Quantitative Techniques: Probability Concepts

Source: CFA® Program Curriculum Level I Volume I

1. In probability theory, exhaustive events are best described as events:

A. with a probability of zero.
B. that are mutually exclusive.
C. that include all potential outcomes.

2. Which probability estimate most likely varies greatly between people?

A. An a priori probability
B. An empirical probability
C. A subjective probability

3. If the probability that Zolaf Company sales exceed last year’s sales is 0.167, the odds for exceeding
sales are closest to:
A. 1 to 5.
B. 1 to 6.
C. 5 to 1.

4. The probability of an event given that another event has occurred is a:

A. joint probability.
B. marginal probability.
C. conditional probability.

5. After estimating the probability that an investment manager will exceed his benchmark return in
each of the next two quarters, an analyst wants to forecast the probability that the investment
manager will exceed his benchmark return over the two- quarter period in total. Assuming that
each quarter’s performance is independent of the other, which probability rule should the analyst
select?
A. Addition rule
B. Multiplication rule
C. Total probability rule

6. Which of the following is a property of two dependent events?

A. The two events must occur simultaneously.
B. The probability of one event influences the probability of the other event.
C. The probability of the two events occurring is the product of each event’s probability.

7. Which of the following best describes how an analyst would estimate the expected value of a firm
under the scenarios of bankruptcy and survivorship? The analyst would use:
A. the addition rule.
B. conditional expected values.
C. the total probability rule for expected value.

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8. An analyst developed two scenarios with respect to the recovery of $100,000 principal from
defaulted loans:
Scenario Probability of Scenario Amount Recovered Probability of Amount (%)
(%) ($)
1 40 50,000 60%
30,000 40%

2 60 80,000 90%
60,000 10%
The amount of the expected recovery is closest to:
A. $36,400.
B. $63,600.
C. $81,600.

9. US and Spanish bonds have return standard deviations of 0.64 and 0.56, respectively. If the
correlation between the two bonds is 0.24, the covariance of returns is closest to:
A. 0.086.
B. 0.670.
C. 0.781.

10. The covariance of returns is positive when the returns on two assets tend to:
A. have the same expected values.
B. be above their expected value at different times.
C. be on the same side of their expected value at the same time.

11. Which of the following correlation coefficients indicates the weakest linear relationship between
two variables?
A. – 0.67
B. – 0.24
C. 0.33

12. An analyst develops the following covariance matrix of returns:

Particulars Hedge Fund Market Index
Hedge Fund 256 110
Market Index 110 81
The correlation of returns between the hedge fund and the market index is closest to:
A. 0.005.
B. 0.073.
C. 0.764.

13. All else being equal, as the correlation between two assets approaches +1.0, the diversification
benefits:
A. decrease.
B. stay the same.
C. increase.

14. Given a portfolio of five stocks, how many unique covariance terms, excluding variances, are
required to calculate the portfolio return variance?

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 A. 10
B. 20
C. 25

15. The probability distribution for a company’s sales is:

Probability Sales ($ million)
0.05 70
0.70 40
0.25 25
The standard deviation of sales is closest to:
A. $9.81 million.
B. $12.20 million.
C. $32.40 million.

16. Which of the following statements is most accurate? If the covariance of returns between two
assets is 0.0023, then:
A. the assets’ risk is near zero.
B. the asset returns are unrelated.
C. the asset returns have a positive relationship.

17. An analyst produces the following joint probability function for a foreign index (FI) and a domestic
index (DI).
Particulars 𝑹𝑫𝑰 = 30% 𝑹𝑫𝑰 = 25% 𝑹𝑫𝑰 = 15%
𝑅 = 25% 0.25
𝑅 = 15% 0.50
𝑅 = 10% 0.25
The covariance of returns on the foreign index and the returns on the domestic index is closest to:
A. 26.39.
B. 26.56.
C. 28.12.

18. A manager will select 20 bonds out of his universe of 100 bonds to construct a portfolio. Which
formula provides the number of possible portfolios?
A. Permutation formula
B. Multinomial formula
C. Combination formula

19. A firm will select two of four vice presidents to be added to the investment committee. How many
different groups of two are possible?
A. 6
B. 12
C. 24

20. From an approved list of 25 funds, a portfolio manager wants to rank 4 mutual funds from most
recommended to least recommended. Which formula is most appropriate to calculate the number
of possible ways the funds could be ranked?
A. Permutation formula
B. Multinomial formula

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 C. Combination formula

CFA Website Questions

21. By definition, the probability of any Event E is a number between:
A. zero and positive infinity.
B. minus one and positive one.
C. zero and positive one.

22. If the probability for an event Z is 14% (i.e., P(Z) = 14%), the odds for Z are closest to:
A. 0.163.
B. 0.071.
C. 0.123.

