Chapter 5 Discrete Probability Distributions

Basic Business Statistics
12th Edition
Chapter 5
Discrete Probability
Distributions
Copyright ©2012 Pearson Education, Inc. publishing as Prentice Hall Chap 5-1 Chap 5-1
Learning Objectives
In this chapter, you learn:
 The properties of a probability distribution
 To compute the expected value and variance of a
probability distribution
 To calculate the covariance and understand its use
in finance
 To compute probabilities from binomial,
hypergeometric, and Poisson distributions

 How to use the binomial, hypergeometric, and
Poisson distributions to solve business problems
Definitions
Random Variables
 A random variable represents a possible

numerical value from an uncertain event.
 Discrete random variables produce outcomes

that come from a counting process (e.g.
number of classes you are taking).
 Continuous random variables produce

outcomes that come from a measurement (e.g.
your annual salary, or your weight).
Definitions Definitions
Random Variables
Random Variables
Random
Variables
Ch. 5 Discrete Continuous Ch. 6

Random Variable Random Variable
Discrete Random Variables
 Can only assume a countable number of values
Examples:
 Roll a die twice

Let X be the number of times 4 occurs
(then X could be 0, 1, or 2 times)
 Toss a coin 5 times.

Let X be the number of heads
(then X = 0, 1, 2, 3, 4, or 5)
Probability Distribution For A
Discrete Random Variable
 A probability distribution for a discrete random
variable is a mutually exclusive listing of all
possible numerical outcomes for that variable and
a probability of occurrence associated with each
outcome.
Number of Classes Taken Probability
2 0.20
3 0.40
4 0.24
5 0.16
Example of a Discrete Random
Variable Probability Distribution
Experiment: Toss 2 Coins. Let X = # heads.

4 possible outcomes
Probability Distribution
T T X Value Probability
0 1/4 = 0.25
T H 1 2/4 = 0.50
2 1/4 = 0.25
H T
Probability
0.50
0.25
H H
0 1 2 X
Expected Value (Measuring Center)
 Expected Value (or mean) of a discrete
random variable (Weighted Average)
N
  E(X)   xi P( X  xi )
i 1
X P(X=xi)
 Example: Toss 2 coins, 0 0.25
X = # of heads, 1 0.50
2 0.25
compute expected value of X:
E(X) = ((0)(0.25) + (1)(0.50) + (2)(0.25))
= 1.0
Measuring Dispersion
 Variance of a discrete random variable
N
σ 2   [x i  E(X)]2 P(X  x i )
i 1
 Standard Deviation of a discrete random variable

N
σ  σ2   i
[x
i 1
 E(X)]2
P(X  x i )
where:
E(X) = Expected value of the discrete random variable X
xi = the ith outcome of X
P(X=xi) = Probability of the ith occurrence of X
Measuring Dispersion
(continued)
 Example: Toss 2 coins, X = # heads,

compute standard deviation (recall E(X) = 1)
σ  xi  E(X)] P(X  x i ) 2
σ  (0  1)2 (0.25)  (1 1)2 (0.50)  (2  1)2 (0.25)  0.50  0.707
Possible number of heads

= 0, 1, or 2
Covariance
 The covariance measures the strength of the

linear relationship between two discrete random
variables X and Y.
 A positive covariance indicates a positive

relationship.
 A negative covariance indicates a negative

relationship.
The Covariance Formula
 The covariance formula:
N
σ XY   [ xi  E ( X )][( yi  E (Y )] P( xi yi )
i 1
where: X = discrete random variable X

Xi = the ith outcome of X
Y = discrete random variable Y
Yi = the ith outcome of Y
P(XiYi) = probability of occurrence of the
ith outcome of X and the ith outcome of Y
Investment Returns
The Mean
Consider the return per $1000 for two types of

investments.
Investment
Economic Condition
Prob. Passive Fund X Aggressive Fund Y
0.2 Recession - $25 - $200
0.5 Stable Economy + $50 + $60
0.3 Expanding Economy + $100 + $350
Investment Returns
The Mean
E(X) = μX = (-25)(.2) +(50)(.5) + (100)(.3) = 50
E(Y) = μY = (-200)(.2) +(60)(.5) + (350)(.3) = 95
Interpretation: Fund X is averaging a $50.00 return

and fund Y is averaging a $95.00 return per $1000
invested.
Investment Returns
Standard Deviation
σ X  (-25  50) 2 (.2)  (50  50) 2 (.5)  (100  50) 2 (.3)

