Hypergeometric Distribution

The probability distribution of a hypergeometric random variable is called

a hypergeometric distribution. This lesson describes how hypergeometric
random variables, hypergeometric experiments, hypergeometric probability, and
the hypergeometric distribution are all related.
Notation
The following notation is helpful, when we talk about hypergeometric distributions
and hypergeometric probability.
 N : The number of items in the population.
 k : The number of items in the population that are classified as successes.
 n: The number of items in the sample.
 x : The number of items in the sample that are classified as successes.
 k C x : The number of combinations of k things, taken x at a time.

 h( x ; N , n , k ): hypergeometric probability - the probability that an n-trial

hypergeometric experiment results in exactly x successes, when the population
consists of N items, k of which are classified as successes.
Hypergeometric Experiments

A hypergeometric experiment is a statistical experiment that has the following

properties:
 A sample of size n is randomly selected without replacement from a
population of N items.
 In the population, k items can be classified as successes, and N - k items can
be classified as failures.
Consider the following statistical experiment. You have an urn of 10 marbles - 5
red and 5 green. You randomly select 2 marbles without replacement and count the
number of red marbles you have selected. This would be a hypergeometric
experiment.
Note that it would not be a binomial experiment. A binomial experiment requires
that the probability of success be constant on every trial. With the above
experiment, the probability of a success changes on every trial. In the beginning,
the probability of selecting a red marble is 5/10. If you select a red marble on the
first trial, the probability of selecting a red marble on the second trial is 4/9. And if
you select a green marble on the first trial, the probability of selecting a red marble
on the second trial is 5/9.
Note further that if you selected the marbles with replacement, the probability of
success would not change. It would be 5/10 on every trial. Then, this would be a
binomial experiment.
Hypergeometric Distribution
A hypergeometric random variable is the number of successes that result from a
hypergeometric experiment. The probability distribution of a hypergeometric
random variable is called a hypergeometric distribution.
Given x , N , n ,∧k , we can compute the hypergeometric probability based on the
following formula:

Hypergeometric Formula. Suppose a population consists of N items, k of which are

successes. And a random sample drawn from that population consists of n items, x of which
are successes. Then the hypergeometric probability is:

h ( x ; N , n , k )=
[ kC x ][ N−k C n−x ]
[ NC n ]

The hypergeometric distribution has the following properties:

 The mean of the distribution is equal to n∗k /N .
 The variance is n∗k∗(N −k )∗(N−n)/[N 2∗(N −1)] .
Example 1
Suppose we randomly select 5 cards without replacement from an ordinary deck of
playing cards. What is the probability of getting exactly 2 red cards (i.e., hearts or
diamonds)?
Solution: This is a hypergeometric experiment in which we know the following:
 N = 52; since there are 52 cards in a deck.
 k = 26; since there are 26 red cards in a deck.
 n = 5; since we randomly select 5 cards from the deck.
 x = 2; since 2 of the cards, we select are red.
We plug these values into the hypergeometric formula as follows:

h ( x ; N , n , k )=
[ kC x ][ N−k C n−x ]
[ NC n ]

h(2; 52 , 5 ,26)=
[ 26C 2 ][ 26C 3 ]
[ 52C 5 ]
[ 325 ] [ 2600 ]
h ( 2 ; 52, 5 , 26 )=
[ 2,598,960 ]
h(2; 52 , 5 ,26)=0.32513

Thus, the probability of randomly selecting 2 red cards is 0.32513.

