defective
computer is 0.02. What is the probability of
purchasing 2 defective computers in a group of 10?
x = 2, n = 10, and π = 0.02

n!
P(X  2 | 10, 0.02)   x (1   ) n  x
x! (n  x)!
10!
 (.02)2 (1  .02)10 2
2!(10  2)!
 (45)(.0004)(.8508)
 .01531

5-31
 The Binomial Distribution
Shape

 The shape of the

P(X=x|5, 0.1)
binomial distribution 0.6
depends on the values 0.4
of π and n 0.2
 Here, n = 5 and π = 0.1 0
0 1 2 3 4 5 x

P(X=x|5, 0.5)
0.6
0.4
 Here, n = 5 and π =0.5 0.2
0
0 1 2 3 4 5 x

5-32
 The Binomial Distribution Using
Binomial Tables (Available On Line)
n = 10
x … π=.20 π=.25 π=.30 π=.35 π=.40 π=.45 π=.50
0 … 0.1074 0.0563 0.0282 0.0135 0.0060 0.0025 0.0010 10
1 … 0.2684 0.1877 0.1211 0.0725 0.0403 0.0207 0.0098 9
2 … 0.3020 0.2816 0.2335 0.1757 0.1209 0.0763 0.0439 8
3 … 0.2013 0.2503 0.2668 0.2522 0.2150 0.1665 0.1172 7
4 … 0.0881 0.1460 0.2001 0.2377 0.2508 0.2384 0.2051 6
5 … 0.0264 0.0584 0.1029 0.1536 0.2007 0.2340 0.2461 5
6 … 0.0055 0.0162 0.0368 0.0689 0.1115 0.1596 0.2051 4
7 … 0.0008 0.0031 0.0090 0.0212 0.0425 0.0746 0.1172 3
8 … 0.0001 0.0004 0.0014 0.0043 0.0106 0.0229 0.0439 2
9 … 0.0000 0.0000 0.0001 0.0005 0.0016 0.0042 0.0098 1
10 … 0.0000 0.0000 0.0000 0.0000 0.0001 0.0003 0.0010 0

… π=.80 π=.75 π=.70 π=.65 π=.60 π=.55 π=.50 x

Examples:
n = 10, π = 0.35, x = 3: P(X = 3|10, 0.35) = 0.2522
n = 10, π = 0.25, x = 8: P(X = 8|10, 0.25) = 0.0004
5-33
 Binomial Distribution
Characteristics

Mean
μ  E(X)  n


 Variance and Standard Deviation

2
σ  nπ (1 - π )
σ  nπ (1 - π )
Where n = sample size
π = probability of the event of interest for any trial
(1 – π) = probability of no event of interest for any trial

5-34
 The Binomial Distribution
Characteristics

Examples
P(X=x|5, 0.1)
μ  n  (5)(0.1)  0.5 0.6
0.4
0.2
σ  n (1 -  )  (5)(0.1)(1  0.1)
0
 0.6708 0 1 2 3 4 5 x

P(X=x|5, 0.5)
μ  nπ  (5)(.5)  2.5 0.6
0.4
σ  n (1 -  )  (5)(0.5)(1  0.5) 0.2
0
 1.118
0 1 2 3 4 5 x

5-35
Using Excel For The
Binomial Distribution

5-36
 The Poisson Distribution
Definitions

 You use the Poisson distribution when you

are interested in the number of times an event
occurs in a given area of opportunity.
 An area of opportunity is a continuous unit or
interval of time, volume, or such area in which
more than one occurrence of an event can
occur.
 The number of scratches in a car’s paint
 The number of mosquito bites on a person
 The number of computer crashes in a day

5-37
 The Poisson Distribution

 Apply the Poisson Distribution when:

 You wish to count the number of times an event
occurs in a given area of opportunity
 The probability that an event occurs in one area of
opportunity is the same for all areas of opportunity
 The number of events that occur in one area of
opportunity is independent of the number of events
that occur in the other areas of opportunity
 The probability that two or more events occur in an
area of opportunity approaches zero as the area of
opportunity becomes smaller
 The average number of events per unit is  (lambda)
5-38
 Poisson Distribution Formula


e  x
P( X  x |  ) 
X!
where:
x = number of events in an area of opportunity
 = expected number of events
e = base of the natural logarithm system (2.71828...)

5-39
 Poisson Distribution
Characteristics

Mean
μλ


 Variance and Standard Deviation

σ λ
2

σ λ
where  = expected number of events

5-40
 Using Poisson Tables
(Available On Line)


X 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90

0 0.9048 0.8187 0.7408 0.6703 0.6065 0.5488 0.4966 0.4493 0.4066

1 0.0905 0.1637 0.2222 0.2681 0.3033 0.3293 0.3476 0.3595 0.3659
2 0.0045 0.0164 0.0333 0.0536 0.0758 0.0988 0.1217 0.1438 0.1647
3 0.0002 0.0011 0.0033 0.0072 0.0126 0.0198 0.0284 0.0383 0.0494
4 0.0000 0.0001 0.0003 0.0007 0.0016 0.0030 0.0050 0.0077 0.0111
5 0.0000 0.0000 0.0000 0.0001 0.0002 0.0004 0.0007 0.0012 0.0020
6 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0001 0.0002 0.0003
7 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

Example: Find P(X = 2 |  = 0.50)

e  λ λ X e 0.50 (0.50)2
P(X  2 | 0.50)    0.0758
X! 2!

5-41
Using Excel For The
Poisson Distribution

5-42
 Graph of Poisson Probabilities

Graphically:
 = 0.50
=
X 0.50
0 0.6065
1 0.3033
2 0.0758
3 0.0126
4 0.0016
5 0.0002
6 0.0000
P(X = 2 | =0.50) = 0.0758
7 0.0000

5-43
 Poisson Distribution Shape

 The shape of the Poisson Distribution

depends on the parameter :
 = 0.50  = 3.00

5-44
 The Hypergeometric
Distribution

 The binomial distribution is applicable when

selecting from a finite population with
replacement or from an infinite population
without replacement.

 The hypergeometric distribution is applicable

when selecting from a finite population without
replacement.

5-45
 Chapter Summary

 Addressed the probability distribution of a

discrete random variable
 Defined covariance and discussed its
application in finance
 Discussed the Binomial distribution
 Discussed the Poisson distribution

5-46