23. Event X and Event Y are independent events. The probability of X is 0.2 [P(X) = 0.2] and the
probability of Y is 0.5 [P(Y) = 0.5]. The joint probability of X and Y, P(XY), is closest to:
A. 0.7.
B. 0.3.
C. 0.1.

24. Two events A and B are independent if the probability of occurrence of A:

A. equals the product of the individual probabilities of occurrence of A and B.
B. is related to the occurrence of B.
C. does not affect the probability of occurrence of B

25. An analyst applies four valuation screens to a set of potential investments. The screens are
independent of each other.
Valuation Screen Probability of Passing
1 0.65
2 0.45
3 0.40
4 0.30
If there are 1,200 potential investments, the number expected to simultaneously pass all four
screens is closest to:
A. 360.
B. 97.
C. 42.

26. The total probability rule is used when an analyst is interested in:
A. all potential outcomes.
B. a set of events.
C. a single outcome.

27. An analyst develops a set of criteria for evaluating distressed credits. Companies that do not
receive a passing score are classed as likely to go bankrupt within the next year. The analyst
concludes the following:
• Forty percent of the companies tested will go bankrupt within a year: P (non-survivor) = 0.40.
• Fifty-five percent of companies tested will pass: P (pass test) = 0.55.

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 • There is an eighty-five percent probability that a company will pass the test given that it survives
a year: P (pass test | survivor) = 0.85.
Using the total probability rule, the probability that a company passed the test given that it goes
bankrupt can be determined. The P (pass test | non-survivor) is closest to:
A. 0.22.
B. 0.35.
C. 0.10.

28. A tree diagram is most likely used when dealing with investment problems that involve outcomes
that are:
A. independent at each node.
B. mutually exclusive.
C. unconditional at each node

29. The conditional expected value of a random variable is best described as the:
A. expected value of a random variable given an event or scenario.
B. probability-weighted average of the possible outcomes of the random variable.
C. weighted average of the probabilities of an event given all possible scenarios.

30. When working backward from the nodes on a binomial tree diagram, the analyst is attempting to
calculate:
A. the number of potential outcomes.
B. the probability of a given scenario.
C. an expected value as of today.

31. Assuming no short selling, a diversification benefit is most likely to occur when the correlations
among the securities contained in the portfolio are:
A. greater than +1.
B. equal to +1.
C. less than +1.

32. The variance of returns of Asset A is 625. The variance of returns of Asset B is 1,225. The covariance
of returns between Asset A and Asset B is 600. The correlation of returns between Asset A and
Asset B is closest to:
A. 0.29.
B. 0.69.
C. 0.47.

33. The following information applies to a portfolio composed of Fund A and Fund B:
Particulars Fund A Fund B
Portfolio weights (%) 70 30
Expected returns (%) 10 16
Standard deviations (%) 7 13
Correlation between the returns of Fund A and Fund B 0.80
The portfolio’s standard deviation of return is closest to:
A. 7.38%.
B. 8.80%.
C. 8.35%.

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34. The joint probability of returns for securities A and B are as follows:
Joint Probability Function of Security A and Security B Returns (Entries Are Joint Probabilities)
Particulars Return on Security B = 30% Return on Security B = 20%
Return on Security A = 25% 0.60 0
Return on Security A = 20% 0 0.40
The covariance of the returns between Securities A and B is closest to:
A. 12.
B. 14.
C. 13.

35. An investor in Abco stock forecasts the probability that Abco exceeded, met, or fell short of
consensus expectations for free cash flow (FCF) during the prior quarter:
• P (FCF exceeded consensus) = 0.50
• P (FCF met consensus) = 0.35
• P (FCF fell short of consensus) = 0.15
While waiting for Abco to release last quarter’s FCF data, the investor learns that Abco will acquire
a competitor. Believing that the upcoming acquisition makes it more likely that last quarter’s FCF
will exceed the consensus, the investor generates a list of FCF events that may have influenced
the acquisition:
• P (Acquisition | FCF exceeded consensus) = 0.40
• P (Acquisition | FCF met consensus) = 0.25
• P (Acquisition | FCF fell short of consensus) = 0.35
Using Bayes’ Formula, calculate the probability that Abco is likely to exceed consensus FCF
expectations for last quarter given the acquisition.
P (FCF exceeded consensus | Acquisition) is closest to:
A. 34%.
B. 59%.
C. 27%.

36. The number of permutations that are possible when choosing 4 objects from a total of 10 objects
is closest to:
A. 30.
B. 210.
C. 5,040.

Solutions
1. C is correct. The term “exhaustive” means that the events cover all possible outcomes.

2. C is correct. A subjective probability draws on personal or subjective judgment that may be

without reference to any particular data.