Cumulative Hypergeometric Probability

A cumulative hypergeometric probability refers to the probability that the
hypergeometric random variable is greater than or equal to some specified lower
limit and less than or equal to some specified upper limit.
For example, suppose we randomly select five cards from an ordinary deck of
playing cards. We might be interested in the cumulative hypergeometric probability
of obtaining 2 or fewer hearts. This would be the probability of obtaining 0 hearts
plus the probability of obtaining 1 heart plus the probability of obtaining 2 hearts,
as shown in the example below.
Example 2
Suppose we select 5 cards from an ordinary deck of playing cards. What is the
probability of obtaining 2 or fewer hearts?
Solution: This is a hypergeometric experiment in which we know the following:
 N = 52; since there are 52 cards in a deck.
 k = 13; since there are 13 hearts in a deck.
 n = 5; since we randomly select 5 cards from the deck.
 x = 0 to 2; since our selection includes 0, 1, or 2 hearts.
We plug these values into the hypergeometric formula as follows:
h( x< x ; N , n , k)=h(x <2 ; 52, 5 , 13)

h( x<2 ; 52 ,5 ,13)=h (x=0 ; 52 ,5 , 13)+h(x=1 ; 52 ,5 , 13)+h(x=2; 52 , 5 ,13)

h( x<2 ; 52 ,5 ,13)=[
[ 13C 0 ][ 39C 5 ] ]+[ [ 13C 1 ][ 39C 4 ] ]+[ [ 13C2 ][ 39C 3 ] ]
[ 52C 5 ] [ 52C 5 ] [ 52C5 ]
( 1 ) ( 575,757 ) ( 13 )( 82,251 ) ( 78 ) ( 9139 )
h( x<2 ; 52 ,5 ,13)=[ ]+[ ]+[ ]
2,598,960 2,598,960 2,598,960

h( x<2 ; 52 ,5 ,13)=[0.2215]+[0.4114]+[0.2743]

h( x<2 ; 52 ,5 ,13)=0.9072

Thus, the probability of randomly selecting at most 2 hearts is 0.9072.

Negative Binomial Distribution

Negative Binomial Experiment
A negative binomial experiment is a statistical experiment that has the following
properties:
 The experiment consists of x repeated trials.
 Each trial can result in just two possible outcomes. We call one of these
outcomes a success and the other, a failure.
 The probability of success, denoted by P, is the same on every trial.
 The trials are independent; that is, the outcome on one trial does not affect
the outcome on other trials.
 The experiment continues until r successes are observed, where r is
specified in advance.
Consider the following statistical experiment. You flip a coin repeatedly and count
the number of times the coin lands on heads. You continue flipping the coin until it
has landed 5 times on heads. This is a negative binomial experiment because:
 The experiment consists of repeated trials. We flip a coin repeatedly until it
has landed 5 times on heads.
 Each trial can result in just two possible outcomes - heads or tails.
 The probability of success is constant - 0.5 on every trial.
 The trials are independent; that is, getting heads on one trial does not affect
whether we get heads on other trials.
 The experiment continues until a fixed number of successes have occurred;
in this case, 5 heads.
Notation
The following notation is helpful, when we talk about negative binomial
probability.
 x : The number of trials required to produce r successes in a negative
binomial experiment.
 r : The number of successes in the negative binomial experiment.
 P: The probability of success on an individual trial.
 Q : The probability of failure on an individual trial. (This is equal to 1 - P.)
 b∗( x ; r , P): Negative binomial probability - the probability that an x-trial
negative binomial experiment results in the rth success on the xth trial, when
the probability of success on an individual trial is P.
  nCr : The number of combinations of n things, taken r at a time.
 n !: The factorial of n (also known as n factorial).
Negative Binomial Distribution
A negative binomial random variable is the number X of repeated trials to produce
r successes in a negative binomial experiment. The probability distribution of a
negative binomial random variable is called a negative binomial distribution. The
negative binomial distribution is also known as the Pascal distribution.
Suppose we flip a coin repeatedly and count the number of heads (successes). If we
continue flipping the coin until it has landed 2 times on heads, we are conducting a
negative binomial experiment. The negative binomial random variable is the
number of coin flips required to achieve 2 heads. In this example, the number of
coin flips is a random variable that can take on any integer value between 2 and
plus infinity. The negative binomial probability distribution for this example is
presented below.
Number of coin flips Probability
2 0.25
3 0.25
4 0.1875
5 0.125
6 0.078125
7 or more 0.109375
Negative Binomial Probability
The negative binomial probability refers to the probability that a negative
binomial experiment results in r - 1 successes after trial x - 1 and r successes after
trial x. For example, in the above table, we see that the negative binomial
probability of getting the second head on the sixth flip of the coin is 0.078125.
Given x ,r ,∧P, we can compute the negative binomial probability based on the
following formula:
 Negative Binomial Formula. Suppose a negative binomial experiment consists of x trials
and results in r successes. If the probability of success on an individual trial is P, then the
negative binomial probability of seeing the rah success on trial x is:
b*(x; r, P) = x-1Cr-1 * PR * (1 - P) x - r
b*(x; r, P) = {(x-1)! / [ (r-1)! (x-r)!]} * PR * (1 - P) x - r
P(X=r) = {(x-1)! / [ (r-1)! (x-r)!]} * PR * (1 - P) x - r

