Econ 325: Introduction to Empirical Economics
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Transcript of Econ 325: Introduction to Empirical Economics
Lecture 3
Discrete Random Variables and Probability Distributions
Econ 325: Introduction to Empirical Economics
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-1
Introduction to Probability Distributions
n Random Variablen Represents a possible numerical value from
a random experimentRandom Variables
Discrete Random Variable
ContinuousRandom Variable
Ch. 4 Ch. 5
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-2
4.1
Discrete Random Variablesn Can only take on a countable number of values
Examples:
n Roll a die twiceLet X be the number of times 4 comes up (then X could be 0, 1, or 2 times)
n Toss a coin 3 times. Let X be the number of heads(then X = 0, 1, 2, or 3)
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-3
Discrete Probability Distribution
x Value Probability
0 1/4 = .25
1 2/4 = .50
2 1/4 = .25
Experiment: Toss 2 Coins. Let X = # heads.
T
T4 possible outcomes
T
T
H
H
H H
Probability Distribution
0 1 2 x
.50
.25
Prob
abili
ty
Show P(x) , i.e., P(X = x) , for all values of x:
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-4
4.2
Random variable
n S = {TT, TH, HT, TH}
n Define a function X(s) by
X({TT})=0, X({TH})=1, X({HT})=1, X({HH})=2
n P(X=0) = P({TT}) = 1/4
n P(X=1) = P ({TH,HT}) = 1/2
Ch. 4-5Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Definition: Random variable
n A random variable X is a function which maps the outcome of an experiment π to the real number π₯.
π: π β π‘βπ π ππππ ππ πn The space of X is given by
ππ = {π₯: π π = π₯, π β π}
Ch. 4-6Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Discrete Probability Distribution
n The space of X = {0,1,2}.n Define a set A = {0,1} in the space of X. Then,
n Notation: Uppercase ``Xββ represents a random variable and lowercase ``xββ represents some constant (e.g., realized value).
Ch. 4-7Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Γ₯Γ
=+====ΓAx
1)P(X0)P(X x)P(X A)P(X
Definition: Probability mass function
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-8
4.3
The probability mass function (pmf) of a discrete random variable X is a function that satisfies the following properties:
1). π β€ ππ π β€ π2). βπβ:; ππ π = 13). π· πΏ β π¨ = βπβπ¨ ππ π
Probability mass function
Ch. 4-9Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
x)P(X)(f X ==x
Cumulative Distribution Function
n The cumulative distribution function, denotedF(x0), is a function defined by the probability of X being less than or equal to x0
Γ₯Β£
=Β£=0xxX00 (x)f)xP(X)F(x
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-10
Question
n Define X = # of heads when you toss 2 coins.
n What is the probability mass function and the cumulative distribution function of X?
Ch. 4-11Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Question
n Define X = a number you get from rolling a die.
n What is the probability mass function and the cumulative distribution function of X?
Ch. 4-12Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Expected Value
n Expected Value (or mean) of a discretedistribution
Γ₯==x
(x)x E(X) ΞΌ Xf
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-13
Example
n What is the expected value when you roll a die once?
n ππΏ π = π πΏ = π = ππ
for π = π, π, β¦ , π
n π¬ πΏ = βπFππ πΓ ππ= π. π
Ch. 4-14Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Clicker Question 3-1
Define X = # of heads when you toss 2 coins.What is the expected value of X?
A). 0.5B). 1C). 1.5
Ch. 4-15Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Variance and Standard Deviation
n Variance of a discrete random variable X
n Standard Deviation of a discrete random variable X
Γ₯ -=-=x
X222 (x)fΞΌ)(xΞΌ)E(XΟ
Γ₯ -==x
X22 (x)fΞΌ)(xΟΟ
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-16
Standard Deviation Example
n Example: Toss 2 coins, X = # heads, compute standard deviation (recall E(x) = 1)
Γ₯ -=x
X2 (x)fΞΌ)(xΟ
.707.50(.25)1)(2(.50)1)(1(.25)1)(0Ο 222 ==-+-+-=
Possible number of heads = 0, 1, or 2
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-17
Clicker Question 3-2
n Toss 1 coin. Let X = 1 if it is head and X=0 if it is tail. What is the variance of this random variable?
A). 1B). 0.5C). 0.25D). 0.1
Ch. 4-18Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Functions of Random Variables
n If P(x) is the probability function of a discrete random variable X , and g(X) is some function of X , then the expected value of function g is
Γ₯=x
X (x)g(x)fE[g(X)]
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-19
Clicker Question 3-3
n Toss 1 coin. Let X = 1 if it is head and X=0 if it is tail. Consider a function g(X) such that g(1) = 100 and g(0) = 0. What is E[g(X)]?
