Introduction to Computational Finance and Financial Econometrics Probability Review - Part 2

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1 You can t see this text! Introduction to Computational Finance and Financial Econometrics Probability Review - Part 2 Eric Zivot Spring 2015 Eric Zivot (Copyright 2015) Probability Review - Part 2 1 / 46

2 Outline 1 Bivariate Probability Distribution - Discrete rv s Marginal distributions Conditional distributions 2 Bivariate Probability Distribution - Continuous rv s 3 Independence 4 Covariance and Correlation Eric Zivot (Copyright 2015) Probability Review - Part 2 2 / 46

3 Example Example: Two discrete rv s X and Y Bivariate pdf Y % 0 1 Pr(X) 0 1/8 0 1/8 X 1 2/8 1/8 3/8 2 1/8 2/8 3/ /8 1/8 Pr(Y ) 4/8 4/8 1 p(x, y) = Pr(X = x, Y = y) = values in table e.g., p(0, 0) = Pr(X = 0, Y = 0) = 1/8 Eric Zivot (Copyright 2015) Probability Review - Part 2 3 / 46

4 Properties of joint pdf p(x, y) S XY = {(0, 0), (0, 1), (1, 0), (1, 1), (2, 0), (2, 1), (3, 0), (3, 1)} p(x, y) 0 for x, y S XY p(x, y) = 1 x,y S XY Eric Zivot (Copyright 2015) Probability Review - Part 2 4 / 46

5 Outline 1 Bivariate Probability Distribution - Discrete rv s Marginal distributions Conditional distributions 2 Bivariate Probability Distribution - Continuous rv s 3 Independence 4 Covariance and Correlation Eric Zivot (Copyright 2015) Probability Review - Part 2 5 / 46

6 Marginal pdfs p(x) = Pr(X = x) = p(x, y) y S Y = sum over columns in joint table p(y) = Pr(Y = y) = p(x, y) x S X = sum over rows in joint table Eric Zivot (Copyright 2015) Probability Review - Part 2 6 / 46

7 Outline 1 Bivariate Probability Distribution - Discrete rv s Marginal distributions Conditional distributions 2 Bivariate Probability Distribution - Continuous rv s 3 Independence 4 Covariance and Correlation Eric Zivot (Copyright 2015) Probability Review - Part 2 7 / 46

8 Conditional Probability Suppose we know Y = 0. How does this knowledge affect the probability that X = 0, 1, 2, or 3? The answer involves conditional probability. Example: Pr(X = 0 Y = 0) = Pr(X = 0, Y = 0) Pr(Y = 0) = joint probability marginal probability = 1/8 4/8 = 1/4 Remark: Pr(X = 0 Y = 0) = 1/4 Pr(X = 0) = 1/8 = X depends on Y The marginal probability, Pr(X = 0), ignores information about Y. Eric Zivot (Copyright 2015) Probability Review - Part 2 8 / 46

9 Definition - Conditional Probability The conditional pdf of X given Y = y is, for all x S X, p(x y) = Pr(X = x Y = y) = Pr(X = x, Y = y) Pr(Y = y) The conditional pdf of Y given X = x is, for all values of y S Y p(y x) = Pr(Y = y X = x) = Pr(X = x, Y = y) Pr(X = x) Eric Zivot (Copyright 2015) Probability Review - Part 2 9 / 46

10 Conditional Mean and Variance µ X Y =y = E[X Y = y] = x Pr(X = x Y = y), x S X µ Y X=x = E[Y X = x] = y Pr(Y = y X = x). y S Y σx Y 2 =y σy 2 X=x = var(x Y = y) = = var(y X = x) = x S X (x µ X Y =y ) 2 Pr(X = x Y = y), y S Y (y µ Y X=x ) 2 Pr(Y = y X = x). Eric Zivot (Copyright 2015) Probability Review - Part 2 10 / 46

11 Example E[X] = 0 1/ / / /8 = 3/2 E[X Y = 0] = 0 1/ / / = 1, E[X Y = 1] = / / /4 = 2, var(x) = (0 3/2) 2 1/8 + (1 3/2) 2 3/8 +(2 3/2) 2 3/8 + (3 3/2) 2 1/8 = 3/4, var(x Y = 0) = (0 1) 2 1/4 + (1 1) 2 1/2 +(2 1) 2 1/2 + (3 1) 2 0 = 1/2, var(x Y = 1) = (0 2) (1 2) 2 1/4 +(2 2) 2 1/2 + (3 2) 2 1/4 = 1/2. Eric Zivot (Copyright 2015) Probability Review - Part 2 11 / 46