Negative Binomial Distribution: Mean and Variance

If we define the mean of the negative binomial distribution as the average number
of trials required to produce r successes, then the mean and variance of the
negative binomial distribution are equal to:
r
μ=
p

r∗( 1−P )
σ 2= 2
P

where μ is the mean of the negative binomial distribution, σ 2 is the variance of the
negative binomial distribution, r is the number of successes, and P is the
probability of a success on any given trial.
Geometric Distribution
The geometric distribution is a special case of the negative binomial distribution.
It deals with the number of trials required for a single success. Thus, the geometric
distribution is negative binomial distribution where the number of successes (r) is
equal to 1.
A Geometric Experiment
A geometric experiment is a statistical experiment that has the following
properties:
 The experiment consists of x repeated trials.
  Each trial can result in just two possible outcomes. We call one of these
outcomes a success and the other, a failure.
 The probability of success, denoted by P, is the same on every trial.
 The trials are independent; that is, the outcome on one trial does not affect
the outcome on other trials.
 The experiment continues until the first success is observed.
An example of a geometric distribution would be tossing a coin until it lands on
heads. We might ask: What is the probability that the first head occurs on the third
flip? That probability is referred to as a geometric probability and is denoted by
g(x ; P).

Geometric Probability
The formula for geometric probability is given below.

Geometric Probability Formula. Suppose a negative binomial experiment consists

of x trials and results in one success. If the probability of success on an individual trial
is P, then the geometric probability is:
P(X=x) = g (x; P) = P * Qi - 1

Geometric Distribution: Mean, Variance, and Mode

If we define the mean of the geometric distribution as the average number of trials
required to produce the first success, then the mean and variance of the negative
binomial distribution are equal to:
1
μ=
P
1∗1−P
σ 2= 2
P

where μ is the mean of the geometric distribution, σ 2 is the variance of the

geometric distribution, and P is the probability of a success on any given trial.
The mode of a geometric distribution is always 1, regardless of probability. This is
because the most likely outcome is that the first success happens immediately on
the first trial.
Problem 1: Negative binomial probability
Bob is a high school basketball player. He is a 70% free throw shooter. That means
his probability of making a free throw is 0.70. During the season, what is the
probability that Bob makes his third free throw on his fifth shot?
Solution: This is an example of a negative binomial experiment. The probability of
success (P) is 0.70, the number of trials (x) is 5, and the number of successes (r) is
3.
To solve this problem, we enter these values into the negative binomial formula.
b∗( x ; r , P)=x−1C r−1∗Pr∗Q x−rb∗(5; 3 , 0.7)=4 C 2∗0.7 3∗0.3 2
b∗(5; 3 , 0.7)=6∗0.343∗0.09=0.18522

Thus, the probability that Bob will make his third successful free throw on his fifth
shot is 0.18522.
Problem 2: Geometric probability
Let's reconsider the above problem from Example 1. This time, we'll ask a slightly
different question: What is the probability that Bob makes his first free throw on
his fifth shot?
Solution: This is an example of a geometric distribution, which is a special case of
a negative binomial distribution. Therefore, this problem can be solved using the
negative binomial formula or the geometric formula. We demonstrate each
approach below, beginning with the negative binomial formula.
The probability of success (P) is 0.70, the number of trials (x) is 5, and the number
of successes (r) is 1. We enter these values into the negative binomial formula.
b∗( x ; r , P)=x−1C r−1∗Pr∗Q x−rb∗(5; 1 , 0.7)=4 C 0∗0.7 1∗0.3 4b∗(5; 3 , 0.7)=0.00567

Now, we demonstrate a solution based on the geometric formula.

g(x ; P)=P∗Q x−1P( X=3)=g(5 ; 0.7)=0.7∗0.3 4=0.00567
Notice that each approach yields the same answer.

