Random variable, outcome, and event

Subjective

Interest rate Empirical (observation)

Types of probability Objective
PV and FV of cash flows Priori (logical analysis)
Probability and odd ratios
PV of unequal cash flows
Time value of money
Odds for/against
Non-​annual & continuous compounding

Addition rule
Solving for I/Y, CAGR, PMT, N

Conditional and joint probability Multiplication rule

Additivity principle

Total probability rule

Nominal (non-​ranked) Probability Concepts
Qualitative Conditional expected value and variance
Ordinal (ranked) (categorical)
Expected value and variance
Tree diagram
Discrete
Quantitative Covariance given a joint probability function
Continuous (numerical)
Data types

Cross-​sectional / Time Series / Panel data

Bayes' formula
Structured (numbers) / Unstructured (text, audio, video, images)

Organizing data
Combination (tổ hợp)
Principles of counting
Frequency distributions
Permutation (chỉnh hợp)

Contingency table
Discrete => Probability mass function: p(x) = P(X = x)

Visualization
Random variables Continuous => Probability density function (pdf): f(x) = P(X = x)

Sample mean (arithmetic)

Cumulative distribution function (cdf): P(X ≤ x); F(x) = P(X ≤ x)

Median
Discrete and continuous uniform

Mode
Bernoulli trial/random variable
Binomial
Outliers
Binomial random variable (x): number of successes in Bernoulli trial Probability of 'x' successes in 'n' trials
Organizing, Visualizing, and Describing Data
Winsorized mean
Univariate/Multivariate distribution
Other means
Geometric mean
'n' Means

Harmonic mean
Common Probability Distributions Multivariate normal distribution for 'n' variables 'n' Variances

Weighted mean Normal

'n(n - 1)/2' Pairwise correlations

Trimmed mean
Suitable for modelling quarterly/yearly returns; NOT suitable for modelling asset prices

Winsorized mean
Standardizing a random variable

Sample variance and standard deviation Measures of Central Tendency & Dispersion
Modern portfolio theory (MPT): the
value of investment opportunities can
Range be meaningfully measured in terms of
mean return and variance of return.
Application of normal distribution
Mean absolute deviation (MAD)
Shortfall risk: The risk that portfolio value
or portfolio return will fall below some
Sample variance and standard deviation minimum acceptable level over some time
horizon.

Interquartile range (IQR) Quantiles

Roy's Safety-​first Ratio

L = (n+1)y/100 Location (L) of the 'y'th percentile with 'n' data entries Quartiles / Quintiles / Deciles / Percentiles
Stress testing: A specific type of scenario
analysis that estimates losses in rare and
Box and whisker plot
extremely unfavorable combinations of
events or scenarios.

Scenario analysis: A technique for exploring

the performance and risk of investment
strategies in different structural regimes.

Suitable for modelling asset prices

Target downside deviation (target semi-​ Mean (μL) of a lognormal random variable = e^(μ + 0.5σ^2)
deviation) and coefficient of variation Lognormal distribution

Variance (σL^2) of a lognormal random variable = e^(2μ + σ^2) × [e^(σ^2) − 1]

Suitable for modelling asset prices

Formula Shape of distributions

Skewness Continuous compounded rate of return

Normal

the continuously compounded return to time T is

Negatively (left) skewed the sum of the one-​period continuously
compounded returns

Positively (right) skewed

Kurtosis Volatility measures the standard deviation of the continuously compounded returns on the
underlying asset (by convention, it is stated as an annualized measure typically done on the
basis of 250 days in a year - the approximate number of days markets are open for trading).

Correlation

Quantitative
methods t-​distribution has fatter tails than normal distribution => more reliable and
conservative downside risk estimate
t-​test, Chi square, F-​test

Chi-​square and F-​test are bounded below by 0

Monte Carlo simulation

Strengths: price complex securities for which no analytic expression is available

Weaknesses:
Provides only statistical estimates, not exact results.
Analytic methods, where available, provide more insights into cause-​effect relationship.

Convenience
Non-​probability Small scale pilot studies

Judgmental
Auditing

Simple random

Probability Systematic: selecting every 'k'th observation

Process of hypothesis testing

Stratified random: population is divided into strata based on classification criteria; simple
Appropriate test statistics random samples are then drawn from each stratum proportionally to the relative size of
Sampling methods each stratum in the population to form a large sample.

Level of significance
Cluster: divides a population into clusters representative of the population and then
randomly draws certain clusters to form a sample.
1-​tailed test
Relatively less accurate but more time-​efficient and cost-​efficient
Decision rule
2-​tailed test
Sampling error: difference between the observed value of a statistic and the quantity it is
Sampling and Estimation intended to estimate as a result of sampling.