A). 0B). 100C). 50D). 10
Ch. 4-20Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Linear Functions of Random Variables
n Let a and b be any constants.
n a)
i.e., if a random variable always takes the value a, it will have mean a and variance 0
n b)
i.e., the expected value of bΒ·X is bΒ·E(X)
0Var(a)andaE(a) ==
E(bX) = bE(X) and Var(bX) = b2Var(X)
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-21
Linear Functions of Random Variables
n Let random variable X have mean Β΅x and variance Ο2x
n Let a and b be any constants. n Let Y = a + bXn Then the mean and variance of Y are
n so that the standard deviation of Y is
E(Y) = E(a + bX) = a + bE(X)
Var(X)bbX)Var(aVar(Y) 2=+=
XY ΟbΟ =
(continued)
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-22
Bernoulli Distribution
n Consider only two outcomes: βsuccessβ or βfailureβ n Let p denote the probability of successn Let 1 β p be the probability of failure n Define random variable X:
X = 1 if success, X = 0 if failuren Then the Bernoulli probability function is
p1)P(X andp)(10)P(X ==-==
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-23
Possible Bernoulli Distribution Settings
n A survey responses of ``I will vote for the Liberal Partyββ or ``I will vote for the Conservative Partyββ
n A manufacturing plant labels items as either defective or acceptable
n A marketing research firm receives survey responses of βyes I will buyβ or βno I will notβ
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-24
Bernoulli DistributionMean and Variance
n The mean is Β΅ = p
n The variance is Ο2 = p(1 β p)
Β΅= E(X) = xx=0,1β P(X = x) = (0)(1β p)+ (1)p = p
Ο 2 = E[(XβΒ΅)2 ]= (xβΒ΅)2P(X = x)x=0,1β
= (0β p)2(1β p)+ (1β p)2p = p(1β p)
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-25
2019 Canadian federal election
Ch. 4-26Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Canada Poll Tracker: CBC News
338Canada
Nanos/CTV-G&M Polls, Sep 25
Ch. 4-27Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
β’ Interview 1200 eligible voters by telephone from Sep 23-Sep 25.
β’ Out of 1200, 432 eligible voters say that they would vote for the LiberaryParty.
Question
Ch. 4-28Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
πK = 1 if ``I will vote for the Liberal Partyββπ = π πK = 1 = the population fraction of voters who vote for the Liberal Party Let πN, πO, and πP be survey responses from randomly sampled three individuals.What is the probability mass function of π = πN + πO + πP?
Question
Ch. 4-29Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Let πK for π = 1,2, β¦ , π are survey responses from randomly sampled n individuals with π πK = 1 = π.
What is the probability mass function of
π = βKFNV πK ?
Binomial Distribution
Consider the sum of n independent Bernoulli random variables:
, where
P(Y=y) = probability of y successes in n trials,with probability of success p on each trial
y = number of βsuccessesβ in sample (y = 0, 1, 2, ..., n)n = sample size (number of trials or observations)p = probability of βsuccessβ
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-30
p1)P(X and p)(10)P(X ii ==-==Γ₯ ==
n
i iXY1
Probability mass function of Binomial distribution
P(y) = probability of y successes in n trials,with probability of success p on each trial
y = number of βsuccessesβ in sample, (y = 0, 1, 2, ..., n)
n = sample size (number of trials or observations)
p = probability of βsuccessβ
P(Y=y)n
y ! n yp (1- p)y n y!
( )!=
--
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-31
Clicker Question 3-4
Randomly sampled 3 individuals. What is the probability that 2 out of 3 person supports the Liberal party if p=0.4?
(A). 0.4 Γ (1 β 0.4)O
(B). (1 β 0.4)Γ (0.4)O
(C). 3Γ0.4 Γ (1 β 0.4)O
(D). 3Γ(1 β 0.4)Γ (0.4)O
Ch. 4-32Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Binomial DistributionMean and Variance
n Mean
Β§ Variance and Standard Deviation
np)E(X)XE(E(Y)Β΅n
1ii
n
1ii ==== Γ₯Γ₯
==
p)-np(1Ο2 =
p)-np(1Ο =
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-33
Average of n independent Bernoulli random variable
Consider the sample average of n independent Bernoulli random variable:
, with
Then, ]π is related to Binomial random variable π = βKFNV πK as
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-34
p)(10)P(X and p1)P(X ii -====Γ₯ ==
n
i iXnX
1
1
Yn
Xn
X n
i i11
1== Γ₯ =
Clicker Question 3-5
Consider the sample average of n independent Bernoulli random variable:
, with
What is πΈ( ]π)?A). pB). 1-pC). np
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-35
p)(10)P(X and p1)P(X ii -====Γ₯ ==
n
i iXnX
1
1
Nanos/CTV-G&M Polls, Sep 25
Ch. 4-36Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
β’ Interview 1200 eligible voters by telephone from Sep 23-Sep 25.