12 Independence Let X and Y be discrete rvs with pdfs p(x), p(y), sample spaces S X, S Y and joint pdf p(x, y). Then X and Y are independent rv s if and only if: p(x, y) = p(x) p(y) for all values of x S X and y S Y Result: If X and Y are independent rv s then, p(x y) = p(x) for all x S X, y S Y p(y x) = p(y) for all x S X, y S Y Intuition: Knowledge of X does not influence probabilities associated with Y Knowledge of Y does not influence probablities associated with X Eric Zivot (Copyright 2015) Probability Review - Part 2 12 / 46

13 Outline 1 Bivariate Probability Distribution - Discrete rv s 2 Bivariate Probability Distribution - Continuous rv s Marginal and conditional distributions 3 Independence 4 Covariance and Correlation Eric Zivot (Copyright 2015) Probability Review - Part 2 13 / 46

14 Bivariate Distributions - Continuous rv s The joint pdf of X and Y is a non-negative function f(x, y) such that: f(x, y)dxdy = 1 Let [x 1, x 2 ] and [y 1, y 2 ] be intervals on the real line. Then, Pr(x 1 X x 2, y 1 Y y 2 ) = x2 y2 x 1 y 1 f(x, y)dxdy = volume under probability surface over the intersection of the intervals [x 1, x 2 ] and [y 1, y 2 ] Eric Zivot (Copyright 2015) Probability Review - Part 2 14 / 46

15 Outline 1 Bivariate Probability Distribution - Discrete rv s 2 Bivariate Probability Distribution - Continuous rv s Marginal and conditional distributions 3 Independence 4 Covariance and Correlation Eric Zivot (Copyright 2015) Probability Review - Part 2 15 / 46

16 Marginal and conditional distributions The marginal pdf of X is found by integrating y out of the joint pdf f(x, y) and the marginal pdf of Y is found by integrating x out of the joint pdf: f(x) = f(y) = f(x, y)dy, f(x, y)dx. The conditional pdf of X given that Y = y, denoted f(x y), is computed as, f(x y) = f(x, y) f(y), and the conditional pdf of Y given that X = x is computed as, f(y x) = f(x, y) f(x). Eric Zivot (Copyright 2015) Probability Review - Part 2 16 / 46

17 Conditional mean and variance The conditional means are computed as: µ X Y =y = E[X Y = y] = x p(x y)dx, µ Y X=x = E[Y X = x] = y p(y x)dy and the conditional variances are computed as, σ 2 X Y =y = var(x Y = y) = (x µ X Y =y ) 2 p(x y)dx, σ 2 Y X=x = var(y X = x) = (y µ Y X=x ) 2 p(y x)dy. Eric Zivot (Copyright 2015) Probability Review - Part 2 17 / 46

18 Outline 1 Bivariate Probability Distribution - Discrete rv s 2 Bivariate Probability Distribution - Continuous rv s 3 Independence 4 Covariance and Correlation Eric Zivot (Copyright 2015) Probability Review - Part 2 18 / 46

19 Independence Let X and Y be continuous random variables. X and Y are independent iff: f(x y) = f(x), for < x, y <, f(y x) = f(y), for < x, y <. Result: Let X and Y be continuous random variables. X and Y are independent iff: f(x, y) = f(x)f(y) The result in the above proposition is extremely useful in practice because it gives us an easy way to compute the joint pdf for two independent random variables: we simple compute the product of the marginal distributions. Eric Zivot (Copyright 2015) Probability Review - Part 2 19 / 46

20 Example Example: Bivariate standard normal distribution Let X N(0, 1), Y N(0, 1) and let X and Y be independent. Then, f(x, y) = f(x)f(y) = 1 2π e 1 2 x2 1 2π e 1 2 y2 = 1 2π e 1 2 (x2 +y 2). To find Pr( 1 < X < 1, 1 < Y < 1) we must solve, π e 1 2 (x2 +y 2) dxdy which, unfortunately, does not have an analytical solution. Numerical approximation methods are required to evaluate the above integral. See R package mvtnorm. Eric Zivot (Copyright 2015) Probability Review - Part 2 20 / 46

21 Independence cont. Result: If the random variables X and Y (discrete or continuous) are independent then the random variables g(x) and h(y ) are independent for any functions g( ) and h( ). For example, if X and Y are independent then X 2 and Y 2 are also independent. Eric Zivot (Copyright 2015) Probability Review - Part 2 21 / 46

22 Outline 1 Bivariate Probability Distribution - Discrete rv s 2 Bivariate Probability Distribution - Continuous rv s 3 Independence 4 Covariance and Correlation Bivariate normal distribution Linear Combination of rv s Eric Zivot (Copyright 2015) Probability Review - Part 2 22 / 46