Sampling Distribution of a Statistic: the distribution of all the distinct possible values that
the statistic can assume when computed from samples of the same size randomly drawn
from the same population.
Hypothesis Testing
CLT: Given a population described by any probability distribution having mean μ and finite
variance σ^2, the sampling distribution of the sample mean computed from random
samples from this population will be approximately normal with mean μ (the population
Making a decision Central limit theorem (CLT) & Distribution of the sample mean
mean) and variance σ^2/n (the population variance divided by n) when the sample size n is
Statistical significance ≠ economic significance
large (n ≥ 30), regardless of the population's distribution.

p-​value below significance level

Standard error of the sample mean: how much inaccuracy of a population parameter
=> null is rejected
estimate comes from sampling.
p-​value

p-​value is the smallest value

where the null can be rejected Unbiased: one whose expected value (the mean of its sampling distribution) equals the
=> then the smaller the p-​value, parameter it is intended to estimate.
the more likely null is rejected
Point estimates of population mean
Efficient: an unbiased estimator is efficient if no other unbiased estimator of the same
False discovery approach: An adjustment in parameter has a sampling distribution with smaller variance.
the p-​values for tests performed multiple times.

False discovery rate (FDR): The rate of Type I errors in testing a null hypothesis multiple Consistent: one for which the probability of estimates getting close to the value of the
times for a given level of significance. population parameter increases as sample size increases.

Multiple Tests and Significance Interpretation z-​statistics

Multiple testing problem: The risk of getting statistically Confidence intervals = Point estimate ± Reliability factor × Standard error
significant test results when performing a test multiple times. t-​statistics
If you run 100 tests and use a 5% level of significance, you
Confidence Intervals for the Population Mean and Sample Size Selection
get 5 false positives, on average.
Sample size selection
Risk of sampling from more than one population and additional expenses of different
Tests for a single mean sample sizes.

With independent samples

Tests for differences between means Bootstrap: repeatedly draws samples with replacement of the selected elements from the
original observed sample, treating the original sample as a new population (often used to
With dependent samples
find standard error or construct confidence intervals of population parameters).

Single variance Resampling

Tests of variances Jackknife: repeatedly draws samples by taking the original observed data sample and
leaving out one observation at a time (without replacement) from the set.
2 variances

Data snooping: determining a model by extensive searching through a dataset

for statistically significant patterns.
When the data we use do NOT meet distributional assumptions. out-​of-​sample test

Sample selection bias: Bias introduced by systematically excluding some members of the
When there are outliers. Usage Parametric vs Non-​parametric tests Sampling biases
population according to a particular attribute—​for example, the bias introduced when data
availability leads to certain observations being excluded from the analysis.
When the data are given in ranks or use an ordinal scale. implicit selection bias: selection bias introduced through the presence of a threshold
that filters out some unqualified members.

When the hypotheses we are addressing do NOT concern a parameter.

Survivorship bias: The exclusion of poorly performing or defunct companies from an index
or database, biasing the index or database toward financially healthy companies.
However, if the assumptions of the parametric test are met, the parametric test is preferred
because it may have a greater ability to reject a false null hypothesis.
Backfill bias: certain surviving hedge funds are added to databases and various hedge fund
indexes only after they are initially successful and start to report their returns.
Pearson correlation
Tests of correlation Look-​ahead bias: bias caused by using information that was unavailable on the test date.
Spearman rank correlation coefficient

Time-​period bias: statistical conclusion may be sensitive to the starting and ending dates of
the sample.

Tests of independence using contingency table

Intercept, slope coefficient, and error term

Sum of squared errors

Measures of variation Estimating parameters

Simple linear regression (SLR)

Linearity

Homoskedasticity
Introduction to Linear Regression
Assumptions
Independence

Normality

Sum of squared errors (SSE):

measures variation in observed
values NOT attributable to the
relationship between the dependent
and independent variables

Total sum of squares (SST):

measures variation of observed
values around the mean

Analysis of variance
Sum of squared regressions (SSR): (ANOVA)
measures variation in observed values
attributable to the relationship between
the dependent and independent variables

Coefficient of determination (R-​squared)

Standard error of the estimate

Slope coefficient
Hypothesis testing of linear regression coefficients
Intercept

Prediction using SLR

Log-​lin

Lin-​log
Functional forms of SLR
Log-​log: useful in calculating elasticities because the slope coefficient is the relative change
in the dependent variable for a relative change in the independent variable.

Selecting functional forms: examining the goodness of fit measures (R-​squared, F-​statistic,
and the standard error of the estimate), and whether there are patterns in the residuals.