β’ 36 percent of eligible voters say that they would vote for the LiberaryParty.
β’ ]π = 0.36
Poisson Distribution Function
n The Poisson probability distribution gives the probability of a number of events occurring in a fixed interval of time or space.
n Examples:n The number of telephone calls to 911 in a large city
from 1am to 5am.n The number of delivery trucks to arrive at a central
warehouse in an hour. n The number of customers to arrive at a checkout
aisle in your local grocery store from 2pm to 3pm.
Ch. 4-37Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Poisson Distribution Function
n Assume an interval is divided into a very large number of ``very shortββ subintervals with equal length h.
1. The number of occurrences in subintervals are independent.
2. The probability of exactly one occurrence in a subinterval of length h is approximately πh.
3. The probability of two or more occurrences approaches zero as the length h approaches zero.
Ch. 4-38Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Poisson Distribution Function
Ch. 4-39Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
n The expected number of occurrences per time/space unit is the parameter l (lambda).
( )xeP x
x
ll-
=!
where:P(x) = the probability of x occurrences over one unit of time or spacel = the expected number of occurrences per time/space unit, l > 0
e = base of the natural logarithm system (2.71828...)
Poisson Distribution Characteristics
n Mean
Β§ Variance and Standard Deviation
where l = expected number of occurrences per time/space unit
Copyright Β© 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-40
Mean and variance of the Poisson distribution
[ ]x E XΒ΅ l= =
( )22xx E X Β΅ ls Γ© ΓΉ= - =Γ« Γ»
s l=
Poisson Distribution Shape
n The shape of the Poisson Distribution depends on the parameter l :
0.00
0.05
0.10
0.15
0.20
0.25
1 2 3 4 5 6 7 8 9 10 11 12
x
P(x)
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0 1 2 3 4 5 6 7
x
P(x)
l = 0.50 l = 3.00
Copyright Β© 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-41
Example
You are the CEO of a grocery store. Customers arrive at checkout counters at an average rate of 1 customer every 2 minutes. Assume that these arrivals are independent over time.
What is the probability that more than two customers arrive within one minute?
In this case, the expected number of customers per minute is π = 1/2 = 0.5
Ch. 4-42Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Using Poisson Tables
X
l
0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90
01234567
0.90480.09050.00450.00020.00000.00000.00000.0000
0.81870.16370.01640.00110.00010.00000.00000.0000
0.74080.22220.03330.00330.00030.00000.00000.0000
0.67030.26810.05360.00720.00070.00010.00000.0000
0.60650.30330.07580.01260.00160.00020.00000.0000
0.54880.32930.09880.01980.00300.00040.00000.0000
0.49660.34760.12170.02840.00500.00070.00010.0000
0.44930.35950.14380.03830.00770.00120.00020.0000
0.40660.36590.16470.04940.01110.00200.00030.0000
Example: Find P(X = 2) if l = .50
.07582!(0.50)e
!Xe)2X(P
20.50X
==l
==-l-
Copyright Β© 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-43
Graph of Poisson Probabilities
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0 1 2 3 4 5 6 7
x
P(x)X
l =0.50
01234567
0.60650.30330.07580.01260.00160.00020.00000.0000
P(X = 2) = .0758
Graphically:l = .50
Copyright Β© 2013 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-44
Clicker Question 3-6
Customers independently arrive at counters at an average rate of 1 customer every 2 minutes.
What is the probability that more than two customers arrive within one minute?
A). 0.0758B). 0.0886C). 0.6065
Ch. 4-45Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Poisson and Binomial Distribution
Ch. 4-46Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
n Divide one unit of time into n subintervals, each of which has length of h = 1/n.
n For sufficiently large n, the probability of one occurrence is given by πh=π/n β a sequence of n Bernoulli trials.
n The number of occurrences within one unit of time is approximate by the sum of n Bernoulli trials, i.e., Binomial distribution:
π π = π₯ β V!d! Ved !
fV
d1 β f
V
Ved
β fghi
d!as n β β
Poisson and Binomial Distribution
Ch. 4-47Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
n Set p = π/n β π=np.n Then, we may approximate the binomial distribution by
the Poisson distribution:
π π = π₯ = V!d! Ved !
