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P1.T2. Quantitative Analysis

Bionic Turtle FRM Practice Questions

Chapter 1: Fundamentals of Probability

This is a super-collection of quantitative practice questions. It represents several years of
cumulative history mapped to the current reading. Previous readings include Miller, Stock, and
Gujarati, which we have retained in this practice question set.

By David Harper, CFA FRM CIPM

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Note that this pertains to Chapters 1-6 in Topic 2, Quantitative Analysis. We will include
this introduction in each of those practice question sets for reference.

Within each chapter, our practice questions are sequenced in reverse chronological order
(appearing first are the questions written most recently). For example, consider Miller’s Chapter
2 (Probabilities), you will notice there are fully three (3) sets of questions:

 Questions T2.708 to 709 (Miller Chapter 2) were written in 2017. The 7XX denotes 2017.
 Questions T2.300 to 301 (Miller Chapter 2 were written in 2013. The 3XX denotes 2103.
 Questions T2.201 & 204 (Stock & Watson) were written in 2012. Relevant but optional.

The reason we include the prior questions is simple: although the FRM’s econometrics readings
have churned in recent years (specifically, for Probabilities and Statistics, from Gujarati to Stock
and Watson to Miller and now to GARP), the learning objectives (AIMs) have remained
essentially unchanged. The testable concepts themselves, in this case, are generally quite
durable over time.

Therefore, do not feel obligated to review all of the questions in this document! Rather,
consider the additional questions as merely a supplemental, optional resource for those who
want to spend additional time with the concepts.

The major sections are:

 This Chapter: Fundamentals of Probabilities (current QA-1, Chapter 1)

o Most Recent BT questions, (20.1 and 20.2)
o Previous BT questions, Miller Chapter 2 (T2.708 & T2.709)
o Previous BT questions, Miller Chapter 2 (T2.300 & T2.301)
o Previous BT questions, Stock & Watson Chapter 2 (T2.201 & T2.204)
o Previous BT questions, Gujarati (T2.59 to T2.61, T2.65)

 Random Variables (current QA-2, Chapter 2)

o Most Recent BT questions (20.3 and 20.4)
o Previous BT questions, Miller Chapter 3 (T2.710 & T2.712)
o Previous BT questions, Miller Chapters 2 & 3 (T2.303 & T2.307)
o Previous BT questions, Gujarati (T2.58, T2.59, T2.62, T2.65 & T2.66 )

 Common Univariate Random Variables (current QA-3, Chapter 3)

o Most Recent BT questions, (20.5 to 20.7)
o Previous BT questions, Miller Chapter 4 (T2.309 to T2.312 & T2.713 to T2.716)
o Previous BT questions ,Stock & Watson Chapter 2 (T2.205)
o Previous BT questions, Rachev Chapters 2 & 3 (T2.110 to T2.126)
o Previous BT questions, Gujarati (T2.59, T2.68, T2.72 to T2.74, T2.82)

 Multivariate Random Variables (current QA-4, Chapter 4)

o Most Recent BT questions Chapter 4 (20.8 to 20.10)
o Previous BT questions, Miller Chapters 2, 3 & 4 (T2.304, T2.709, T2.711 & T2.716)
o Previous BT questions, Stock & Watson Chapters 2 & 3 (T2.202, T2.212 to T2.213 )
o Previous BT questions, Gujarati (T2.62, T2.64, T2.65 & T2.67)

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 Sample Moments (current QA-5, Chapter 5)

o Most Recent BT questions (20.11 to 20.13)
o Previous BT questions, Miller Chapter 3 (T2.303 to T2.308, T2.710 to T2.712)
o Previous BT questions, Stock & Watson Chapters 2 & 3 (T2.203,T2.206 to T2.208,
T2.213)
o Previous BT questions, Gujarati (T2.66, T2.67, T2.69 to T2.71)

 Hypothesis Testing & Confidence Intervals (current QA-6, Chapter 6)

o Most Recent BT questions (20.14 to 20.15)
o Previous BT questions, Miller Chapters 5 & 7 (T2.313 – T2.315, T2.718 & T2.719)
o Previous BT questions, Stock & Watson Chapter 3 (T2.209 to T2.212)
o Previous BT questions, Gujarati (T2.75, T2.77, T2.79 to T2.81)

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PROBABILITIES - KEY IDEAS ................................................................................................. 5