 43.30
σ Y  (-200  95) 2 (.2)  (60  95) 2 (.5)  (350  95) 2 (.3)

 193.71
Interpretation: Even though fund Y has a higher

average return, it is subject to much more variability
and the probability of loss is higher.
Investment Returns
Covariance
σ XY  (-25  50)(-200  95)(.2)  (50  50)(60  95)(.5)

 (100  50)(350  95)(.3)
 8,250
Interpretation: Since the covariance is large and

positive, there is a positive relationship between the
two investment funds, meaning that they will likely
rise and fall together.
The Sum of
Two Random Variables
 Expected Value of the sum of two random variables:
E(X  Y)  E( X)  E( Y )
 Variance of the sum of two random variables:
Var(X  Y)  σ 2X  Y  σ 2X  σ 2Y  2σ XY
 Standard deviation of the sum of two random variables:
σ X  Y  σ 2X  Y
Portfolio Expected Return and
Expected Risk
 Investment portfolios usually contain several

different funds (random variables)
 The expected return and standard deviation of

two funds together can now be calculated.
 Investment Objective: Maximize return (mean)

while minimizing risk (standard deviation).
Portfolio Expected Return
and Portfolio Risk
 Portfolio expected return (weighted average
return):
E(P)  w E( X)  (1  w ) E( Y )
 Portfolio risk (weighted variability)
σ P  w 2σ 2X  (1  w )2 σ 2Y  2w(1 - w)σ XY
Where w = proportion of portfolio value in asset X

(1 - w) = proportion of portfolio value in asset Y
Portfolio Example
Investment X: μX = 50 σX = 43.30
Investment Y: μY = 95 σY = 193.21
σXY = 8250
Suppose 40% of the portfolio is in Investment X and

60% is in Investment Y:
E(P)  0.4 (50)  (0.6) (95)  77
σP  (0.4) 2 (43.30) 2  (0.6) 2 (193.71) 2  2(0.4)(0.6)(8,250)

 133.30
The portfolio return and portfolio variability are between the values
for investments X and Y considered individually
Probability Distributions
Probability
Distributions
Ch. 5 Discrete Continuous Ch. 6

Probability Probability
Distributions Distributions
Binomial Normal
Poisson Uniform
Hypergeometric Exponential
Binomial Probability Distribution
 A fixed number of observations, n
 e.g., 15 tosses of a coin; ten light bulbs taken from a warehouse
 Each observation is categorized as to whether or not the
“event of interest” occurred
 e.g., head or tail in each toss of a coin; defective or not defective
light bulb
 Since these two categories are mutually exclusive and
collectively exhaustive
 When the probability of the event of interest is represented as π,
then the probability of the event of interest not occurring is 1 - π
 Constant probability for the event of interest occurring
(π) for each observation
 Probability of getting a tail is the same each time we toss the
coin
Binomial Probability Distribution
(continued)
 Observations are independent

 The outcome of one observation does not affect the
outcome of the other
 Two sampling methods deliver independence
 Infinite population without replacement
 Finite population with replacement
Possible Applications for the
Binomial Distribution
 A manufacturing plant labels items as
either defective or acceptable
 A firm bidding for contracts will either get a
contract or not
 A marketing research firm receives survey
responses of “yes I will buy” or “no I will
not”
 New job applicants either accept the offer
or reject it
The Binomial Distribution
Counting Techniques
 Suppose the event of interest is obtaining heads on the

toss of a fair coin. You are to toss the coin three times.
In how many ways can you get two heads?
 Possible ways: HHT, HTH, THH, so there are three

ways you can getting two heads.
 This situation is fairly simple. We need to be able to
count the number of ways for more complicated
situations.
Counting Techniques
Rule of Combinations
 The number of combinations of selecting X

objects out of n objects is
n!
n Cx 
x!(n  x)!
where:
n! =(n)(n - 1)(n - 2) . . . (2)(1)
X! = (X)(X - 1)(X - 2) . . . (2)(1)
0! = 1 (by definition)
Counting Techniques
Rule of Combinations
 How many possible 3 scoop combinations could you

create at an ice cream parlor if you have 31 flavors to
select from?
 The total choices is n = 31, and we select X = 3.
31! 31! 31  30  29  28!