pd 1 β p Ved
β npghnpd!
if n is large
Joint probability mass functions
n A joint probability mass function is used to express the probability that X takes the specific value x and simultaneously Y takes the value y, as a function of x and y
n The marginal probabilities are
y)Y,xP(Xy)f(x, ===
Γ₯=y
X y)f(x,(x)f Γ₯=x
Y y)f(x,(y)f
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-48
4.7
Stochastic Independence
n The jointly distributed random variables X and Y are said to be independent if and only if
for all possible pairs of values x and y
n A set of k random variables are independent if and only if
(y)(x)ffy)f(x, YX=
)(xf)(x)f(xf)x,,x,f(x k21k21 21 kXXX !! =
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-49
Clicker Question 3-7
n Is X and Y stochastically independent?
A). X and Y are independentB). X and Y are not independent
Copyright Β© 2010 Pearson Education, Inc. Publishing as
Prentice HallCh. 3-50
Y=30 Y=60 Y=100 Marginal Dist. of XX=0 0.24 0.12 0.04 0.40X=1 0.12 0.36 0.12 0.60Marginal Dist. of Y
0.36 0.48 0.16 1.00
Conditional probability mass functions
n The conditional probability mass function of the random variable Y is define by
n Similarly, the conditional probability mass function of X given Y = y is:
(x)fy)f(x,x)|(yf
XX|Y =
(y)fy)f(x,y)|(xf
YY|X =
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-51
Question
n What is the conditional probability mass function of Y given X=1?
Copyright Β© 2010 Pearson Education, Inc. Publishing as
Prentice HallCh. 3-52
Y=30 Y=60 Y=100 Marginal Dist. of XX=0 0.24 0.12 0.04 0.40X=1 0.12 0.36 0.12 0.60Marginal Dist. of Y
0.36 0.48 0.16 1.00
Conditional Mean and Variance
Ch. 4-53Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
n The conditional mean is
n E[Y|X=x] is a function of x and, therefore, is also called as ``conditional expectation function (CEF)ββ
n The conditional variance is
x)|f(yy x]X|[YEΞΌy
X|YxX|Y Γ₯====
Γ₯ === -==-=y
2xX|Y
2xX|YX|Y
2xX|Y x)|f(y)ΞΌ(yx]X|)ΞΌ[(YEΟ
Clicker Question 3-8
n What is E[X|Y=30]?
A). 1/2 B). 1/3 C). 2/3 D).1/4
Copyright Β© 2010 Pearson Education, Inc. Publishing as
Prentice HallCh. 3-54
Y=30 Y=60 Y=100 Marginal Prob of XX=0 0.24 0.12 0.04 0.40X=1 0.12 0.36 0.12 0.60Marginal Prob of Y
0.36 0.48 0.16 1.00
Clicker Question 3-9
n What is Var[X|Y=30]?
A). 1/9 B). 1/3 C). 2/9 D). 2/27
Copyright Β© 2010 Pearson Education, Inc. Publishing as
Prentice HallCh. 3-55
Y=30 Y=60 Y=100 Marginal Prob of XX=0 0.24 0.12 0.04 0.40X=1 0.12 0.36 0.12 0.60Marginal Prob of Y
0.36 0.48 0.16 1.00
πΈl|;[π|π] as a random variable
n Viewing X as a random variable, πΈl|;[π|π] is a random variable because the value of πΈl|;[π|π]depends on a realization of X.
n The Law of Iterated Expectations:
πΈ;[πΈl|;[π|π]] = πΈl[π]
Ch. 4-56Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Covariance
n Let X and Y be discrete random variables with means ΞΌX and ΞΌY
n The expected value of (X - ΞΌX)(Y - ΞΌY) is called the covariance between X and Y
n For discrete random variables
Γ₯Γ₯ --=--=x y
YXYX y))f(x,ΞΌ)(yΞΌ(x)]ΞΌ)(YΞΌE[(XY)Cov(X,
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-57
Correlation
n The correlation between X and Y is:
n Ο = 0 : no linear relationship between X and Yn Ο > 0 : positive linear relationship between X and Y
n when X is high (low) then Y is likely to be high (low)n Ο = +1 : perfect positive linear dependency
n Ο < 0 : negative linear relationship between X and Yn when X is high (low) then Y is likely to be low (high)n Ο = -1 : perfect negative linear dependency
YXΟΟY)Cov(X,Y)Corr(X,Ο ==
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-58
Uncorrelatedness, Mean Independence, Stochastic Independence
n X and Y are said to be uncorrelated when Cov(X,Y)=0 or π = 0.
n X is said to be mean independent of Y when πΈ;|l π π = πΈ;[π].
n X and Y are said to be stochastically independent when π π₯, π¦ = π; π₯ πl π¦ .