Probabilities
P1.T2.20.1. CONDITIONALLY INDEPENDENT EVENTS .................................................................. 7
P1.T2.20.2. MORE PROBABILITIES AND BAYES RULE .................................................................10
P1.T2.708. PROBABILITY FUNCTION FUNDAMENTALS ................................................................14
P1.T2.709. JOINT PROBABILITY MATRICES ...............................................................................17
P1.T2.300. PROBABILITY FUNCTIONS (MILLER) ........................................................................20
P1.T2.301. MILLER'S PROBABILITY MATRIX...............................................................................23

Probabilities (Stock & Watson Chapter 2)

P1.T2.201. RANDOM VARIABLES .............................................................................................26
P1.T2.204. JOINT, MARGINAL, AND CONDITIONAL PROBABILITY FUNCTIONS ................................29

Statistics (Gujarati’s Essentials of Econometrics)

P1.T2.59. GUJARATI’S INTRODUCTION TO PROBABILITIES ..........................................................31
P1.T2.60. BAYES THEOREM ....................................................................................................34
P1.T2.61. STATISTICAL DEPENDENCE ......................................................................................36
P1.T2.65. VARIANCE AND CONDITIONAL EXPECTATIONS ............................................................39

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Probabilities - Key Ideas

 Risk measurement is largely the quantification of uncertainty. We quantify uncertainty by
characterizing outcomes with random variables. Random variables have distributions
which are either discrete or continuous.
 In general, we observe samples; and use them to make inferences about a population
(in practice, we tend to assume the population exists but it not available to us)
 We are concerned with the first four moments of a distribution:
o Mean, typically denoted µ
o Variance, the square of the standard deviation. Annualized standard deviation is
called volatility; e.g., 12% volatility per annum. Variance is almost always
denoted σ^2 and standard deviation by sigma, σ
o Skew (a function of the third moment about the mean): a symmetrical distribution
has zero skew or skewness
o Kurtosis (a function of the fourth moment about the mean).
 The normal distribution has kurtosis = 3.0
 Excess kurtosis = 3 – Kurtosis. The normal distribution, being the
benchmark, has excess kurtosis equal to zero
 Kurtosis > 3.0 refers to a heavy-tailed distribution (a.k.a., leptokurtosis).
Heavy-tailed distributions do tend to exhibit higher peaks, but our
emphasis in risk is their heavy tails.
 The concepts of joint, conditional and marginal probability are important.
 To test a hypothesis about a sample mean (i.e., is the true population mean different
than some value), we use a student t or normal distribution
o Student t if the population variance is unknown (it usually is unknown)
o If the sample is large, the student t remains applicable, but as it approximates the
normal, for large samples the normal is used since the difference is not material
 To test a hypothesis about a sample variance, we use the chi-squared
 To test a joint hypothesis about regression coefficients, we use the F distribution
 In regard to the normal distribution:
o N(mu, σ^2) indicates the only two parameters required. For example,
N(3,10) connotes a normal distribution with mean of 3 and variance of 10 and,
therefore, standard deviation of SQRT(10)
o The standard normal distribution is N(0,1) and therefore requires no parameter
specification: by definition it has mean of zero and variance of 1.0.
o Please memorize, with respect to the standard normal distribution:
 For N(0,1) Pr(Z < -2.33) ~= 1.0% (CDF is one-tailed)
 For N(0,1)  Pr (Z< -1.645)~ = 5.0% (CDF is one-tailed)

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 The definition of a random sample is technical: the draws (or trials) are independent and
identically distributed (i.i.d.)
o Identical: same distribution
o Independence: no correlation (in a time series, no autocorrelation)

 The assumption of i.i.d. is a precondition for:

o Law of large numbers
o Central limit theorem (CLT)
o Square root rule (SRR) for scaling volatility; e.g., we typically scales a daily
volatility of (V) to an annual volatility with V*SQRT(250). Please note that i.i.d.
returns is the unrealistic precondition.

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Probabilities
P1.T2.20.1. Conditionally independent events
P1.T2.20.2. More probabilities and Bayes rule
P1.T2.708. Probability function fundamentals
P1.T2.709. Joint probability matrices
P1.T2.300. Probability functions
P1.T2.301. Miller's probability matrix

P1.T2.20.1. Conditionally independent events

Learning objectives: Describe an event and an event space. Describe independent events
and mutually exclusive events. Explain the difference between independent events and
conditionally independent events.