3. A is correct. Given odds for E of a to b, the implied probability of E = a/(a + b). Stated in terms of
odds a to b with a = 1, b = 5, the probability of E = 1/(1 + 5) = 1/6 = 0.167. This result confirms that
a probability of 0.167 for beating sales is odds of 1 to 5.

4. C is correct. A conditional probability is the probability of an event given that another event has
occurred.

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5. B is correct. Because the events are independent, the multiplication rule is most appropriate for
forecasting their joint probability. The multiplication rule for independent events states that the
joint probability of both A and B occurring is P(AB) = P(A)P(B).

6. B is correct. The probability of the occurrence of one is related to the occurrence of the other. If
we are trying to forecast one event, information about a dependent event may be useful.

7. C is correct. The total probability rule for expected value is used to estimate an expected value
based on mutually exclusive and exhaustive scenarios.

8. B is correct. If Scenario 1 occurs, the expected recovery is 60% ($50,000) + 40% ($30,000) =
$42,000, and if Scenario 2 occurs, the expected recovery is 90% ($80,000) + 10% ($60,000) =
$78,000. Weighting by the probability of each scenario, the expected recovery is 40% ($42,000) +
60% ($78,000) = $63,600. Alternatively, first calculating the probability of each amount occurring,
the expected recovery is (40%)(60%)($50,000) + (40%)(40%)($30,000) + (60%)(90%)($80,000) +
(60%)(10%)($60,000) = $63,600.

9. A is correct. The covariance is the product of the standard deviations and correlation using the
formula Cov (US bond returns, Spanish bond returns) = σ(US bonds) × σ (Spanish bonds) × ρ(US
bond returns, Spanish bond returns) = 0.64 × 0.56 × 0.24 = 0.086.

10. C is correct. The covariance of returns is positive when the returns on both assets tend to be on
the same side (above or below) their expected values at the same time, indicating an average
positive relationship between returns.

11. B is correct. Correlations near +1 exhibit strong positive linearity, whereas correlations near –1
exhibit strong negative linearity. A correlation of 0 indicates an absence of any linear relationship
between the variables. The closer the correlation is to 0, the weaker the linear relationship.

12. C is correct. The correlation between two random variables 𝑅 and 𝑅 is defined as ρ (𝑅 ,𝑅 ) = Cov
(𝑅 ,𝑅 ) / [σ(𝑅 )σ(𝑅 )]. Using the subscript i to represent hedge funds and the subscript j to
represent the market index, the standard deviations are σ (𝑅 ) = 2561/2 = 16 and σ (𝑅 ) = 811/2 =
9. Thus, ρ (𝑅 ,𝑅 ) = Cov (𝑅 ,𝑅 ) / [σ (𝑅 ) σ (𝑅 )] = 110 / (16 × 9) = 0.764.

13. A is correct. As the correlation between two assets approaches +1, diversification benefits
decrease. In other words, an increasingly positive correlation indicates an increasingly strong
positive linear relationship and fewer diversification benefits.

14. A is correct. A covariance matrix for five stocks has 5 × 5 = 25 entries. Subtracting the 5 diagonal
variance terms results in 20 off- diagonal entries. Because a covariance matrix is symmetrical, only
10 entries are unique (20/2 = 10).

15. A is correct.

STEP 1
Press 2nd 7 to enter data
Press 2nd CLR Work
X01= 70, Y01= 5

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 X02= 40, Y01= 70
X03= 25, Y01= 25

STEP 2
Press 2nd 8 (STAT)
Press 2nd down arrow till you get 1-V
Press down arrow 4 times
Standard Deviation σ = 9.80

16. C is correct. The covariance of returns is positive when the returns on both assets tend to be on
the same side (above or below) their expected values at the same time.

17. B is correct. The covariance is 26.56, calculated as follows. First, expected returns are
E(𝑅 ) = (0.25 × 25) + (0.50 × 15) + (0.25 × 10)
= 6.25 + 7.50 + 2.50 = 16.25 and

E(𝑅 ) = (0.25 × 30) + (0.50 × 25) + (0.25 × 15)

= 7.50 + 12.50 + 3.75 = 23.75.

Covariance is
Cov (𝑅 , 𝑅 ) = 0.25 [(25 – 16.25)(30 – 23.75)] + 0.50[(15 – 16.25) (25 – 23.75)] + 0.25[(10 –
16.25)(15 – 23.75)] = 13.67 + (–0.78) + 13.67 = 26.56.

18. C is correct. The combination formula provides the number of ways that r objects can be chosen
from a total of n objects, when the order in which the r objects are listed does not matter. The
order of the bonds within the portfolio does not matter.

19. A is correct. The answer is found using the combination formula

!
𝑛𝐶𝑟 = ( )! !
Here, n = 4 and r = 2, so the answer is 4! / [(4 – 2)!2!] = 24 / [(2) × (2)] = 6. This result can be verified
by assuming there are four vice presidents, VP1–VP4. The six possible additions to the investment
committee are VP1 and VP2, VP1 and VP3, VP1 and VP4, VP2 and VP3, VP2 and VP4, and VP3 and
VP4.

