CFA LEVEL 1

QUANTITATIVE METHOD
Lecturer: Tran Trong Kien, CFA
Email: Trankien88@gmail.com

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READING 6: THE TIME VALUE OF MONEY

READING 7: STATISTICAL CONCEPTS AND MARKET RETURNS

READING 8: PROBABILITY CONCEPTS

READING 9: COMMON PROBABILITY DISTRIBUTIONS

READING 10: SAMPLING AND ESTIMATION

READING 11: HYPOTHESIS TESTING

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 READING 6: THE TIME VALUE OF MONEY
 Learning outcomes:

MODULE 6.1: EAY AND COMPOUNDING FREQUENCY:

DEFINITION:

- Compound interest or interest on interest: the growth in the value of the

investmentfrom perio
- d to period reflects not only the interest earned on the original
principalamount but also on the interest earned on the previous period’s
interest earnings;
- Time value of investment: frequently call for determining the FV of an
investment CF as a result of effects of compound interest;

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 - Future value: projecting the cash flows forward, on the basis of an
appropriate compound interest rate, to the end of investment’s life;
- Present value: bringing the CF from investment back to the beginning of the
investment’s life based on an appropriate compound rate;
- Time line: a diagram of the CF associated with a TVM problem;
 Note:
- Cash flow at the end of one period is the same as the beginning of the next
period.

6.a Interpret interest rates as required rate of return, discount rate, or

opportunity cost:

- Required rate of return: is equilibrium IR for a particular investment,

return that investors and savers require to get them to lend their fund.

- Discount rate=Required rate of return

- Opportunity cost: interest rate of current consumption;

6.b Explain an interest rate as the sum of a real-free rate and premiums that
compensate investors for bearing distinct type of risk:

- Real risk-free rate: theoretical rate on single-period loan that has no

expectation of inflation in it, investor’s increase in purchasing power.

Nominal risk-free rate = real risk-free rate + expected inflation rate

- Other type of risk: each added to increase the required rate of return
+ Default risk: risk a borrower will not make a promised payments in a
timely manner;
+ Liquidity risk: risk of receiving less than fair value for an investment if it
must be sold for cash quickly;
+ Maturity risk: prices of long-term bonds are more volatile than those
short-term bonds.
Longer maturity bonds have more maturity risk than short-term bonds and
require a maturity risk premium.
Required interest rate on a security = nominal risk free rate (T-bills) +
default risk premium + liquidity risk premium + maturity risk premium.

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6.c. Calculate and interpret the effective annual rate, given the stated
annual interest rate and the frequency of compounding:
-Effective annual rate (EAR) or effective annual yield (EAY): annual rate
of return actually being earned after adjustments have been made for
different compounding periods.

Periodic rate = stated annual rate/m

m=the number of compounding periods per year
Note: the greater the compounding frequency, the greater the EAR will be in
comparison to the stated rate.
Example: using a stated rate of 6%, compute EARs for semiannual,
quarterly, monthly, and daily compounding.

6.d Solve time value of money problems for different frequencies of

compounding:
Example: Growth with quarterly compounding
Jone plans to invest $2500 in an account that will earn 8% per year with
quarterly compounding. How much will be in account at the end of two
years?

6.e Calculate and interpret the FV, PV of a single sum of money, an

ordinary annuity, an annuity due, a perpetuity, and series of unequal
cash flow.
-Future value: amount to which a current deposit will grow over time when
it is placed in an account paying compound interest.
Formula:

PV: amount of money invested today (present value)

r: rate of return per period
N= total number periods
(1 + r)N is future value factor or future value investment factor

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 Example: FV of a single sum
Calculate the FV of a $200 investment in the at the end of two years if it
earns an annually compounded rate of return of 10%.
- With more than compounding period per year, the future value:

rs:stated annual interest rate; m: number of compounding period; N:

number of years

- Continuous compounding: number of compounding periods per year

become infinite, interest rate is said to compound continuously

-Present value of a single sum:

The interest rate used in discounting process is commonly referred to
discount rate, opportunity cost, required rate of return and cost of capital.

1/(1+r)N is present value factor, present value interest factor or discount

rate

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 Example: PV of a single sum
Given a discount rate of 10%, calculate the PV of $200 cash flow that will
be received in two years.

- Annuities: is a stream of equal cash flows that occur at equal intervals over
a given period
+ Ordinary annuities: cash flows that occur at the end of each compounding
period.
+ Annuity due: payments or receipts occur at the beginning of the period
Example: FV of an ordinary annuity
What is the future value of an ordinary annuity that pays $200 per year at
the end of the next three years, given the investment is expected to earn a
10% rate of return?

Example: PV of an ordinary annuity

What is the PV of an ordinary annuity that pays $200 per year at the end of
each next three years, given a 10% discount rate?

Example: PV of an ordinary annuity beginning later than t=1

What is the present value of four $100 end of year payments if the first
payment is to be received three years from today and the appropriate of
return is 9%?

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-Future vale of annuity due:

Note: annuity due payments are made or received at the beginning of each
period, FV of an annuity due is calculated as of the end of last period.
Formula:

Example: Given a discount rate is 10%, what is the future value of an

annuity that pays $200 per year at the beginning of each of the next three
years, starting today?

-Present value of perpetuity:

Perpetuity is financial instrument that pays a fixed amount of money at set
interval over an infinite period of time. Preferred stock is an example of
perpetuities.
Formula:

Example: Kodon Corporation issues preferred stock that will pay 4.5$ per
year in annual dividends beginning next year and plans to follow this dividend
policy forever. Given an 8% rate of return, what is the value of Kodon’s preferred
stock today.
Example: PV of a deferred perpetuity
Assume the Kodon preferred stock in the preceding examples is scheduled to
pay its first dividend in four years and is non-cumulative (i.e does not pay
any dividends for the first three years). Given an 8% required rate of return,
what is the value of Kodon’s preferred stock today?

MODULE 6.3: UNEVEN CASH FLOWS

-Uneven cash flow:
Example: Computing the FV of an uneven cash flow series

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 Using a rate of return 10%, compute the future value of three-year uneven
cash flow stream of 300 USD year 1, 600 USD year 2 and 200 USD year 3.

Example: Computing PV of an uneven cash flow series

Compute the present value of this three-year uneven cash flow stream
described previously using a 10% rate of return.

Solving time value of money problems when compounding periods are

other than annual:
Increase in the frequency of compounding increase effective rate of interest,
it also increases the FV of a given CF and decreases the PV of a given CF.
Example: The effect of compounding frequency of FV and PV
Compute the FV one year from now of $1000 today and the PV of $1000 to
be received one year from now using a stated annual interest rate of 6% with a
range of compounding periods: annual, semiannual, quarterly, monthly, daily

6.f Demonstrate the use of time line in modeling and solving time value
of money problems.
Example: Computing a loan payment
Suppose you are considering applying for a $2000 loan that will be repaid
with equal end-of-year payments over the next 13 years. If the annual interest rate
for the loan is 6%, how much will your payment be?