31 C 3     31  5  29  4,495
3!(31  3)! 3!28! 3  2  1  28!
Binomial Distribution Formula
n! x nx
P(X=x |n,π)  π (1-π)
x! (n  x )!
P(X=x|n,π) = probability of x events of interest

in n trials, with the probability of an
Example: Flip a coin four
“event of interest” being π for
times, let x = # heads:
each trial
n=4
x = number of “events of interest” in sample,
π = 0.5
(x = 0, 1, 2, ..., n)
1 - π = (1 - 0.5) = 0.5
n = sample size (number of trials
or observations) X = 0, 1, 2, 3, 4
π = probability of “event of interest”
Example:
Calculating a Binomial Probability
What is the probability of one success in five
observations if the probability of an event of
interest is 0.1?
x = 1, n = 5, and π = 0.1
n!
P(X  1 | 5,0.1)   x (1   ) n  x
x!(n  x)!
5!
 (0.1)1 (1  0.1) 51
1!(5  1)!
 (5)(0.1)(0.9) 4
 0.32805
Example
Suppose the probability of purchasing a defective
computer is 0.02. What is the probability of
purchasing 2 defective computers in a group of 10?
x = 2, n = 10, and π = 0.02
n!
P(X  2 | 10, 0.02)   x (1   ) n  x
x!(n  x)!
10!
 (.02) 2 (1  .02)10 2
2!(10  2)!
 (45)(.0004)(.8508)
 .01531
Shape
 The shape of the

P(X=x|5, 0.1)
binomial distribution .6
depends on the values .4
of π and n .2
 Here, n = 5 and π = .1 0
0 1 2 3 4 5 x
P(X=x|5, 0.5)
.6
.4
 Here, n = 5 and π = .5 .2
0
0 1 2 3 4 5 x
The Binomial Distribution Using
Binomial Tables (Available On Line)
n = 10
x … π=.20 π=.25 π=.30 π=.35 π=.40 π=.45 π=.50
0 … 0.107 0.056 0.028 0.013 0.006 0.002 0.0010 10

1 … 4 3 2 5 0 5 0.0098 9
2 … 0.268 0.187 0.1211 0.072 0.040 0.020 0.0439 8
3 … 4 7 0.233 5 3 7 0.1172 7
4 … 0.302 0.281 5 0.175 0.120 0.076 0.2051 6
0 6 0.266 7 9 3
5 … 0.2461 5
0.201 0.250 8 0.252 0.215 0.166
6 … 0.2051 4
3 3 0.200 2 0 5
7 … 0.1172 3
0.088 0.146 1 0.237 0.250 0.238
8 … 1 0 7 8 4 0.0439 2
0.102
9 … 0.026 0.058 9 0.153 0.200 0.234 0.0098 1
10 … 4 4 0.036 6 7 0 0.0010 0
0.005 0.016 8 0.068 0.1115 0.159
5 2 0.009 9 0.042 6
0.000 0.003 0 0.021 5 0.074
8 1 0.001 2 0.010 6
Examples: 0.000 0.000 4 0.004 6 0.022
1 4 0.000 3 0.001 9
n = 10, π = 0.35, x = 3: P(X = 3|10, 0.35) = 0.2522
0.000 0.000 1 0.000 6 0.004
0 0 0.000 5 0.000 2
n = 10, π = 0.75, x = 8: P(X = 2|10, 0.75) = 0.0004
0.000 0.000 0 0.000 1 0.000
0 0 0 3
… π=.80 π=.75 π=.70 π=.65 π=.60 π=.55 π=.50 x
Binomial Distribution
Characteristics
 Mean
μ  E(X)  n
 Variance and Standard Deviation
2
σ  nπ (1 - π )
σ  nπ (1 - π )
Where n = sample size
π = probability of the event of interest for any trial
(1 – π) = probability of no event of interest for any trial
Characteristics
Examples P(X=x|5, 0.1)

μ  nπ  (5)(.1)  0.5 .6
.4
.2
σ  nπ (1 - π )  (5)(.1)(1  .1)
0
 0.6708 0 1 2 3 4 5 x
P(X=x|5, 0.5)
μ  nπ  (5)(.5)  2.5 .6
.4
σ  nπ (1 - π )  (5)(.5)(1  .5) .2
0
 1.118 0 1 2 3 4 5 x
Using Excel For The
Binomial Distribution (n = 4, π = 0.1)
Using Minitab For The Binomial
Distribution (n = 4, π = 0.1)
2
5
4
The Poisson Distribution
Definitions
 You use the Poisson distribution when you

are interested in the number of times an event
occurs in a given area of opportunity.
 An area of opportunity is a continuous unit or
interval of time, volume, or such area in which
more than one occurrence of an event can
occur.
 The number of scratches in a car’s paint
 The number of mosquito bites on a person
 The number of computer crashes in a day
 Apply the Poisson Distribution when:

 You wish to count the number of times an event
occurs in a given area of opportunity
 The probability that an event occurs in one area of
opportunity is the same for all areas of opportunity
 The number of events that occur in one area of
opportunity is independent of the number of events
that occur in the other areas of opportunity
 The probability that two or more events occur in an
area of opportunity approaches zero as the area of
opportunity becomes smaller
 The average number of events per unit is  (lambda)
Poisson Distribution Formula

e  x
P( X  x |  ) 
x!
where:
x = number of events in an area of opportunity
 = expected number of events
e = base of the natural logarithm system (2.71828...)
Poisson Distribution
Characteristics
 Mean
μλ
 Variance and Standard Deviation
σ2  λ
σ λ
where  = expected number of events
Using Poisson Tables (Available
On Line)

X 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90
0 0.9048 0.8187 0.7408 0.6703 0.6065 0.5488 0.4966 0.4493 0.4066

1 0.0905 0.1637 0.2222 0.2681 0.3033 0.3293 0.3476 0.3595 0.3659
2 0.0045 0.0164 0.0333 0.0536 0.0758 0.0988 0.1217 0.1438 0.1647
3 0.0002 0.0011 0.0033 0.0072 0.0126 0.0198 0.0284 0.0383 0.0494
4 0.0000 0.0001 0.0003 0.0007 0.0016 0.0030 0.0050 0.0077 0.0111
5 0.0000 0.0000 0.0000 0.0001 0.0002 0.0004 0.0007 0.0012 0.0020
6 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0001 0.0002 0.0003
7 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
Example: Find P(X = 2 |  = 0.50)
e  λ λ x e 0.50 (0.50) 2
P(X  2 | 0.50)    0.0758
x! 2!
Using Excel For The
Poisson Distribution (λ= 3)
Using Minitab For The Poisson
Distribution (λ = 3)
2
3
5
Graph of Poisson Probabilities
Graphically:
 = 0.50
=
X 0.50
0 0.6065
1 0.3033
2 0.0758
3 0.0126
4 0.0016
5 0.0002
6 0.0000
7 0.0000 P(X = 2 | =0.50) = 0.0758
Poisson Distribution Shape
 The shape of the Poisson Distribution

depends on the parameter  :
 = 0.50  = 3.00
The Hypergeometric
Distribution
 The binomial distribution is applicable when

selecting from a finite population with
replacement or from an infinite population
without replacement.
 The hypergeometric distribution is applicable

when selecting from a finite population without
replacement.
The Hypergeometric
Distribution
 “n” trials in a sample taken from a finite
population of size N
 Sample taken without replacement
 Outcomes of trials are dependent
 Concerned with finding the probability of “X=xi”
items of interest in the sample where there are
“A” items of interest in the population
Hypergeometric Distribution
Formula
 A  N  A
   
P(X  x | n, N, A) 
[ A C x ][ N  A C n  x ]
  x  nx 
N Cn  N
 
 n
Where
N = population size
A = number of items of interest in the population
N – A = number of events not of interest in the population
n = sample size
x = number of items of interest in the sample
n – x = number of events not of interest in the sample
Properties of the
 The mean of the hypergeometric distribution is
nA
μ  E(X) 
N
 The standard deviation is
nA(N - A) N - n
σ 2

N N -1
Where N - n is called the “Finite Population Correction Factor”

N -used
1 when sampling without replacement from a
finite population
Using the
■ Example: 3 different computers are selected from 10 in
the department. 4 of the 10 computers have illegal
software loaded. What is the probability that 2 of the 3
selected computers have illegal software loaded?
N = 10 n=3
A= 4 x=2
 A  N  A  4  6
       
 x  n  x    2   1   (6)(6)  0.3
P(X  2 | 3,10,4) 
 N  10  120
   
 n  3 
The probability that 2 of the 3 selected computers have illegal

software loaded is 0.30, or 30%.
Using Excel for the
Hypergeometric Distribution (n = 8, N = 30, A = 10)
Using Minitab For The Hypergeometric
Distribution (n = 8, N = 30, A = 10)
2
Chapter Summary
 Addressed the probability distribution of a

discrete random variable
 Defined covariance and discussed its
application in finance
 Discussed the Binomial distribution
 Discussed the Poisson distribution
 Discussed the Hypergeometric distribution
Basic Business Statistics
12th Edition
On Line Topic
The Poisson Approximation To

Copyright ©2012 Pearson Education, Inc. publishing as Prentice Hall Chap 5-54
Learning Objectives
In this topic, you learn:
 When to use the Poisson distribution to
approximate the binomial distribution