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-59
Uncorrelatedness, Mean Independence, Stochastic Independence
Stochastic Independence π π₯, π¦ = π; π₯ πl π¦
βMean Independence
πΈ;|l π π = πΈ;[π] or πΈl|; π π = πΈl[π]
βUncorrelatedness
Cov(X,Y)=0Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-60
Clicker Question 3-10
n Suppose X and Y are stochastically independent. Then,
A). the conditional mean of X given Y=y is the same as the unconditional mean of X.
B). the conditional mean of X given Y=y may not be the same as the unconditional mean of X.
Ch. 4-61Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
πππ ππ + ππ
n For any constant a and b and any two random variables X and Y,
πππ ππ + ππ = πOπππ π + πOπππ π+2ππ πΆππ£ π, π
Ch. 4-62Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Clicker Question 3-10
n Which of the following is true.
A). πππ ππ + ππ = πOπππ π + πOπππ π+2ππ πΆπππ π, π
B). πππ ππ + ππ = πOπππ π + πOπππ π+2πππ;πlπΆπππ π, π
C). πππ ππ + ππ = πOπππ π + πOπππ π+2πππΆπππ π, π /π;πl
Ch. 4-63Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Portfolio Analysis
n Let random variable X be the share price for stock A n Let random variable Y be the share price for stock B
n The market value, W, for the portfolio is given by the linear function
n ``aββ and ``bββ are the numbers of shares of stock A and B, respectively.
n The return from holding the portfolio W:
bYaXW +=
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-64
YbXaW D+D=D
Portfolio Analysis
n The mean value for βW is
n The variance for βW is
or using the correlation formula
(continued)
Y]bE[X]aE[Y]bXE[aW]E[
D+D=D+D=D
Y),2abCov(ΟbΟaΟ 2Y
22X
22W DD++= DDD X
YX2Y
22X
22W ΟY)ΟX,2abCorr(ΟbΟaΟ DDDDD DD++=
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-65
Asset Class Correlation Matrix
Ch. 4-66Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall
Example: Investment Returns
Return per $100 for two types of investments
P(βX,βY) Economic condition Bond Fund X Aggressive Fund Y
0.2 Recession + $ 7 - $20
0.5 Stable Economy + 4 + 6
0.3 Expanding Economy + 2 + 35
Investment
E(βX) = (7)(.2) +(4)(.5) + (2)(.3) = 4
E(βY) = (-20)(.2) +(6)(.5) + (35)(.3) = 9.5
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-67
Computing the Standard Deviation for Investment Returns
P(βX,βY) Economic condition Bond Fund X Aggressive Fund Y
0.2 Recession + $ 7 - $20
0.5 Stable Economy + 4 + 6
0.3 Expanding Economy + 2 + 35
Investment
731.3
(0.3)4)(2(0.5)4)(4(0.2)4)(7X)Var( 222X
Β»=
-+-+-=D=Ds
19.3725.375
(0.3)9.5)(35(0.5)9.5)(6(0.2)9.5)(-20Y)Var( 222Y
Β»=
-+-+-=D=Ds
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-68
Covariance for Investment Returns
P(βX,βY) Economic condition Bond Fund X Aggressive Fund Y
0.2 Recession + $ 7 - $20
0.5 Stable Economy + 4 + 6
0.3 Expanding Economy + 2 + 35
Investment
-339.5)(.3)4)(35(2
9.5)(.5)4)(6(49.5)(.2)20-4)((7Y)X,Cov(YX
=--+
--+--=DD=DDs
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-69
Portfolio Example
Investment X: E(βX)= 4 ΟβX = 1.73Investment Y: E(βY)= 9.5 ΟβY = 19.32
ΟβXβY = -33
Suppose 40% of the portfolio (W) is in Investment X and 60% is in Investment Y:
πππ βπ = .4(1.73)O+ .6(19.32)O+2 .4 (.6)(β33) = 14.47
The portfolio return and portfolio variability are between the values for investments X and Y considered individually
3.7)5.9()6(.)4(4.W)E( =+=D
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-70
Interpreting the Results for Investment Returns
n The aggressive fund has a higher expected return, but much more risk
E(βY)= 9.5 > E(βX) = 4but
ΟβY = 19.32 > ΟβX = 1.73
n The Covariance of -33 indicates that the two investments are negatively related and will vary in the opposite direction
Copyright Β© 2010 Pearson Education, Inc. Publishing as Prentice Hall Ch. 4-71