Example: Computing the number of periods in annuity

How many $100 end of year payments are required to accumulate $920 if
the discount rate is 9%

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 Example: Computing the of years in an ordinary annuity
Suppose you have a $1000 ordinary annuity earning an 8% return. How
many annual end-of-year $150 withdrawals can be made?

Example: Computing the rate of return for annuity

Suppose you have the opportunity to invest $100 at the end of each of next
five years in exchange for $600 at the end of the fifth year. What is the annual rate
of return for this investment?

Funding future obligation:

Example: Computing the required payment to fund an annuity due
 Suppose you must take five annual $1000 payments, the first one
starting at the beginning of year 4 (end of year 3). To accumulate the
money to make these payments, you want to make three equal
payments into an investment account, the first to be made one year
from today. Assuming 10% rate of return, what is the amount of these
three payments?

 The connection between present values, future values, and series of cash
flow:
- The cash flow additivity principle:present value of any stream of cash flows
equal the sum of the present value of the cash flows.
Example: Additivity principle
A security will make the following payments at the end of the next four
years: $100, $100, $400 and $100. Calculate the present value of these cash

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flows using the concept of the present value of an annuity when the
appropriate discount rate is 10%.

READING 7: STATISTICAL CONCEPTS AND MARKET RETURNS

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 MODULE 7.1 DESCRIBING DATA SETS
7.a Distinguish between descriptive statistics and inferential statistics,
between a population and a sample, among the types of measurement scales:
-Statistics: referring to the data and methods use to analyze the data
+ Descriptive statistics: summarize the important characteristics of large
data sets.
+ Inferential statistics: procedures to make forecasts, estimates, or
judgments about a larger set of data on the basis of the statistical characteristics of
a smaller set.
-Population: set of all possible members of stated group.
-Sample: subset of population of interest
-Types of measurement scales:
+ Nominal scale: containing least information, classified or counted with no
particular order. (là thang đo dùng để phân chia hay đặt tên nhóm được khảo sát thành các
lớp phân loại khác nhau chứ không có ý nghĩa nào khác, ví dụ thành thị =1, nông thôn=2 ở đây
không thể nói nông thông lớn hơn thành thị và ngược lại)
+Ordinal scale: every observation is assigned to one of several categories.
These categories are ordered with respect to a specified characteristic. (Bản chất là
thang định danh nhưng các lớp khác nhau được sắp xếp theo một thứ hạng giảm dần hoặc tăng
dần, ví dụ: hạng nhất/hạng nhì/hạng ba, khoảng cách giữa các điểm đo không chắc đều nhau và
hiệu số không có ý nghĩa)

+ Interval scale: provide relative ranking, like ordinal scales, plus the
assurance that differences between scale are equal.( Bản chất là thang thứ bậc có các
khoảng cách đều nhau nhưng không có điểm gốc 0 tuyệt đối. Quan hệ giữa các điểm đo trên
thang   là  A>B>C>D và  A - B = B – C. Một đặc điểm quan trọng của thang định khoảng là
thang này không có điểm 0 tuyệt đối, nghĩa là điểm 0 không có thật, chỉ là quy ước (như 0 độ C
không phải là "không có nhiệt độ" mà là "tại nhiệt độ đó nước từ thể rắn chuyển sang thể lỏng"
và còn có thể xuống thấp hơn mức 0 độ). Điều này dẫn đến việc so sánh tỷ lệ giữa các trị số đo
là không có ý nghĩa (phép chia). Ta không thể nói: 40 độ C là nóng gấp 4lần 10 độ C)

Weakness: measurement of zero does not necessarily indicate total absence

of measuring. Interval scale based ratio are meaningless.

+ Ratio scale: provide ranking and equal differences between scale values
and also have true zero point as origin. (Là thang đokhoảngvớiđiểm 0 tuyệtđối. Vídụ: thang
đovớicácthôngsốvậtlý: dài, rộng, cao, cânnặng; thunhập, chi tiêu...  Nhờđiểmgốcvàmộttiêuchuẩnđocụthể, ta
cóthểsửdụngđượcmọicôngcụtoán - thốngkêđểphântíchdữliệu, so sánhđượctỷlệgiữacáctrịsốđo. Ta
cóthểnói: ngườicóthunhập 10 triệuđồng/thánglàgấpđôingườicóthunhập 5 triệuđồng/tháng.)

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 Order, interval, and ratios all make sense with a ratio scale.
7.b define a parameter, a sample statistic, and frequency distribution:
-Parameter: describe a characteristic of population (e.x: mean return,
standard deviation…)
-Sample statistic: measure characteristic of sample;
-Frequency distribution: tabular presentation of statistical data,
summarizing statistical data by assigning it to specified groups or intervals;
 Constructing a frequency distribution:
-Step 1: Define the intervals:
+ Refer to a class, set of values that observation may take on;
+ Each interval must have a lower and upper limit, inclusive and non-
overlapping;
+ Modal interval: interval with greatest frequency
-Step 2: Tally the observation:
+ Observations must be tallied;
+ or assigned to their appropriate interval;
-Step 3: Count the observation:
+ Absolute frequency or simple frequency is actual number of observations
fall within interval;
Example: Constructing a frequency distribution
Use the data in table A to construct a frequency distribution for the returns
on Intelco’s common stock:

7.c Calculate and interpret relative frequencies and cumulative relative

frequency, given a frequency distribution:
- Relative frequency: is the percentage of total observations;

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 - Cumulative frequency: summing absolute or relative frequencies starting
at the lowest interval and progressing through the highest.

7.d Describe the properties of data set presented as a histogram or a

frequency polygon:

-Histogram: graphical representation of the absolute frequency distribution;

simply bar chart of continuous data has been classified into a frequency
distribution.

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 - Frequency polygon: mid point of each interval is plotted on the horizontal
axis and absolute frequency is plotted on the vertical axis.

MODULES 7.2: MEAN AND VARIANCE

7.e Calculate and interpret measures of central tendency, including the

population mean, sample mean, arithmetic mean, weighted average or mean,
geometric mean, harmonic mean, median and mean:

- Population mean:

- Sample mean:

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 Example: Population mean and sample mean
You have calculated the stock return for AXZ Corporation over the last five
years as 25%, 34%, 19%, 54% and 17%. Given this information, estimate
the mean of distribution of return.

-Weighted mean: different observations may have a disproportionate

influence on the mean.

Important concept for return of portfolio is the weighted average return of

individual assets in the portfolio.
Example: A portfolio consists of 50% common stock, 40% bond and 10%
cash. If the return on common stock is 12%, the return on bonds is 7%, and the
return on cash is 3%, what is the portfolio return?

-Median: midpoint of data set when data is arranged in ascending or

descending order.
Example: What is the median return for five portfolio managers with 10
year annualized total records of: 30%, 15%, 25%, 21% and 23%.

Suppose we add a sixth manager to the previous example with a return of

28%. What is the median return?