20.1.1. A specialized credit portfolio contains only three loans but they are very risky, as each
has a single-period default probability of 10.0%. They are independent (therefore, we have the
i.i.d. condition). You know enough probability to determine (for example) that, at the end of a
single period, the probability that all three loans default is 0.1% and the probability that all three
loans survive is 72.9%. However, at the end of the period, the portfolio manager gives you a
piece of additional information when she tells you that "AT LEAST two of the bonds have
defaulted." What is the (conditional) probability that the other (third) bond also defaulted?

a) 0.09%
b) 0.10%
c) 3.57%
d) 10.0%

20.1.2. Yesterday a web page hosted by Acme received tens of thousands of page views but
some were views by malicious bots. Acme utilizes two software applications to detect these
malicious "bot-views." It uploads the same data file from yesterday to both applications. The first
application detects 200 bot-views and the second application detects 300 bot-views. Among
these, only 40 bot-views were detected by both applications. All bot-views are equally likely to
be located, but clearly both applications only identify a minority of the bot-views (otherwise there
would be a much higher number of identified bot-views common to both applications). Further,
the identification of a bot-view by one application is independent of its identification by the other
application. How many malicious bot-views did the web page experience on this day?

a) 300
b) 460
c) 540
d) 1,500

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20.1.3. Albert and Betty share an office where each month they attempt to predict the best-
performing industry within their respective sectors. Albert's sector is Financials and Betty's
sector is Information Technology. Each contains several industries. Without any help, the
probability that Albert predicts the best-performing industry (within Financials) is 12.0%, and the
probability that Betty predicts the best-performing industry (within I.T.) is 15.0%. Put another
way, their unconditional success probabilities are, respectively, P(A) = 12.0% and P(B) = 15.0%.
Without any help, the probability that they both simultaneously predict their best industry is
1.80%; that is, the joint Pr(A ∩ B) = 1.80%. Their firm also subscribes to software with artificial
intelligence and the software boosts their predictive abilities. In fact, when using the software to
help them, their respective success probabilities double. Specifically, P(A | S) = 24.0% and P(B |
S) = 30.0%; for example, the probability that Betty picks the best-performing industry conditional
on her utilization of the software jumps to 30.0%. When they both use the software, their joint
probability of success is 15.0%. In regard to the observed dependencies, which of the following
statements is accurate?

a) Independent and conditionally independent

b) Independent but conditionally dependent
c) Dependent but conditionally independent
d) Dependent and conditionally dependent

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Answers:

20.1.1. C. True: 3.57%

The unconditional probability that TWO or MORE loans default equals 3*(10%^2*90%) + 10%^3
= 2.80% such that the conditional probability, Pr (3 default | two or more default) = 0.10% /
2.80% = 3.5714%.

20.1.2. D. True: 1,500

The second application identified 40/200 = 20.0% of those identified by the first application,
therefore (per the independence), we can infer that its own 300 identifications is about 20.0% of
the total number such that we estimate 300 / 20% = 1,500 total bot-views. Similarly, the first
application identified 40/300 = 13.33% of those identified by the second application, so we can
infer that its own 200 identification represents about 13.33% of the total, which is also
200/13.33% = 1,500.

20.1.3. B. Independent but conditionally dependent

They are independent because P(A)*P(B) = 12%*15% = 1.80% and this is equal to the joint
P(AB) = 1.80%. However, they are conditionally dependent because it is not true that P(A|S) *
P(B|S) = P(AB|S). The product, P(A|S)* P(B|S) = 24.0% * 30% = 7.20%, but the P(AB|S) is
given as 15.0%.

Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-1-

conditionally-independent-events.23249/

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P1.T2.20.2. More probabilities and Bayes rule

Learning objectives: Calculate the probability of an event for a discrete probability
function. Define and calculate a conditional probability. Distinguish between conditional
and unconditional probabilities. Explain and apply Bayes’ rule.

20.2.1. The probability graph below illustrates event A (the yellow rectangle) and event B (the
blue rectangle). The unconditional probability of event A is 50.0% and the unconditional
probability of event B is 44.0%; i.e., Pr(A) = 50.0% and Pr(B) = 44.0%. Their overlap is graphed
by the green rectangle such that Pr(A ∩ B) = 27.0%. The orange rectangle conditions on the
event C. For example, conditional on event C, there is a 50.0% probability that event A occurs,
Pr(A | C) = 50.0%.