20. A is correct. The permutation formula is used to choose r objects from a total of n objects when
order matters. Because the portfolio manager is trying to rank the four funds from most
recommended to least recommended, the order of the fund’s matters; therefore, the
permutation formula is most appropriate.

21. C is correct. The two defining properties of a probability are as follows:The probability of any
Event E is a number between zero and one and the sum of the probabilities of any set of mutually
exclusive and exhaustive events equals one.

22. A is correct. Odds are calculated as P(Z) / [1 − P(Z)]. In this problem, 0.14/0.86 = 0.16279 ~ 0.163.

23. C is correct. Given that X and Y are independent, their joint probability is equal to the product of
their individual probabilities. In this case: P(XY) = P(X)P(Y) = 0.2 × 0.5 = 0.1.

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24. C is correct. When two events are independent, the events are unrelated and the probability of
occurrence of one event does not affect the other.

25. C is correct. As the screens are independent, the probability of passing all four simultaneously is
the product of their respective probabilities:
P(ABCD) = P(A)P(B)P(C)P(D)
where P(A) = 0.65 and is the probability of passing valuation screen 1
P(B) = 0.45 and is the probability of passing valuation screen 2
P(C) = 0.40 and is the probability of passing valuation screen 3
P(D) = 0.30 and is the probability of passing valuation screen 4
P(ABCD) = 0.65 × 0.45 × 0.40 × 0.30 = 0.0351.
Given 1,200 potential investments, approximately 1,200 × 0.0351 = 42.12 ~ 42 will pass the
screens.

26. A is correct. When the scenarios (conditioning events) are mutually exclusive and exhaustive, no
possible outcomes are left out, thereby covering all potential outcomes.

27. C is correct. Using tree, take P(Non- Survivor Pass Test) = x, P( Survivor, Pass test) = (0.60)(0.85),
Given, P(Pass Test) =0.55
P(Pass Test) = P(Non- Survivor Pass Test) + P( Survivor, Pass test)
0.55 = x(0.40) + (0.60)(0.85) => x = 0.10

28. B is correct. A tree diagram is a diagram with branches emanating from nodes representing either
mutually exclusive outcomes or mutually exclusive decisions. Mutually exclusive outcomes are
dependent (the occurrence of one outcome does affect the probability of occurrence of the other
outcome). In addition, outcomes at each node are conditional (the probability of an outcome is
conditioned on another outcome).

29. A is correct. The conditional expected value of a random variable is the expected value of a
random variable given an event or scenario.

30. C is correct. In a tree diagram, a problem is worked backward to formulate an expected value as
of today.

31. C is correct. As long as security returns are not perfectly positively correlated, diversification
benefits are possible.

32. B s correct. Correlation of returns between asset i and j, ρ(Ri,Rj), is defined as:
ρ(Ri,Rj) = Cov(Ri,Rj)/σ(Ri)σ(Rj)
In this problem, the correlation is:
= 0.69
(√ )√ )

33. C is correct. The covariance between Fund A and Fund B, given the standard deviation of returns
and the correlation between the two funds, is calculated as:
Cov(RA,RB) = ρ(RA,RB)σ(RA)σ(RB) = 0.80 × 7% × 13% = 0.00728.
Then the portfolio standard deviation of returns is calculated as follows:

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 σ (Rportfolio) = √0.70 × 0.07 + 0.30 × 0.13 + 2 × 0.70 × 0.3 × 0.00728 = 8.35%

34. A is correct. First calculate the expected returns on securities A and B:

Expected return on security A = 0.6 × 25% + 0.4 × 20% = 15% + 8% = 23%
Expected return on security B = 0.6 × 30% + 0.4 × 20% = 18% + 8% = 26%
Then calculate the covariance of returns between securities A and B
Cov(RA,RB) = 0.6[(25-23)(30-26)] + 0.4[(20-23)(20-26)] = 12

35. B is correct. The updated probability P(FCF exceeded consensus | Acquisition) is 59%.
Calculate the unconditional probability that Abco will acquire the competitor firm:
P(Acquisition) = (0.50 × 0.40) + (0.35 × 0.25) + (0.15 × 0.35) = 0.34, or 34%.

Calculate the updated probability that Abco exceeded consensus expectations for FCF given that
they acquire the competitor firm: P(FCF exceeded consensus | Acquisition) = [P(Acquisition | FCF
exceeded consensus)/P(Acquisition)] × P(FCF exceeded consensus) = (0.40/0.34) × (0.50) = 0.59
or 59%.

36. C is correct. Press 10, then 2nd - sign and then 4 to get 5,040. (nPr formula via calc)

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