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 -Mode: value that occurs most frequently in data set. It may have more than
one mode or even no mode.
+ Unimodal: one value appears most frequently
+ Bimodal and trimodals: set of data has two or three values
Example: The mode
What is the mode of the following data set?
Data set: 30%, 28%, 25%, 23%, 28%, 15% and 5%.

-Geometric mean: calculating investment return over multiple periods or

when measuring compound growth rates.

This equation has a solution only if the product under the radical sign is non-
negative.
When calculating the geometric mean for a returns data set, it is necessary to
add 1 toeach value under the radical and then subtract 1 from the result

-Harmonic mean: is used for certain computations, such as the average cost
of shares purchased over time.

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 For values that are not equal: harmonic mean< geometric mean<
arithmetic mean
- Holding period return:

7.f Calculate and interpret quartiles, quintiles, deciles and percentiles:

-Quantile (known as measure of location): value at or below which stated
proportion of the data in a distribution lies.
+ Quartiles-the distribution is divided into quarters;
+ Quintiles-the distribution is divided into fifths;
+ Decile-the distribution is divided into tenths;
+ Percentile-the distribution is divided into hundredths (percent);

-When the location, Ly, is a whole number, the location corresponds to an actual
observation.
-When Ly is not a whole number or integer, Ly lies between the two closest integer
numbers (one above and one below), and we use linear interpolation between those
two places to determine Py

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Investment analysts use quantiles every day to rank performance—for example, the
performance of portfolios. The performance of investment managers is often
characterized in terms of the quartile in which they fall relative to the performance
of their peer group of managers
LOS 7.g: Calculate and interpret 1) a range and a mean absolute deviation
and 2) the variance and standard deviation of a population and of a sample.
-Dispersion is defined as the variability around the central tendency.
+ Central tendency: measure of the reward;
+ Dispersion: measure of risk;
-Range: is the distance between the largest and the smallest value
(maximum value – minimum value);

-Mean absolute deviation (MAD):average of the absolute values of the

deviations of individual observations from the arithmetic mean.

-Population variance: average of the squared deviations from the mean;

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 -Population standard deviation: is the square root of the population
variance and is calculated as follow:

-Sample variance: s2 measure of dispersion applying when we are

evaluating a sample of n observation from a population.

The quantity n − 1 is also known as the number of degrees of freedom in

estimating the population variance
-Sample standard deviation: calculated by taking the square root of the
sample variance.

MODULE 7.3: SKEW, KURTOSIS AND SHARPE RATIO

7.h Calculate and interpret the proportion of observations falling within a
specified number of standard deviations of the mean using Chebyshev’s
inequality

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 -Chebyshev’s inequality: the percentage of the observations that lie within k
standard deviations of the mean is at least 1-1/k2 for all k>1.

The importance of Chebyshev’s inequality stems from its generality. The

inequality holds for samples and populations and for discrete and continuous data
regardless of the shape of the distribution.
LOS 7.i: Calculate and interpret the coefficient of variation.
-Relative dispersion: amount of variability in a distribution relative to a
reference point benchmark, and measured with coefficient of variation (CV);

If we need to compare the dispersion among data sets stated in different

units of measurement, the coefficient of variation can be useful because it is free
from units of measurement
LOS 7.j: Explain skewness and the meaning of a positively or negatively
skewed return distribution.
In calculations of variance, for example, the deviations around the mean are
squared, so we do not know whether large deviations are likely to be positive or
negative.One important characteristic of interest to analysts is the degree of
symmetry in return distributions.
-Symmetrical: it is shaped identically on both sides of the mean, implying
that intervals of losses and gains will exhibit the same frequency.

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 + For symmetrical distribution, unimodal distribution, the mean, median and
mode are equal

-Skewness: distribution is not symmetrical, may be either positively or

negatively skewed and result from the occurrence of outliers in the data set.
(Outliers: observations with extraordinary large values, either positive or
negative.)

+ Positively skewed: distribution with many outliers in the upper region, or

right tail. positive skew has frequent small losses and a few extreme gains

+ For unimodal distribution,

+ Negative skewed: distribution has a disproportionately large amount of

outliers that fall within its lower tail. skewed distribution shown has a long tail on
its left side

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 -A symmetric distribution has skewness of 0;
- A positively skewed distribution has positive skewness;
- A negatively skewed distribution has negative skewness;
LOS 7.l: Explain measures of sample skewness and kurtosis.
-Kurtosis: measure of combined weight of the tails of distribution relative to
the rest of distribution – that is, proportion of the total probability in the tail;
+ Leptokurtic:a distribution has fatter tails than normal distribution tends to
generate more-frequent extremely large deviation from the mean than normal
distribution;
+ Platykurtic: a distribution has thinner tails than normal distribution;
+ Mesokurtic: same kurtosis as a normal distribution;

+Excess kurtosis: characterizes kurtosis relative to the normal distribution, is

defined as kurtosis minus three. Normal distribution, computed kurtosis is three;
(Normal distribution: excess kurtosis equal 0; leptokurtic: excess kurtosis
greater than 0; platykurtosis: excess kurtosis less than 0)

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 Most risk managers focus more on the distribution of returns in the tails of
the distribution. General, greater positive kurtosis and negative skew indicates
increased risk.
Measures of sample skew and kurtosis:
-Sample skewness: equal to the sum of the cubed deviations from the mean
divided by the cubed standard deviations and number of observations.

When a distribution is right skewed, sample skewness is positive;

When a distribution is left skewed, sample skewness is negative;
Value of sample skewness in excess of 0.5 in absolute value are considered
significant.
-Sample kurtosis: is measured using deviations raised the fourth power:

- Interpret kurtosis: measured relative to the kurtosis of a normal distribution,

which is 3.
+ leptokurtic: positive value of excess kurtosis;
+ platykurtic: negative value of excess kurtosis;
+ excess kurtosis = sample kurtosis – 3;
Excess kurtosis >1 in absolute value are considered large;
Most equity return series have been found to be leptokurtic. If a return
distribution has positive excess kurtosis (leptokurtosis) and we use statistical
models that do not account for the fatter tails, we will underestimate the likelihood
of very bad or very good outcomes
LOS 7.m: Compare the use of arithmetic and geometric means when
analyzing investment returns.
-Geometric mean: of past annual returns is appropriate measure of past
performance, it gives the average annual compound return.

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 + It is used for multi-year return, captures how the total returns are linked
over time.
-Arithmetic mean:
+ average return over a one-year period horizon;
+ is used for forward-looking context.