Continuous Uniform
What is meant by the continuous uniform distribution?
 This is a special case of a probability density function for a continuous
random variable
o The normal distribution is another special case covered in S1
 The uniform, or rectangular, distribution is a p.d.f that is constant and non-
zero over a range of values but zero everywhere else

 Since the area under the graph has to total 1, the height of the uniform
distribution would be
 1
b−a

 Therefore, the probability density function is given by

{
1
a ≤ x ≤b
f ( x )= b−a
0 otherwise

How do I find probabilities for a continuous uniform distribution?

 Sketch the graph of y=f (x )
 Probabilities are the area under the graph, all such areas will now
be rectangles
o Finding the area of a rectangle is likely to be easier than integration!
 The symmetrical properties of rectangles may also be used to find
probabilities
How do I find the mean, median, mode and variance of a continuous uniform
distribution?
 The mean, or expected value, is given by
1
E ( x )= ( a+ b )
2

 This is the (vertical) axis of symmetry of the rectangle

b

 Should the above be forgotten, E ( x )=∫ xf ( x ) dx can still be applied

a

 You be may asked to use this to prove the result

 The median can also be found by symmetry and will be equal to the mean
 There is no mode as f (x) is equal - and so at its greatest - for all values of x
1 2
 The variance is given by Var ( x )= 12 ( b−a )
∞

Should the above be forgotten, Var ( x )=∫ x f ( x ) dx−[ E ( X ) ] or

2 2

−∞
2
Var ( X )=E ( x ) −[ E ( x ) ] can still be applied
2
 o You may be asked to use this to prove the result
o The standard deviation is the square root of the variance
Worked Example
A continuous random variable, X , is modelled by the uniform distribution such that
f ( x )=0.4 for a ≤ x ≤ 4 and f ( x )=0 otherwise.

a is a constant.
(a) Show that the value of a is 1.5.

(b) Find
(i) P ( 2.5 ≤ X ≤ 3 )
(ii) E( X )

(c) Find the standard deviation of X, giving your answer in the form a √ 3,
where a is a rational number.
Normal Distribution
Normal distribution, also known as the Gaussian distribution, is a probability
distribution that is symmetric about the mean, showing that data near the mean are
more frequent in occurrence than data far from the mean. The normal distribution
appears as a "bell curve" when graphed.
Properties of Normal Distribution
The normal distribution is the most common type of distribution assumed in
technical stock market analysis. The standard normal distribution has two
parameters: the mean and the standard deviation. In a normal distribution, mean
(average), median (midpoint), and mode (most frequent observation) are equal.
These values represent the peak or highest point. The distribution then falls
symmetrically around the mean, the width of which is defined by the standard
deviation.
The normal distribution model is key to the Central Limit Theorem (CLT) which
states that averages calculated from independent, identically distributed random
variables have approximately normal distributions, regardless of the type of
distribution from which the variables are sampled.
The normal distribution is one type of symmetrical distribution. Symmetrical
distributions occur when a dividing line produces two mirror images. Not all
symmetrical distributions are normal since some data could appear as two humps
or a series of hills in addition to the bell curve that indicates a normal distribution.
Observations
The Empirical Rule
For all normal distributions, 68.2% of the observations will appear within plus or
minus one standard deviation of the mean; 95.4% will fall within +/- two standard
deviations; and 99.7% within +/- three standard deviations.
This fact is sometimes called the "empirical rule," a heuristic that describes where
most of the data in a normal distribution will appear. Data falling outside three
standard deviations ("3-sigma") would signify rare occurrences.

