Chapter 1:
Probability
Dr. Saeed Mousa
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content
1. An Introduction to Probabilities
2. Probability Rules for More Than One Event
3. Applications in the financial markets
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1. An Introduction to Probabilities
A probability is a numerical value ranging
from 0 to 1.
Probability indicates the chance, or likelihood,
of a specific event occurring.
• If there is no chance of the event occurring, the
probability is 0.
• If the event is absolutely going to occur, the
probability of it occurring is 1.
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Definitions
Experiment
• The process of measuring or observing an activity
for the purpose of collecting data
• An example is rolling a single six-sided dice
Sample space
• All the possible outcomes, or results, of an
experiment
• The sample space for our single-die experiment is
{1, 2, 3, 4, 5, 6}.
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Sample Space Examples
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Methods of Assigning Probability
Methods of Assigning Probability
Classical Empirical Subjective
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Classical Probability
Methods of Assigning Probability
Classical Empirical Subjective
• Used when the number of possible outcomes of the
event of interest is known
• Formula for classical probability
Number of possible outcomes that constitute Event A
P(A) =
Total number of possible outcomes in the sample space
where:
P(A) = The probability that Event A will occur
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Classical Probability Example
Experiment: Roll a dice once
Sample space = {1, 2, 3, 4, 5, 6}
Define Event A as rolling a five
• There are six possible outcomes in the sample space.
• Event A (rolling a five) can happen one way.
P(A) = 1/6 = 0.167, or a 16.7% probability
• This is a Simple Probability: it represents the
likelihood of a single (simple) event occurring by itself
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Classical Probability Example
Experiment: Roll a dice once
Sample space = {1, 2, 3, 4, 5, 6}
Classical probability assumes that each event
in the sample space has the same likelihood
of occurring.
The set of events is collectively exhaustive if
the sample space includes every possible
simple event that can occur.
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Empirical Probability
Methods of Assigning Probability
Classical Empirical Subjective
• Involves conducting an experiment to observe the
frequency with which an event occurs
• Formula for empirical probability
Frequency in which Event A occurs
P(A) =
Total number of observations
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Empirical Probability
Example: A survey of 400 new graduates asked how much they
owed in student loans. The results are shown in the following
table:
Amount Frequency
€30,000 or more 47
€20,000–€29,999 66
€10,000–€19,999 144
€5,000–€9,999 102
Less than €5,000 41
Total 400
a) What is the probability that a randomly selected graduate has between
€5,000–€9,999 in student loans?
b) What is the probability that a randomly selected graduate has €20,000
or more in student loans?
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Empirical Probability
Example: (Continued)
Amount Frequency
€30,000 or more 47
€20,000–€29,999 66
€10,000–€19,999 144
€5,000–€9,999 102
Less than €5,000 41
Total 400
a) What is the probability that a randomly selected graduate has between
€5,000–€9,999 in student loans?
b) What is the probability that a randomly selected graduate has €20,000
or more in student loans?
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Subjective Probability
Methods of Assigning Probability
Classical Empirical Subjective
Used when classical and empirical probabilities
are not available
• Instead use experience or intuition to estimate the
probabilities
• Example: The probability that inflation will be
greater than 4% next year
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2. Probability Rules for More Than
One Event
Many situations involve two or more events
that intersect with one another.
A contingency table can be used to show the
number of occurrences of events that are
classified according to two categorical variables.
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Contingency Tables
Use the contingency table to calculate the probability of
events A and B, where
Event A = a student living in the dorm being a female
Event B = a student living in the dorm being a freshman
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Contingency Tables
Use the contingency table to calculate the probability of
events A and B, where
Event A = a student living in the dorm being a female
Event B = a student living in the dorm being a freshman
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The Intersection of Events
The intersection of Events A and B represents
the number of instances in which Events A
and B occur at the same time.
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The Intersection of Events
The probability of the intersection of two events
is known as a joint probability.
Find the probability that a student will be a female and a freshman,
i.e. the intersection of events A and B.
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The Intersection of Events
The probability of the intersection of two events
is known as a joint probability.
Find the probability that a student will be a female and a freshman,
i.e. the intersection of events A and B.
The number of students that
meet the criteria is the
intersection of the Freshman
column and the Female row.
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The Union of Events
The union of Events A and B represents the
number of instances where either Event A or
B occur or both events occur together.
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The Union of Events
Using the same events, find the probability that a
student is a female (Event A) or a freshman (Event B).
Calculate the total
instances that include
either Event A or Event B.
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The Addition Rule
The addition rule for probabilities is used to
calculate the probability of the union of events.
• the probability that Event A, or Event B, or both events
will occur
Two events are considered to be mutually exclusive if they
cannot occur at the same time during the experiment.
mutually exclusive not mutually exclusive
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The Addition Rule
For mutually exclusive events, the addition rule states
that the probability of two events occurring is simply
the sum of their individual probabilities:
P(A or B) = P(A) + P(B)
If Events A and B are not mutually exclusive:
P(A or B) = P(A) + P(B) - P(A and B)
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The Addition Rule
Calculate the probability that a student either
earned an A (Event A) or is female (Event B).
Consider the union of “A” students or Freshman students.
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The Addition Rule
Calculate the probability that a student either
earned an A (Event A) or is female (Event B).
Consider the union of “A” students or Freshman students.
Don’t count the women
with six A grades twice.
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The Addition Rule
+ –
P(A or B) = P(A) + P(B) - P(A and B)
Don’t count common elements twice.
Note: P(A and B) = 0 if events A and B are mutually exclusive.