READING 8: PROBABILITY CONCEPTS

MODULE 8.1: CONDITIONAL AND JOINT PROBABILITIES
Los 8.a: Define a random variable, an outcome, an event, mutually exclusive
events, and exhaustive events:
-Random variable: an uncertain quantity/number;
- Outcome: observed value of a random variable;
- An event: single outcome (the portfolio earns a return of 10 percent) or a
set of outcomes(the portfolio earns a return below 10 percentcontains an infinite
number of outcomes);
-Mutually exclusive event: are events that cannot both happen at the same
time;
- Exhaustive events: those that include all possible outcomes;
LOS 8.b: State the two defining properties of probability and distinguish
among empirical, subjective, and a priori probabilities.
-Two defining properties of probability:

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E.x: A = the portfolio earns a return of 10 percent and B = the portfolio earns a
return below 10 percent, C = the portfolio earns a return above 10 percent
-Objective probability:
+Empirical probability: established by analyzing past data;
+ Priori probability: one based on logical analysis rather than on
observation or personal judgment;
-Subjective probability: involves the use of personal judgment;
LOS 8.c: State the probability of an event in terms of odds for and against the
event.
-Odds: an event will or will not occur is an alternative way of expressing
probabilities;
(Odds cũngcóđịnhnghĩatươngtựnhưxácsuất, nhưng ở đâychínhlàtỉlệcủa 2 xácsuất. Cụthể,
Odds đượcđịnhnghĩalàtỉlệgiữaxácsuấtxảyra 1 sựkiện so vớixácsuấtkhôngxảyrasựkiệnđó)
- Probability of occurrence of 0.125;
- The odds the event will occur are (1/8)/(7/8)=1/7;
- The odds against the event occurring are the reciprocal of 1/7; is seven to
one;
1.Odds for E = P(E)/[1 − P(E)]. The odds for E are the probability of E divided by
1 minus the probability of E. Given odds for E of “a to b” the implied probability
of E is a/(a + b).
If a race horse runs 100 races and wins 25 times and loses the other 75 times, the
probability of winning is 25/100 = 0.25 or 25%, but the odds of the horse winning
are 25/75 = 0.333 or 1 win to 3 loses.
2.Odds against E = [1 − P(E)]/P(E), the reciprocal of odds for E. Given odds
against E of “a to b,” the implied probability of E is b/(a + b).
LOS 8.d: Distinguish between unconditional and conditional probabilities.

-Unconditional probability (marginal probability) probability of an event

regardless of the past or future occurrence of other events.
-A conditional probability: is one where the occurrence of one event affects
the probability of the occurrence of another event.
+ F.x: the probability of a recession given that the monetary authority
increases interest rates.
+ Using probability notation, “the probability of A giventheoccurrence of B”
is expressed as P(A|B), where the vertical bar (|) indicates“given,” or “conditional
upon.
LOS 8.e: Explain the multiplication, addition, and total probability rules.

-Multiplication rule of probability: determine the joint probability two

events;

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 - Addition rule of probability is used to determine the probability that at
least one of two events will occur. If A and B shares any outcomes.

For mutually exclusive events,

- Total probability rule: determine the unconditional probability of an event,

given conditional probabilities

LOS 8.f: Calculate and interpret 1) the joint probability of two events, 2) the
probability that at least one of two events will occur, given the probability of
each and the joint probability of the two events, and 3) a joint probability of
any number of independent events.
-Joint probability: two events is the probability that they will both occur.
+ Multiplication rule of probability:

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 Calculating a joint probability of any number of independent events:

MODULE 8.2: CONDITIONAL EXPECTAITONS, CORRELATION

LOS 8.g: Distinguish between dependent and independent events.
-Independent events : events for which the occurrence of one has no
influence on the occurrence of the others.

LOS 8.h: Calculate and interpret an unconditional probability using the total
probability rule.
-Total probability rule: highlights the relationship between unconditional
and conditional probabilities of mutually exclusive and exhaustive events.

-Expected value: weighted average of the possible outcomes for the

variable.

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 -Expected variance: The variance is calculated as the probability-weighted
sum of the squared differences between each possible outcome and expected EPS

LOS 8.i: Explain the use of conditional expectation in investment applications

-Expected value: can be calculated using conditional probabilities;
- Conditional expected values: are contingent upon the outcome of some
other event.
The expected value of random variable X given an event or scenario S
denoted . Suppose the random variable X can take on any one of n distinct
outcomes X1, X2,..,Xn

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 - Tree diagram:

LOS 8.k: Calculate and interpret covariance and correlation and interpret a
scatterplot.
-Covariance: measure how two assets move together;

+ The covariance of RA with itself is equal to the variance of RA;

+ The covariance measures how one random variable moves with another
random variable, it may range from negative infinity to positive infinity;
+ Covariance of return is negative, when the return on one asset is above
expected value, the return on the other asset below its expected value;
+ Covariance of return is positive, returns on the both assets tend to be on
the same side;

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-Sample covariance:determine covariance using historical data

-Correlation coefficient:

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 - Scatterplots are a method for displaying the relationship between two
variables. With onevariable on the vertical axis and the other on the horizontal
axis, their paired observations caneach be plotted as a single point

A key advantage of creating scatter plots is that they can reveal non-linear
relationships,which are not described by the correlation coefficient.

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 Limitations of Correlation Analysis.
Correlation measures the linear association between two variables, but it
may not always be reliable. Two variables can have a strong nonlinear relation and
still have a very low correlation.
For example, the relation Y= (X− 4)2is a nonlinear relation contrasted to the
linear relation Y= 2X− 4. Even though these two variables are perfectly associated,
there is no linear association between them
Role of outliers (extreme values) in the correlation of two variables; If
removing the outliers significantly reduces the calculated correlation,further
inquiry is necessary into whether the outliers provide information or are caused by
noise (randomness) in the data used
- Spurious correlation refers to correlation that is either the result of chance
relationships in a particular data setor present due tochanges in both variables over
time that is caused by their association with a third variable.

MODULE 8.3: PORTFOLIO VARIANCE, BAYES, AND COUNTING

PROBLEMS

8.l Calculate and interpret the expected value, variance and standard
deviation of a random variable and of return on a portfolio.
-Weight of portfolio asset:

-Portfolio expected value:

33
 -Portfolio variance:

LOS 8.m: Calculate and interpret covariance given a joint probability

function.

Calculating covariance using the joint probability function of random

variables

34
 LOS 8.n: Calculate and interpret an updated probability using Bayes’
formula.

-Bayes’ formula: update a given set of prior probabilities for a given event
in response to the arrival of new information:

Example: Bayes’ formula

LOS 8.o: Identify the most appropriate method to solve a particular

counting problem and solve counting problems using factorial, combination,
and permutation concepts
- Multiplication Rule of counting: If one task can be done n1 ways and a
second task, given the first, can be done in n2 ways and third task, given the
first two tasks, can be done in n3 ways and so on for k tasks, then the number
of ways the k tasks can be done is (n1)(n2)(n3)…(nk)
If we have n analysts, the number of ways we could assign them to n tasks:
or n factorial
-Labeling: there are n items that can each receive one of k different labels.
The total number of ways that label can be assigned:

The symbol “!” stands for factorial

35
 -Combination formula: general formula for labeling when k=2;

-Permutation formula: different group of size r in specific order can be

chosen from n objects.