 How to use the Poisson distribution to approximate
the binomial distribution
The Poisson Distribution Can Be Used To
Approximate The Binomial Distribution
 Most useful when n is large and π is very small
 The approximation gets better as n gets larger

and π gets smaller
The Formula For The
Approximation
 n
e ( n ) X
P( X ) 
X!
Where
P(X) = probability of X events of interest given the parameters n and π
n = sample size
π = probability of an event of interest
e = mathematical constant approximated by 2.71828
X = number of events of interest in the sample (X = 0, 1, 2, . . . , n)
The Mean & Standard Deviation Of
  E ( X )    n
    n
Calculating Probabilities
 Suppose π = 0.08 and n = 20 then μ = 1.6

 Can calculate by hand or can use Poisson
probability tables
e 20*0.08 ( 20 * 0.08)1
P ( X  1)   0.3230
1!
λ=nπ
X 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0
0 .3329 .3012 .2725 .2466 .2231 .2019 .1827 .1653 .1496 .1353
l .3662 .3614 .3543 .3452 .3347 .3230 .3106 .2975 .2842 .2707
2 .2014 .2169 .2303 .2417 .2510 .2584 .2640 .2678 .2700 .2707
3 .0738 .0867 .0998 .1128 .1255 .1378 .1496 .1607 .1710 .1804
4 .0203 .0260 .0324 .0395 .0471 .0551 .0636 .0723 .0812 .0902
Topic Summary
In this topic, you learned:

 When to use the Poisson distribution to
approximate the binomial distribution

 How to use the Poisson distribution to approximate
the binomial distribution

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Basic Business Statistics

 To compute the expected value and variance of a

hypergeometric, and Poisson distributions

Poisson distributions to solve business problems

 A random variable represents a possible

 Discrete random variables produce outcomes

 Continuous random variables produce

Ch. 5 Discrete Continuous Ch. 6

 Roll a die twice

 Toss a coin 5 times.

Experiment: Toss 2 Coins. Let X = # heads.

 Standard Deviation of a discrete random variable

 Example: Toss 2 coins, X = # heads,

σ  (0  1)2 (0.25)  (1 1)2 (0.50)  (2  1)2 (0.25)  0.50  0.707

Possible number of heads

 The covariance measures the strength of the

 A positive covariance indicates a positive

 A negative covariance indicates a negative

where: X = discrete random variable X

Consider the return per $1000 for two types of

0.2 Recession - $25 - $200

0.5 Stable Economy + $50 + $60

0.3 Expanding Economy + $100 + $350

E(X) = μX = (-25)(.2) +(50)(.5) + (100)(.3) = 50

E(Y) = μY = (-200)(.2) +(60)(.5) + (350)(.3) = 95

Interpretation: Fund X is averaging a $50.00 return

σ X  (-25  50) 2 (.2)  (50  50) 2 (.5)  (100  50) 2 (.3)

σ Y  (-200  95) 2 (.2)  (60  95) 2 (.5)  (350  95) 2 (.3)

Interpretation: Even though fund Y has a higher

σ XY  (-25  50)(-200  95)(.2)  (50  50)(60  95)(.5)

Interpretation: Since the covariance is large and

 Variance of the sum of two random variables:

 Standard deviation of the sum of two random variables:

 Investment portfolios usually contain several

 The expected return and standard deviation of

 Investment Objective: Maximize return (mean)

 Portfolio risk (weighted variability)

Where w = proportion of portfolio value in asset X

Suppose 40% of the portfolio is in Investment X and

σP  (0.4) 2 (43.30) 2  (0.6) 2 (193.71) 2  2(0.4)(0.6)(8,250)

Ch. 5 Discrete Continuous Ch. 6

 Observations are independent

 Suppose the event of interest is obtaining heads on the

 Possible ways: HHT, HTH, THH, so there are three

 The number of combinations of selecting X

 How many possible 3 scoop combinations could you

31! 31! 31  30  29  28!

P(X=x|n,π) = probability of x events of interest

 The shape of the

0 … 0.107 0.056 0.028 0.013 0.006 0.002 0.0010 10

Examples P(X=x|5, 0.1)

 You use the Poisson distribution when you

 Apply the Poisson Distribution when:

X 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90

0 0.9048 0.8187 0.7408 0.6703 0.6065 0.5488 0.4966 0.4493 0.4066

Example: Find P(X = 2 |  = 0.50)

 The shape of the Poisson Distribution

 The binomial distribution is applicable when

 The hypergeometric distribution is applicable