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Conditional Probability
Conditional probability is the probability of Event A
occurring, given the condition that Event B has occurred.
Example:
Event A = score in 601-800 range
Event B = Completed Prep Class
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Conditional Probability
Conditional probability is the probability of Event A
occurring, given the condition that Event B has occurred.
Example:
Event A = score in 601-800 range
Event B = Completed Prep Class
Given that event B has Called a Prior probability:
occurred, only look at the Determined without any
70 students who additional information that
completed the Prep Class could influence the event
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Practical
Exercises
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Exercise 1
Survey Question: For Seattle's two tourist sites Space
Needle and Pike's Place Market, select one of the
following choices:
Visted in Seattle Frequency
Both 78
Neither 58
Only Pike's Place Market 52
Only Space Needle 12
Grand Total 200
P(Space Needle)
P(Pike's Place Market)
P(Space Needle AND Pike's Place Market)
P(Space Needle OR Pike's Place Market) 30
Exercise 2
Age
movies per week under 60 and SUM (m)
30 - 60
30 over
0 15 50 10 75
1-2 25 100 75 200
3-5 55 60 60 175
6 and over 5 15 30 50
SUM (A) 100 225 175 500
Find following probabilities:
- watching 6 or more movies
- watching 2 or less movies
- watching 6 or more movies OR is 60 years old or more
- watching 6 or more movies given the person is 60 years or
older
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Exercise 3
Calculate the probability that a randomly selected people uses Facebook
given that they use YouTube. A random survey of social media use was
conducted and the results are presented in a cross tab report. From the
report, calculate the probability that a randomly selected people uses
Facebook given that they use YouTube. Said a different way: If a randomly
selected user uses YouTube, what is probability that they also use
Facebook?
Frequency YouTube
Facebook Not Use YT Use YT Total
Not Use FB 16 46 62
Use FB 22 116 138
Total 38 162 200
P(Use YT) =
P(Use FB AND Use YT) =
P(Use FB / Use YT) =
P(Use YT / Use FB) = 32
Exercise 4
Classify following statements as true or false, then justify:
- If two events are independent, they cannot happen at the
same time.
- A probability of 0.2 means the event will occur once every five
trials.
- If P(A) = 0.7, then P(A′) = 0.3.
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Exercise 5
Based on the topic of “Designing the Experiment”
1. Define an experiment related to university life (e.g., exam
results, attendance, online platform usage).
2. Specify:
• The sample space
• At least three events (simple and compound)
3. Identify whether classical, empirical, or subjective probability
is most appropriate.
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Exercise 6
A country’s annual inflation rate over the last 10 years is
reported below.
Year Inflation Rate (%)
1 1.8
2 2.1
3 3.5
4 4.2
5 5.1
6 6.0
7 4.6
8 3.2
9 2.7
10 4.8
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Exercise 6
In addition, recent economic conditions suggest:
• Rising energy prices,
• Strong wage growth,
• Persistent supply-chain constraints.
Tasks
1. Using the historical data above, calculate the empirical
probability that inflation exceeds 4% in a given year.
2. Based on the qualitative economic information provided,
propose a subjective probability that inflation will exceed 4%
next year.
3. Briefly explain the difference between empirical and
subjective probability in this context. 36
Exercise 7
A company runs a marketing campaign and collects the following data from
100 customers regarding whether they received a promotion and whether
they made a purchase.
Purchase No Purchase Total
Received promotion 40 20 60
No promotion 30 10 40
Total 70 30 100
Tasks
1. Calculate the joint probability that a customer received a promotion and
made a purchase.
2. Calculate the conditional probability that a customer made a purchase
given that they received a promotion.
3. Determine whether events A and B are independent, and justify your
answer. 37
Exercise 8
At a university:
• 40% of students have high academic performance.
• 30% of students come from low-income households.
• 10% of students satisfy both conditions.
Tasks
1. Calculate the probability that a randomly selected student is eligible
for a scholarship, defined as having high academic performance or
low income (or both).
2. Explain why the probability of students who satisfy both conditions
must be subtracted in the calculation.
3. State whether events A and B are mutually exclusive.
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Exercise 9
A financial institution evaluates loan default risk based on a
borrower’s credit score category and whether the borrower is
self-employed.
A sample of 1,000 borrowers yields the following data:
• 500 borrowers have a High credit score
• 300 borrowers have a Medium credit score
• 200 borrowers have a Low credit score
Credit Score Self-Employed Defaulted Did Not Default Total
High Yes 20 80 100
High No 20 380 400
Medium Yes 45 105 150
Medium No 45 105 150
Low Yes 70 30 100
Low No 60 40 100 39
Exercise 9
Tasks
1. Calculate the probability that a randomly selected borrower
defaults.
2. Calculate the conditional probability of default given that the
borrower is self-employed.
3. Calculate the probability that a borrower defaults or has a low
credit score
4. Determine whether default and self-employment are
independent events, and justify your answer mathematically.
5. Suppose the bank earns €2,000 on a non-defaulting loan and
loses €6,000 on a defaulted loan. Compute the expected profit
per loan.
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Exercise 10
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Exercise 10
Tasks
1. Compute the unconditional probability of recession.
2. Compute the conditional probability of recession given declining
investment.
3. Compute the probability that interest rates increased given that a
recession occurred.
4. Determine whether rising interest rates and declining investment are
independent events.
5. A recession causes a welfare loss of €100 billion, while avoiding
recession yields €0 loss. Compute the expected welfare loss given
that business investment is declining.
6. Based on your results, explain whether the observed decline in
investment should be considered a serious early-warning signal for
policymakers.
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End
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