36
 -Multiplication Rule of Counting.If one task can be done in n1 ways, and
a second task, given the first, can be done in n2 ways, and a third task, given the
first two tasks, can be done in n3 ways, and so on for ktasks, then the number of
ways the ktasks can be done is (n1)(n2)(n3 ) … (nk).
-Factorial: assign every member of a group of size n to one of n slots (or
tasks);
- The labeling:formulaapplies to three or more subgroupsof predetermined
size.Each element of the entire group must be assigned a place, or label, in one of
thethree or more subgroups.
- The combination:formula applies to only two groupsof predetermined
size. Lookfor the word “choose” or “combination.”
-The permutation:formula applies to only two groupsof predetermined size.
Look for a specific reference to “order” being important.

37
READING 9: COMMON PROBABILITY DISTRIBUTIONS

38
Module 9.1: Uniform and binomial distribution:
Los 9.a Define a probability distribution and distinguish between discrete and
continuous random variables and their probability functions:
Los 9.b Describe the set of possible outcomes of a specified discrete random
variable:
-A probability distribution: probabilities of all possible outcomes for a
random variable.
+ The probabilities of all possible outcomes must sum to 1.
E.x: A simple probability distribution is that for the roll of one fair die; there are
six possible outcomes and each one has a probability of 1/6, so they sum to 1
- Random variable: quantity whose future outcomes are uncertain.
-A discrete random variable: number of possible outcomes can be counted,
+ For each possible outcome, there is measureable and positive probability;
E.x: the number of days it will rain in a given month
-A probability function: p(x) specifies the probability that a random variable
is equal to specific value.
Two key properties of a probability function are:
+ 0 ≤ p(x) ≤ 1;
+ ∑ p(x) =1;

-A continuous random variable: number of possible outcome is infinite,

even if a lower and upper bound exist.
E.X: The actual amount of daily rainfall between zero and 100 inches is an
example of a continuous random variable because the actual amount of rainfall
can take on an infinite number of values. Daily rainfall can be measured in inches,
half inches, quarter inches, thousandths of inches, or even smaller increments
+ Continuous random variables, the probability function is denoted f(x) and
called the probability density function
Discrete distribution Continuous distribution
-p(x) = 0 when x cannot occur; - p(x) =0 even though x can occur;
- p(x) > 0 if it can; - only consider P(x1≤X≤x2) where x1 and
E.x: the probability of it raining on 33 x2 are actual number;
days in June is zero because this cannot - P(x1≤X≤x2)=P(x1<X< x2);
occur E.X the probability of receiving two
39
 inches of rain in June is zero because
two inches is a single point in an infinite
range of possible values. On the other
hand, the probability of the amount of
rain being between 1.99999999 and
2.00000001 inches has some positive
value
In finance, some discrete distributions are treated as though they are continuous
because the number of possible outcomes is very large
E.X : The probability of a change of exactly $1.33 or $1.34 or any other specific
change is almost zero
in other words p(price change = 1.33) is essentially zero, but p($1 < price change
< $2) is greater than zero
LOS 9.c: Interpret a cumulative distribution function.
LOS 9.d: Calculate and interpret probabilities for a random variable, given
its cumulative distribution function.
-Cumulative distribution function (cdf): or simply distribution function,
defines the probability that a random variable, X, takes on a value equal to or less
than a specific value, x.
+ It represents the sum, or cumulative value, of the prob for the outcomes up
to and including a specified outcome.
+ It may be expressed as F(x)=P(X≤x);

40
With eight outcomes, p(x) = 1/8, or 0.125, for all values of X (X = 1, 2, 3, 4, 5, 6,
7, 8);

LOS 9.e: Define a discrete uniform random variable, a Bernoulli random

variable, and a binomial random variable.
LOS 9.f: Calculate and interpret probabilities given the discrete uniform and
the binomial distribution functions.
A discrete uniform random variable: probabilities for all possible outcomes
for a discrete random variable are equal.
+The cumulative distribution for the nth outcome, F(x)=np(x);

41
 + The probability for a range of outcome is p(x)k, where k is the number of
possible outcomes in the range.
E.xSuppose that the possible outcomes are the integers (whole numbers) 1
to 8, inclusive, and the probability that the random variable takes on any of these
possible values is the same for all outcomes (that is, it is uniform). With eight
outcomes, p(x) = 1/8, or 0.125, for all values of X (X = 1, 2, 3, 4, 5, 6, 7, 8). The
distribution has a finite number of specified outcomes, and each outcome is
equally likely

The Binomial Distribution:

Binomial random variable: defined as number of “success” or “failure” in a
given number of trial.
+ The probability of success, p, is constant for each trial, and the trials are
independent;
Bernoulli random variable: binomial random variable for the number of
trials is 1;

42
 The binomial probability function defines the probability of x successes in n
trials can be expressed using the following formula:

Expected value and variance of a binomial random variable:

For a given series of n trials, prob of success on each trial is p;
-Expected value of X=E(x)=np;
-Variance of X=np(1-p);

43
LOS 9.g: Construct a binomial tree to describe stock price movement.
-A binomial tree: showing all possible combination of up-moves and down-
moves over a number of successive periods;

LOS 9.h: Define the continuous uniform distribution and calculate and
interpret probabilities, given a continuous uniform distribution.
-Continuous uniform distribution: defined over a range the spans between
some lower limit, a, and some upper limit, b.
+ Even if a<x<b, P(X=x)=0;

44
MODULE 9.2: NORMAL DISTRIBUTION
LOS 9.i: Explain the key properties of the normal distribution.

45
LOS 9.j: Distinguish between a univariate and a multivariate distribution and
explain the role of correlation in the multivariate normal distribution.
A univariate distribution describes a single random variable
A multivariate distributionspecifiesthe probabilities associated with a
group of random variables
-the return on a given stock and the return on the S&P 500 or some other
market index will have special significance;
-Regardless of the specific variables, the simultaneous analysis of two or
more random variables requires an understanding of multivariate distributions.
The multivariate normal distribution for the return of n assets can be defined
by following 3 sets of parameters:

Example: if there are two assets, n = 2, then the multivariate returns

distribution can be described with two means, two variances, and one correlation
[0.5(2)(2 − 1) = 1].
LOS 9.k: Determine the probability that a normally distributed random
variable lies inside a given interval.
-Confidence interval: is a range of values around the expected outcome
within which we expect the actual outcome to be specified percentage of the time.
- For a normal distribution:
+ 68% of the outcomes are within one standard deviation;
+ 95% of the outcomes are within two standard deviation;

Three confidence intervals of most interest are given by:

46
LOS 9.l: Define the standard normal distribution, explain how to standardize
a random variable, and calculate and interpret probabilities using the
standard normal distribution.
There are as many different normal distributions as there are choices for mean (μ)
and variance (σ2).For the sake of efficiency, however, we would like to refer all
probability statements to a single normal distribution
-Standard normal distribution: is a normal distribution that has been
standardized so that it has a mean of zero and standard deviation of 1, N[0,1];
+ Standardization: is the process of converting an observed value for a
random variable to its z-value.