23 Covariance and Correlation - Measuring linear dependence between two rv s Covariance: Measures direction but not strength of linear relationship between 2 rv s σ XY = E[(X µ X )(Y µ Y )] = = x.y S XY (x µ X )(y µ Y ) p(x, y) (discrete) (x µ X )(y µ Y )f(x, y)dxdy (cts) Eric Zivot (Copyright 2015) Probability Review - Part 2 23 / 46

24 Example Example: For the data in Table 2, we have σ XY = Cov(X, Y ) = (0 3/2)(0 1/2) 1/8 +(0 3/2)(1 1/2) 0 + +(3 3/2)(1 1/2) 1/8 = 1/4 Eric Zivot (Copyright 2015) Probability Review - Part 2 24 / 46

25 Properties of Covariance Cov(X, Y ) = Cov(Y, X) Cov(aX, by ) = a b Cov(X, Y ) = a b σ XY Cov(X, X) = Var(X) X, Y independent = Cov(X, Y ) = 0 Cov(X, Y ) = 0 X and Y are independent Cov(X, Y ) = E[XY ] E[X]E[Y ] Eric Zivot (Copyright 2015) Probability Review - Part 2 25 / 46

26 Correlation Correlation: Measures direction and strength of linear relationship between 2 rv s ρ XY = Cor(X, Y ) = Cov(X, Y ) SD(X) SD(Y ) = σ XY σ X σ Y = scaled covariance Eric Zivot (Copyright 2015) Probability Review - Part 2 26 / 46

28 Properties of Correlation 1 ρ XY 1 ρ XY = 1 if Y = ax + b and a > 0 ρ XY = 1 if Y = ax + b and a < 0 ρ XY = 0 if and only if σ XY = 0 ρ XY = 0 X and Y are independent in general ρ XY = 0 = independence if X and Y are normal Eric Zivot (Copyright 2015) Probability Review - Part 2 28 / 46

29 Outline 1 Bivariate Probability Distribution - Discrete rv s 2 Bivariate Probability Distribution - Continuous rv s 3 Independence 4 Covariance and Correlation Bivariate normal distribution Linear Combination of rv s Eric Zivot (Copyright 2015) Probability Review - Part 2 29 / 46

30 Bivariate normal distribution Let X and Y be distributed bivariate normal. The joint pdf is given by: f(x, y) = { exp 1 2(1 ρ 2 ) 1 2πσ X σ Y 1 ρ 2 [ ( x µx σ X ) 2 ( ) ]} + y µy 2 σ Y 2ρ(x µ X )(y µ Y ) σ X σ Y where E[X] = µ X, E[Y ] = µ Y, SD(X) = σ X, SD(Y ) = σ Y, and ρ = cor(x, Y ). Eric Zivot (Copyright 2015) Probability Review - Part 2 30 / 46

31 Outline 1 Bivariate Probability Distribution - Discrete rv s 2 Bivariate Probability Distribution - Continuous rv s 3 Independence 4 Covariance and Correlation Bivariate normal distribution Linear Combination of rv s Eric Zivot (Copyright 2015) Probability Review - Part 2 31 / 46

32 Linear Combination of 2 rv s Let X and Y be rv s. Define a new rv Z that is a linear combination of X and Y : Z = ax + by where a and b are constants. Then, µ Z = E[Z] = E[aX + by ] = ae[x] + be[y ] = a µ X + b µ Y Eric Zivot (Copyright 2015) Probability Review - Part 2 32 / 46

33 Linear Combination of 2 rv s cont. and, σ 2 Z = Var(Z) = Var(a X + b Y ) = a 2 Var(X) + b 2 Var(Y ) + 2a b Cov(X, Y ) = a 2 σ 2 X + b 2 σ 2 Y + 2a b σ XY If X N(µ X, σ 2 X ) and Y N(µ Y, σ 2 Y ) then Z N(µ Z, σ 2 Z ). Eric Zivot (Copyright 2015) Probability Review - Part 2 33 / 46

34 Example Example: Portfolio returns R A = return on asset A with E[R A ] = µ A and Var(R A ) = σ 2 A R B = return on asset B with E[R B ] = µ B and Var(R B ) = σ 2 B Cov(R A, R B ) = σ AB and Cor(R A, R B ) = ρ AB = σ AB σ A σ B Portfolio: x A = share of wealth invested in asset A, x B = share of wealth invested in asset B x A + x B = 1 (exhaust all wealth in 2 assets) R P = x A R A + x B R B = portfolio return Eric Zivot (Copyright 2015) Probability Review - Part 2 34 / 46

35 Problem Portfolio Problem: How much wealth should be invested in assets A and B? Portfolio expected return (gain from investing): E[R P ] = µ P = E[x A R A + x B R B ] = x A E[R A ] + x B E[R B ] = x A µ A + x B µ B Eric Zivot (Copyright 2015) Probability Review - Part 2 35 / 46