Skewness
Skewness measures the degree of symmetry of a distribution. The normal
distribution is symmetric and has a skewness of zero. If the distribution of a data
set instead has a skewness less than zero, or negative skewness (left-skewness),
then the left tail of the distribution is longer than the right tail; positive skewness
(right-skewness) implies that the right tail of the distribution is longer than the left.

Kurtosis
Kurtosis measures the thickness of the tail ends of a distribution to the tails of a
distribution. The normal distribution has a kurtosis equal to 3.0. Distributions with
larger kurtosis greater than 3.0 exhibit tail data exceeding the tails of the normal
distribution (e.g., five or more standard deviations from the mean).
This excess kurtosis is known in statistics as leptokurtic, but is more colloquially
known as "fat tails." The occurrence of fat tails in financial markets describes what
is known as tail risk. Distributions with low kurtosis less than 3.0 (platykurtic)
exhibit tails that are generally less extreme ("skinnier") than the tails of the normal
distribution.

Formula
The normal distribution follows the following formula. Note that only the values of
the mean (μ) and standard deviation (σ) are necessary
( )
2
−1 x− μ
1 2 σ
f ( x )= e
σ √2 π

Where:
 x = value of the variable or data being examined and f(x) the probability
function
 μ= the mean
 σ = the standard deviation

How Normal Distribution Is Used in Finance

The assumption of a normal distribution is applied to asset prices and price action.
Traders may plot price points to fit recent price action into a normal distribution.
The further price action moves from the mean, in this case, the greater the
likelihood that an asset is being over or undervalued. Traders can use the standard
deviations to suggest potential trades. This type of trading is generally done on
very short time frames as larger timescales make it much harder to pick entry and
exit points.
Similarly, many statistical theories attempt to model asset prices and assume they
follow a normal distribution. In reality, price distributions tend to have fat tails and,
therefore, have kurtosis greater than three. Such assets have had price movements
greater than three standard deviations beyond the mean more often than expected
under the assumption of a normal distribution. Even if an asset has gone through a
long period where it fits a normal distribution, there is no guarantee that the past
performance truly informs the future.
Example of a Normal Distribution
Many naturally occurring phenomena appear to be normally distributed. For
example, the average height of a human is roughly 175 cm (5' 9"), counting both
males and females.
As the chart below shows, most people conform to that average. Taller and shorter
people exist with decreasing frequency in the population. According to the
empirical rule, 99.7% of all people will fall with +/- three standard deviations of
the mean, or between 154 cm (5' 0") and 196 cm (6' 5"). Those taller and shorter
than this would be rare (just 0.15% of the population each).
What Is Meant by the Normal Distribution?
The normal distribution describes a symmetrical plot of data around its mean
value, where the width of the curve is defined by the standard deviation. It is
visually depicted as the "bell curve."
Why Is the Normal Distribution Called "Normal?"
The normal distribution is technically known as the Gaussian distribution;
however, it took on the terminology "normal" following scientific publications in
the 19th century showing that many natural phenomena appeared to "deviate
normally" from the mean. This idea of "normal variability" was made popular as
the "normal curve" by the naturalist Sir Francis Galton in his 1889 work, Natural
Inheritance.
What Are the Limitations of the Normal Distribution in Finance?
Although normal distribution is a statistical concept, its applications in finance can
be limited because financial phenomena—such as expected stock-market returns—
do not fall neatly within a normal distribution. Prices tend to follow more of a log-
normal distribution, right-skewed and with fatter tails. Therefore, relying too
heavily on a bell curve when making predictions can lead to unreliable results.
Although most analysts are well aware of this limitation, it is relatively difficult to
overcome this shortcoming because it is often unclear which statistical distribution
to use as an alternative.
The Bottom Line
Normal distribution, also known as the Gaussian distribution, is a probability
distribution that appears as a "bell curve" when graphed. The normal distribution
describes a symmetrical plot of data around its mean value, where the width of the
curve is defined by the standard deviation.