Suppose we have a normal random variable, X, with μ = 5 and σ = 1.5. We

standardize X with Z = (X − 5)/1.5. For example, a value X = 9.5 corresponds to a
standardized value of 3, calculated as Z = (9.5 − 5)/1.5 = 3. The probability that we
will observe a value as small as or smaller than 9.5 for X ~ N(5,1.5) is exactly the
same as the probability that we will observe a value as small as or smaller than 3
for Z ~ N(0,1).

Calculating probabilities using z-values:

-z-table are the probabilities of observing a z-value that is less than a given
value, z [i.e.,P(Z<z)];
- z-table contains value generated using the cumulative density function for a
standard normal distribution, denoted by F(Z);
- F(-Z) = 1 – F(Z);
47
 Example: Using the z-table

MODULE 9.3: LOGNORMAL DISTRIBUTION, SIMULATIONS

Los 9.m: Define shortfall risk, calculate the safety-first ratio, and select
an optimal portfolio using Roy’s safety-first criterion:
-Short fall risk: the probability that a port value or return will fall below a
particular (target) value or return over a given time period;
-Roy’s safety-first criterion: the optimal port minimizes the prob that return
of the port falls below some minimum acceptable level.
- Threshold level: minimum acceptable level;
- Roy’s safety-first criterion can be stated as:

48
- Formula for Roy’s safety-first criterion:

49
LOS 9.n: Explain the relationship between normal and lognormal
distributions and why the lognormal distribution is used to model asset prices.

-Lognormal distribution: is generated by the function ex, where x is

normally distributed.

+ The lognormal distribution is skewed to the right

+ The lognormal distribution is bounded from below by zero so that it is
useful for modeling asset prices which never takes negative values;
+ A price relative is just the end-of-period price of the asset divided by the
beginning price (S1/S0) and is equal to (1 + the holding period return);
+ To get the end-of-period asset price, we can simply multiply the price
relative times the beginning-of-period asset price
LOS 9.o: Distinguish between discretely and continuously compounded rates
of return and calculate and interpret a continuously compounded rate of
return, given a specific holding period return.
-Discretely compounded: returns are just compound returns, given some
discrete compounding period, such as semiannual or quarterly.
+ More frequent the compounding, the greater the effective annual return.
-Continuous compounding: the effective annual rate based on continuous
compounding for a stated annual rate of Rcc
+ Effective annual rate = eRcc -1

50
 - Compounded rates of return are additive for multiple periods;

In general, the holding period return after T years, when the annual continuously
compounded rate is Rcc, is given by

Given investment results over a 2-year period, we can calculate the 2-year
continuously compounded return and divide by two to get the annual rate.
Consider an investment that appreciated from $1,000 to $1,221.40 over a 2-year
period. The 2-year continuously compounded rate is ln(1,221.40 / 1,000) = 20%,
and the annual continuously compounded rate (Rcc) is 20% / 2 = 10%.
LOS 9.p: Explain Monte Carlo simulation and describe its applications and
limitations.
-Monte Carlo simulation: is a technique based on the repeated generation of
one or more risk factors that affect security values to generate a distribution of
security values.
1. Valuing an Asian call option on stock. C iT to represent the value of the option at
maturity T. The subscript i in C iT indicates that CiT is a value resulting from the
ith simulation trial
2. Specify a time grid. Take the horizon in terms of calendar time and split it into a
number of subperiods, say K in total.
3. Specify distributional assumptions for the risk factors that drive the underlying
variables
-For example, stock price is the underlying variable for the Asian call, so we
need a model for stock price movement

Zk is a risk factor in the simulation

4. Using a computer program or spreadsheet function, draw K random values of
each risk factor. In our example, the spreadsheet function would produce a draw
of K values of the standard normal variable Zk: Z1, Z2, Z3, …, ZK.
5. Calculate the underlying variables using the random observations generated in
Step 4. Using the above model of stock price dynamics, the result is K
observations on changes in stock price.
6. The first calculation is the value of an Asian call at maturity, C iT. A second
calculation discounts this terminal value back to the present to get the call value
as of today, Ci0
7. Iteratively go back to Step 4 until a specified number of trials, I, is completed.
Finally, produce statistics for the simulation. The key value for our example is

51
 the mean value of Ci0 for the total number of simulation trials. This mean value
is the Monte Carlo estimate of the value of the Asian call

- The limitation of MC:

+ fairly complex;
+ answer depends on the distribution of the risk factors and pricing/valuation
model used;
+ it is statistical not analytic ;
+ cannot provide the insights that analytic methods can;
LOS 9.q: Compare Monte Carlo simulation and historical simulation.
-Historical simulation: based on actual changes in value or actual changes
in risk factors over some period of times.
E.x we base the simulation on the record of daily stock returns over the last
five years and randomly draw K returns from that record to generate one
simulation trial
-Advantage: using the actual distribution of risk factor.
-Disadvantage:
+past changes in risk factors may not be a good indication of future changes.
+ cannot address the what if questions

52
 READING 10: SAMPLING AND ESTIMATION

MODULE 10.1: CENTRAL LIMIT THEOREM AND STANDARD

ERROR:
LOS 10.a: Define simple random sampling and a sampling distribution. LOS
10.b: Explain sampling error.
-Simple random sampling: method of selecting a sample in such a way that
each item or person in the population being studied has the same likelihood of
being included in the sample.
-Systematic sampling: selecting every nth member form a population;
-Sampling error: is the difference between a sample statistic (the mean,
variance, or standard deviation of the sample) and its corresponding population
parameter (the true mean, variance, or standard deviation of the population)

A Sampling Distribution: of sample statistic is a prob distribution of all

possible sample statistics computed from a set of equal-size samples that were
randomly drawn from the sample population.

53
 LOS 10.c: Distinguish between simple random and stratified random
sampling.
-Stratified random sampling: use a classification system to separate the
population into smaller groups based on one or more distinguished characteristics.
+ From each subgroup, or stratum, a random sample is taken and the results
are pooled.
+ The size of the samples from each stratum is based on the size of the
stratum relative to the population.\
LOS 10.d: Distinguish between time-series and cross-sectional data.
-Time series data: consists of observation taken over a period of time at
specific and equally spaced time intervals.
- Cross-sectional data: sample of observations taken at a single point in
time.
- Longitudinal data: observations over time of multiple characteristic of the
same entity, such as unemployment, inflation, and GDP growth rates for a country
over 10 years.
- Panel data: contains observations over time of the same characteristic for
multiple entities, such as debt/equity ratios for 20 companies over the most recent
24 quarters.
LOS 10.e: Explain the central limit theorem and its importance.

Important properties of the central limit theorem:

+ If the sample size n is sufficiently large (n≥30), the sampling distribution
of the sample mean will approximately normal.
+ The mean of the population, μ, and the mean of the distribution of all
possible sample means are equal.
+ The variance of the distribution of sample mean is σ 2/n, the population
variance divided by the sample size.
LOS 10.f: Calculate and interpret the standard error of the sample mean.
-Standard error of the sample mean: standard distribution of the
distribution of the sample means.