36 Problem cont. Portfolio variance (risk from investing): Var(R P ) = σp 2 = Var(x A R A + x B R B ) = x 2 AVar(R A ) + x 2 BVar(R B )+ 2 x A x B Cov(R A, R B ) SD(R P ) = = x 2 Aσ 2 A + x 2 Bσ 2 B + 2x A x B σ AB Var(R P ) = σ P ) 1/2 = (x 2 AσA 2 + x 2 BσB 2 + 2x A x B σ AB Eric Zivot (Copyright 2015) Probability Review - Part 2 36 / 46

37 Linear Combination of N rv s Let X 1, X 2,, X N be rvs and let a 1, a 2,..., a N be constants. Define, N Z = a 1 X 1 + a 2 X a N X N = a i X i i=1 Then, µ Z = E[Z] = a 1 E[X 1 ] + a 2 E[X 2 ] + + a N E[X N ] N N = a i E[X i ] = a i µ i i=1 i=1 Eric Zivot (Copyright 2015) Probability Review - Part 2 37 / 46

38 Linear Combination of N rv s cont. For the variance, σ 2 Z = Var(Z) = a 2 1Var(X 1 ) + + a 2 NVar(X N ) + 2a 1 a 2 Cov(X 1, X 2 ) + 2a 1 a 3 Cov(X 1, X 3 ) + + 2a 2 a 3 Cov(X 2, X 3 ) + 2a 2 a 4 Cov(X 2, X 4 ) + + 2a N 1 a N Cov(X N 1, X N ) Note: N variance terms and N(N 1) = N 2 N covariance terms. If N = 100, there are = 9900 covariance terms! Result: If X 1, X 2,, X N variables then, are each normally distributed random N Z = a i X i N(µ Z, σz) 2 i=1 Eric Zivot (Copyright 2015) Probability Review - Part 2 38 / 46

39 Example Example: Portfolio variance with three assets R A, R B, R C are simple returns on assets A, B and C x A, x B, x C are portfolio shares such that x A + x B + x C = 1 R p = x A R A + x B R B + x C R C Portfolio variance, σ 2 P = x 2 Aσ 2 A + x 2 Bσ 2 B + x 2 Cσ 2 C + 2x A x B σ AB + 2x A x C σ AC + 2x B x C σ BC Note: Portfolio variance calculation may be simplified using matrix layout, x A x B x C x A σa 2 σ AB σ AC x B σ AB σb 2 σ BC x C σ AC σ BC σc 2 Eric Zivot (Copyright 2015) Probability Review - Part 2 39 / 46

40 Example Example: Multi-period continuously compounded returns and the square-root-of-time rule r t = ln(1 + R t ) = monthly cc return r t N(µ, σ 2 ) for all t Cov(r t, r s ) = 0 for all t s Annual return, r t (12) = 11 r t j j=0 = r t + r t r t 11 Eric Zivot (Copyright 2015) Probability Review - Part 2 40 / 46

42 Example cont. And, Var(r t (12)) = Var = 11 r t j j= Var(r t j ) = σ 2 j=0 j=0 = 12 σ 2 (σ 2 = monthly variance) SD(r t (12)) = 12 σ (square root of time rule) Then, r t (12) N(12µ, 12σ 2 ) Eric Zivot (Copyright 2015) Probability Review - Part 2 42 / 46

43 Example cont. For example, suppose: r t N(0.01, (0.10) 2 ) Then, E[r t (12)] = 12 (0.01) = 0.12 Var(r t (12)) = 12 (0.10) 2 = 0.12 SD(r t (12)) = 0.12 = r t (12) N(0.12, (0.346) 2 ) Eric Zivot (Copyright 2015) Probability Review - Part 2 43 / 46

45 Covariance between two linear combinations of random variables Consider two linear combinations of two random variables: Then, X = X 1 + X 2 Y = Y 1 + Y 2 cov(x, Y ) = cov(x 1 + X 2, Y 1 + Y 2 ) = cov(x 1, Y 1 ) + cov(x 1, Y 2 ) + cov(x 2, Y 1 ) + cov(x 2, Y 2 ) The result generalizes to linear combinations of N random variables in the obvious way. Eric Zivot (Copyright 2015) Probability Review - Part 2 45 / 46

Introduction to Computational Finance and Financial Econometrics Matrix Algebra Review

You can t see this text! Introduction to Computational Finance and Financial Econometrics Matrix Algebra Review Eric Zivot Spring 2015 Eric Zivot (Copyright 2015) Matrix Algebra Review 1 / 54 Outline 1