Chapter Four:

The Characteristics of the

Opportunity Set Under Risk

Probability and Probability

Distributions
used to deal with making decisions in an uncertain environment
a Probability is a numerical measure of the likelihood of an
event=s occurrence
let Pj indicate the probability of a state or an event j
0 Pj 1
the sum of Pj over all j must be 1 (i.e. something must happen)

Pj = 0 means we are CERTAIN that the event or state will NOT happen

Pj =1 the event or state WILL happen

Probability and Probability

Distributions (cont)
a probability distribution is a way to
represent all possible outcomes for a
random variable
a random variable is a variable that
takes on numerical values determined
by the outcome of a random
experiment

example of a probability
distribution:
Ptoss a die: the random variable (r.v.) is the number observed on
the face of the die: could observe a 1, 2, 3, 4, 5, 6
Pthe probability distribution of a random variable is a
representation of the probabilities for all possible outcomes for that
r.v.
P This representation might be algebraic, graphical or tabular
Pif the die is equally likely, then each side of the die has the same
chance of coming up so the P(X=x) = 1/6 for each x

Tabular representation
tabular representation of the probability distribution of the value of
the die is:
X

P(X)

1 1/6
2 1/6
3 1/6
4 1/6
5 1/6
6 1/6
SUM

note: all probabilities are between 0 and 1

and the sum of the probabilities = 1

Algebraic Representation

P(X=x) = 1/6 for x = 1 , 2, 3, 4, 5, 6

the Graphical representation is:

Probabilities and their sums

no matter how the probability distribution is represented,
the following will be true:
all probabilities are between 0 and 1
and the sum of the probabilities is 1.

To summarize a Probability
Distribution
Measures of Central Tendency: (where is the center of the distribution)
Mean
Mode
Median

Measures of Dispersion
variance and standard deviation
Range
mean absolute deviation

The Mean Return

let the random variable be Ri, the rate of return on asset i,
let the possible outcomes be denoted j for various states of
nature
Pij is the probability of that state of nature j for asset i and
Rij is the return in the state of nature j for asset i
The Expected return or the mean return on asset i is:

E(Ri ) Ri i

P R
ij

ij

Mean Return (cont)

If J=M equally likely outcomes then

1
1
E(Ri ) Ri i Rij
M
j M

ij

The Variance of the return

i Pij Rij Ri
2

j 1

i Var [ Ri ] V [ Ri ] E [( Rij Ri ) ]
2

while the standard deviation is denoted S(Ri) or SD(Ri) and is

simply the square root of the variance

Standard Deviation versus the

Variance
The standard deviation and/or the variance are often used as a measure of
risk
If A2 >

2
B

then A > B and vice versa

The standard deviation is often used instead of the variance because it is a

number in terms of the original units (return) rather than in terms of the
units squared (as for the variance)
notice that for these measures of risk, a deviation above the mean is
treated the same as a deviation below the mean (due to the squaring).
This is acceptable as long as the probability distribution is symmetric (or
more or less) about the mean. If it is not symmetric then we might have to
calculate the skewness (later).

Example (Mean and Std Dev)

We are considering holding only one stock.
We must choose between two stocks: stock A and stock B
the respective probability distributions for their holding period
returns are given below:
Asset A

Asset B

RAj

PAj

RBj

PBj

4.1

1/7

5.8

1/7

2.3

1/7

2.3

1/7

1.6

1/7

1.6

1/7

-.18

1/7

-3.72

1/7

3.7

1/7

4.3

1/7

1.6

1/7

1.6

1/7

4.8

1/7

6.04

1/7

Notes
all probabilities are positive
all probabilities sum to one
all probabilities are equal in this case but this need not be true
To summarize the probability distribution for each asset and thus
to help us make a decision, we could calculate
the Expected Return on each asset and
The Variance of Return on each asset

Calculating the mean and variance

Asset A

RAj

PAj

RAj PAj

[RAj - E (RAj) ] 2 PAj

4.1

1/7

4.1 * 1/7

[4.1 - 2.56] 2 * 1/7

2.3

1/7

2.3 * 1/7

[2.3 - 2.56] 2 * 1/7

1.6

1/7

1.6 * 1/7

[1.6 - 2.56] 2 * 1/7

-.18

1/7

-.18 * 1/7

[-.18 - 2.56] 2 * 1/7

3.7

1/7

3.7 * 1/7

[3.7 - 2.56] 2 * 1/7

1.6

1/7

1.6 * 1/7

[1.6 - 2.56] 2 * 1/7

4.8

1/7

4.8 * 1/7

[4.8 - 2.56] 2 * 1/7

SUM

2.56

2.5867429

Calculating the mean and the

variance
Asset B

RBj

PBj

RBj PBj

[RBj - E (RBj) ] 2 PBj

5.8

1/7

5.8 * 1/7

[5.8 - 2.56] 2 * 1/7

2.3

1/7

2.3 * 1/7

[2.3 - 2.56] 2 * 1/7

1.6

1/7

1.6 * 1/7

[1.6 - 2.56] 2 * 1/7

-3.72

1/7

-3.72 * 1/7

[-3.72 - 2.56] 2 * 1/7

4.3

1/7

4.3 * 1/7

[4.3 - 2.56] 2 * 1/7

1.6

1/7

1.6 * 1/7

[1.6 - 2.56] 2 * 1/7

6.04

1/7

6.04 * 1/7

[6.04 - 2.56] 2 * 1/7

SUM

2.56

9.5692571

This material is review.

1. agree
2. disagree

Mean =

Sample mean and variance

above formulas assume you have the population of data but usually
we only have a sample or subset of the data, in this case the formulas are:

1
Ri
M

R
j 1

ij

1 M
2
Rij Ri
s

M 1 j 1
2

Copyright information
Slides prepared by and the property of
Marie Racine. Copyright Racine Marie,
2016