54
 When donnot know the population standard deviation and need to use sample
standard deviation

55
 LOS 10.g: Identify and describe desirable properties of an estimator.
Desirable properties of an estimator are unbiasedness, efficiency and consistency
-An unbiased estimator: the expected value of the estimator is equal to the
parameter you are trying to estimate. E.g,
-An efficient estimator: is also efficient if the variance of its sampling
distribution is smaller than all the other unbiased estimators.
+ The sample mean, is an unbiased and efficient estimator of the population
mean.
+ The sample variance is an efficient estimator of population variance.
-A consistent estimator: accuracy of the parameter estimate increases as the
sample size increases.
+ As the sample size increases, the standard error of the sample mean falls,
and the sampling distribution bunches more closely around the population mean.
MODULE 10.2: CONFIDENCE INTERVAL AND T-DISTRIBUTIONS
LOS 10.h: Distinguish between a point estimate and a confidence interval
estimate of a population parameter.
-Point estimates: are single values used to estimate population parameters.
+ The formula used to compute the point estimate is called the estimator.
+ E.g: The sample mean, is an estimator of the population mean μ

LOS 10.i: Describe properties of Student’s t-distribution and calculate and

interpret its degrees of freedom
-Student’s t-distribution: or simple the t-distribution, is a bell-shaped
probability distribution that is symmetrical about its mean.
+ It is appropriate distribution to use when constructing confidence intervals
based on small samples (n<30) from population with unknown variance, or
approximately normal distribution;
+ It may be appropriate to use the t-distribution when population variance is
unknown and sample size is large that central limit theorem will assure sampling
distribution is approximately normal.

56
 - Characterisitic of t-distribution:
+ symmetrical distribution that is centered around zero;
+ t-distribution has fatter and thicker tail than normal distribution;
+ As the number of observation increases, t-distribution become more
spiked and its tail become thinner;
+ As the number of degrees of freedom increases without bound, the t-
distribution converge to z-distribution, more outliers
+ Hypothesis using t-distribution more difficult to reject the null relative to
hypothesis testing using z-distribution.
+ This means that confidence intervals for a random variable that follows a
t-distribution must be wider (narrower) when degrees of freedom are less (more)
for a given significance level.
+ The greater the degree of freedom, the greater the percentage of
observation near center of distribution and lower percentage of observations in the
tail.

57
LOS 10.j: Calculate and interpret a confidence interval for a population
mean, given a normal distribution with 1) a known population variance, 2) an
unknown population variance, or 3) an unknown population variance and a
large sample size.
-Confidence interval: range of value within which the actual value of a parameter
will lie, given the probability of 1-α,
+ α is called the level of significance;
+ 1-α is degree of confidence it will contain the parameter it is intended to
estimate;
+ E.g: population mean of random variables will range from 15 to 25 with a
95% degree of confidence.
+ Confidence intervals take on the following form:

If the population has a normal distribution with a known variance,

confidence interval for the population mean can be calculated:

58
 The most basis confidence interval for the population mean arise when
sampling from a normal distribution with known variance. The reliability factor in
this case based on the standard normal distribution with mean 0 and variance of 1

59
 Confidence interval can be interpreted from a probabilistic perspective or a
practical perspective: (rarely we know population variance in practice)

Confidence intervals for the Population Mean: Normal with Unknown

Variance:

-Population is normal with unknown variance: use the t-distribution

- Due to the relatively fatter tails of the t-distribution, confidence intervals

constructed using t-reliability factors (tα/2) will be more conservative (wider) than
those constructed using z-reliability factors (z α/2).

60
Confidence Interval for a population mean when the population variance is
unknown given a large sampe from any type of distribution

-Distribution is nonnormal but the population variance is known, the z-

statistic can be used as long as the sample size is large (n≥30).
-Distribution is nonnormal and the population variance is unknown, the t-
statistic can be used as long as the sample size is large (n≥30). It is acceptable to
use the z-statistic, although t-statistic is more conservative

If the sample is not random, the central limit theorem doesn’t apply, cannot
form unbiased confidence intervals.
LOS 10.k: Describe the issues regarding selection of the appropriate sample
size, datamining bias, sample selection bias, survivorship bias, look-ahead
bias, and time-period bias.
-Data mining: analysts repeatedly use the same database to search for
patterns or trading rules ;
-Data-mining bias: results where the statistical significance of the pattern is
overestimated because the results were found
+ The best way to avoid data mining is to test use out-of-sample data.
-Sample selection bias: some data is systematically excluded from the
analysis, usually because of the lack of availability.
+ Observed value to be nonrandom
+ Conclusion drawn from this sample can’t be applied to population
61
 -Survivorship bias:is a common type of sample selection bias
-Look-ahead bias: study test a relationship using sample data that was not
available on the test date.
-Time-period bias: if the time period over which the data is gathered is
either too short or too long.
+ Time period is too short, research results may reflect phenomena specific
to that time period, or event data mining.
+ Time period is too long, the fundamental economic relationships
underlying the results may have changed.

62
 READING 11: HYPOTHESIS TESTING

Module 11.1: Hypothesis tests and types of errors

-Hypothesis is a statement about the value of a population parameter
developed for the purpose of testing a theory or belief.
+ Hypotheses are stated in terms of the population parameter to be tested,
like the population mean.
+ Hypothesis testing procedure:

63
 The Null Hypothesis and Alternative Hypothesis:
- The null hypothesis: is the hypothesis that the researcher wants to reject.
-The alternative hypothesis: what is concluded if there is sufficient evidence
to reject the null hypothesis. It is the hypothesis that are really trying to assess.
-can be one-sided or two-sided.
+ One-sided is referred to as a one-tailed test;
+ Two-sided test is referred to as a two-tailed test;
- Two-tailed test for the population mean may be structured as:

- Two-tailed test uses two critical values, the general decision is:
Reject Ho if: test statistic > upper critical value or test statistic < lower
critical value.

64
 -One-tailed hypothesis test of the population mean, the null and alternative
hypotheses are either:

The appropriate of hypotheses depends on whether we believe the

population mean, μ, to be greater than (upper tail) or less than (lower tail) the
hypothesized value, μ0.
–z0.05= –1.645 corresponds to a cumulative probability equal to 5%, and the
z0.05=1.645 corresponds to a cumulative probability of 95%

LOS 11.c: Explain a test statistic, Type I and Type II errors, a significance
level, and how significance levels are used in hypothesis testing.

-Hypothesis testing involvestwo statistics: the test statistic calculated from

sample data and the critical value of the test statistic.
-A test statistic: is calculated by comparing the point estimate of the
population parameter with hypothesized value of parameter.

+ Population standard deviation is known:

65
 + Population standard deviation is not known:

Type I and Type II error:

Keep in mind that hypothesis testing is used to make inferences about the
parameters ofa given population on the basis of statistics computed for a sample
that is drawn fromthat population.
Must be aware that there is some probability that the sample, insome way,
does not represent the population, and any conclusion based on the sampleabout
the population may be made in error
When drawing inferences from a hypothesis test, there are two types of
error:
+ Type I: the rejection of null hypothesis when it is actually true;
+ Type II: the failure to reject the null hypothesis when it is false;
The significance level is the probability of making a Type I error.
LOS 11.d: Explain a decision rule, the power of a test, and the relation
between confidence intervals and hypothesis tests.
-The decision rule: either to reject the null hypothesis or fail to reject the
null hypothesis.
+ Determine a one-tailed or two-tailed hypothesis test;
+ Determine the distribution of the test statistic;
+ Determine critical value;
+ If the test statistic is greater than the value X, reject the null.
-The power of the test: the probability of correctly rejecting the null
hypothesis when it is false or 1 – P(type II error).

Decreasing the significance level from 5% to 1 %, will increase the

probability of failing to reject the false null (Type II error), reduce the power of the
test.
66
 - For given of sample size: increase the power of the test with the cost that
the probability of rejecting the true null increases (Type 1 error);
- For given significance level: decrease the probability of type II error and
increase the power of the test, by increasing sample size.
The Relation between confidence intervals and Hypothesis test:
- Confidence interval: a range of values within which the researcher
believes the true population parameter will lie
+ Formula to determine confidence interval:

Or

The range within which we fail to reject the null for a two-tailed hypothesis
test at a given significance level.

MODULES 11.2: TEST OF MEANS AND P-VALUES

LOS 11.e: Distinguish between a statistical result and an economically
meaningful result.
-Statistical significance doesnot necessarily imply economic significance.
LOS 11.f: Explain and interpret the p-value as it relates to hypothesis testing.
- The p-value is the probability of obtaining a test statistic leading to a
rejection of the null hypothesis, assuming the null hypothesis is true.
+ It is the smallest level of significance for which the null hypothesis can be
rejected.

67
LOS 11.g: Identify the appropriate test statistic and interpret the results for a
hypothesis test concerning the population mean of both large and small
samples when the population is normally or approximately normally
distributed and the variance is 1) known or 2) unknown.
The t-Test: employs a test statistic distributed according to a t-distribution;
Using the t-test if the population variance is unknown and either of the
following conditions exist:
+ The sample is large (n≥30);
+ The sample is small (less than 30), but the distribution of the population is
normal or approximately normal.
-If the sample is small and distribution is nonnormal, no reliable statistical
test.
-t-statstic with n-1 degrees of freedom computed as:

To conduct a t-test, the t-statistic is compared to a critical t-value at the

desired level of significance with the appropriate degrees of freedom.

68
 The z-test:
The z-test is the appropriate hypothesis test of the population mean when the
population is normally distributed with known variance.
The z-statistic for a hypothesis test for a population mean is computed as
follows

When the sample size is largeand the population variance is unknown, the z-
statistic is:

This is acceptable if the sample size is large, although the t-statistic is the
more conservative measure when the population variance is unknown.

69
MODULES 11.3: MEAN DIFFERECNES, DIFFERENCE IN MEAN
LOS 11.h: Identify the appropriate test statistic and interpret the results for a
hypothesis test concerning the equality of the population means of two at least
approximately normally distributed populations, based on independent
random samples with 1) equal or 2) unequal assumed variances
-A pooled variance is used with the t-test for testing the hypothesis that the
means of two normally distributed populations are equal, when the variances of the
populations are unknown but assumed to be equal.
Assuming independent samples, the t-statistic in this case is computed as:

70
 The t-test for equality of population means when the populations are
normally distributed and have variances that are unknown and assumed to be
unequalusesthe sample variances for both populations.
Assuming independent samples, the t-statistic in this case is computed as
follows:

71
LOS 11.i: Identify the appropriate test statistic and interpret the results for a
hypothesis test concerning the mean difference of two normally distributed
populations.
-If the observations in the two samples both depend on some other factor,
using “paired comparison”
+ “paired comparison”:test of whether the means of the differences
between observationsfor the two samples are different,
+ “paired comparison”:requires that the sample data be normally
distributed.
The general form of the test for anyhypothesized mean difference, μdz
, is as follows:

n=number of paired observations;

72
LOS 11.j: Identify the appropriate test statistic and interpret the results for a
hypothesis test concerning 1) the variance of a normally distributed
population, and 2) the equality of the variances of two normally distributed
populations based on two independent random samples.
-The chi-square testis used for hypothesis tests concerning the variance of a
normally distributed population.
- The hypotheses for a two-tailed test of a singlepopulation variance are
structured as:

The chi-square distribution is asymmetrical and approaches thenormal

distribution in shape as the degrees of freedom increase.

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 The chi-square test compares the test statistic, ,toa critical chi-square
value at a given level of significance and n − 1 degrees of freedom.

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Testing the equality of the variances of two normally distributed populations,
based on two independent random samples

Independent random samples:

-The hypotheses concerned with the equality of the variances of two

populations are tested with an F-distributed test statistic.

-The F-test is used under the assumption that the populations from which
samples are drawn are normally distributed and that the samples are independent.

-The hypotheses for the two-tailed F-test of differences in the variances

canbe structured as:

-The F-distribution is right-skewed and is bounded by zero on the left-hand

side;
-The shape of the F-distribution is determined by two separate degrees of
freedom, the numerator degrees of freedom, df1,and the denominator degrees of
freedom, df2.

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 - The upper critical value is always greater than one;
- The lower critical value is always less than one;

LOS 11.k: Formulate a test of the hypothesis that the population correlation
coefficient equals zero and determine whether the hypothesis is rejected at a
given level of significance.
Correlation measures the strength of the relationship between two variables.
If the correlation between two variables is zero, there is no linear relationship
between them.
When the sample correlation coefficient for two variables is different from zero,
we must address the question of whether the true population correlation coefficient
(ρ) is equal to zero.

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The appropriate test statistic for the hypothesis that the population correlation
equals zero, when the two variables are normally distributed, is:

LOS 11.l: Distinguish between parametric and nonparametric tests and

describe situations in which the use of nonparametric tests may be
appropriate.
-Parametric testsrely on assumptions regarding the distribution of the
population andare specific to population parameters (Mean and variances).
-Nonparametric testseither do not consider a particular population
parameter or havefew assumptions about the population that is sampled.
- Nonparametric tests are used:
+there is concern about quantities other than the parameters of a distribution;
+the assumptions of parametric tests can’t be supported;
- Situations where a nonparametric test is called for are the following:
+ The assumptions about the distribution of the random variable that support
aparametric test are not met;
+ When data are ranks (an ordinal measurement scale) rather than values;
+ Test that is not concerned with a parameter or makes minimal assumptions
about the population from which the sample comes (whether a sample is
random or coming from a population following a particular probability
distribution);

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 The Spearman rank correlation testcan be used when the data are not
normallydistributed.
+ A large positive value of the Spearman rank correlations, such as
0.85,would indicate that a high (low) rank in one year is associated with a high
(low) rank inthe second year.
+ Alternatively, a large negative rank correlation would indicate that a
high rank in year 1 suggests a low rank in year 2, and vice versa

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