Which of the following is TRUE about, respectively, the unconditional and conditional
relationship between events A and B?

a) A and B are unconditionally dependent but conditionally (on event C) independent

b) A and B are unconditionally dependent and also conditionally (on event C) dependent
c) A and B are unconditionally independent but conditionally (on event C) dependent
d) A and B are unconditionally independent and also conditionally (on event C)
independent

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20.2.2. Rebecca is a risk analyst who wants to characterize the loss frequency distribution of a
certain minor operational process during each day. On most days, there is no loss event; i.e.
Pr(X = 0) > 50.0%. On days when there is at least one loss, there occurs either one, two, three,
or four loss events. For this process, she likes the shape of the Poisson distribution with a low
mean (e.g., lambda = 1) but the problem is that the Poisson has a long, thin right tail. However,
given her frequency outcome is finite, Rebecca prefers a domain limited to only five outcomes
including zero: X = {0, 1, 2, 3, or 4}, but X cannot be five or more. She settles on an elegant
formula to express the density probability as a function of a constant. Her function is Pr(X = x) =
(5-x)^3*a, where (a) is a constant, over the domain mentioned. Specifically Pr(X = 0) = 125*a,
Pr(X = 1) = 64*a, and so on.

Basically, this assigns the lowest probability (a) to an outcome of four. An outcome of three is
eight times (8a) more likely than an outcome of four. An outcome of two is 27 times more likely
(27a) than an outcome of four, an outcome of one is 64 times more likely (64a) than a four, and
an outcome of zero is 125 times more likely (125a) than an outcome of four. This allows her to
fit her sample database by characterizing the distribution of outcomes in relative terms; i.e.,
relative to an outcome of four which is the least likely. Specifically, it reflects her want of a
distribution under which a zero or one occurs more than 80.0% of the time, yet in rare cases the
outcome can be as much as four. Unlike the Poisson, it has no tail beyond an outcome of four.
Her probability mass distribution looks like the following:

What is the probability that X will be at least two, Pr(X≥2), which in this case of a discrete
distribution is the same as Pr(X > 1)?

a) 2.78%
b) 9.50%
c) 16.00%
d) 36.00%

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20.2.3. Among a set of filtered stocks, a stock screener assigns stocks to one of three style
categories: value, quality, or momentum. At the end of each month, the stock's performance is
compared to the S&P such that it either beats or does not beat the index The prior beliefs (aka,
unconditional probabilities) are the following: Pr(Style = Value) = 15.0%, Pr(Style = Quality) =
30.0%, and Pr(Style = Momentum) = 55.0%. The stock screener also knows that a Moment
stock is more likely than a Quality stock, and much more likely than a Value stock, to beat the
index; specifically, the screener knows the following conditional probabilities:

 Pr(Beat | Value) = 40.0%

 Pr(Beat | Quality) = 60.0%
 Pr(Beat | Momentum ) = 80.0%

If we observe that a stock beats the index, what is the probability it is a momentum stock; ie.,
what is Pr(Momentum | Beat)?

Bonus question: if we observe the stock beats the index two months in a row, what is the
probability it is a momentum stock; i.e., what is Pr(Momentum | Two consecutive Beats)?

a) 39.6%
b) 55.0%
c) 64.7%
d) 83.3%

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Answers:

20.2.1. A. True: A and B are unconditionally dependent but conditionally (on event C)
independent

If A and B are unconditionally independent, then it must be true that Pr(A ∩ B) = P(A)*P(B);
however, in this case, P(A)*P(B) = 50.0% * 44.0% = 22.0%, but Pr(A ∩ B) = 27.0%. Therefore,
A and B are unconditionally dependent. On the other hand, A and B are conditionally
independent because it is true that Pr(A ∩ B | C) = Pr(A | C) * Pr(B | C). The Pr(A ∩ B | C) =
5.0%/20.0% = 25.0%, and Pr(A | C) * Pr(B | C) = (10.0%/20.0%) * (10.0%/20.0% = 0.50 * 0.50 =
25.0%.

20.2.2. C. True: 16.00%

The sum of 1a + 8a + 27a + 64a + 125a = 225a but we know that (due to the definition of a
probability) is MUST be the case that the sum of discrete probabilities must be one: 225a = 1.0.
Therefore a = 1/225. Consequently, the probabilities are: Pr(X = 0) = 125*1/225 = 55.6%; Pr(X =
1) = 64*1/225 = 28.44%, etc. The probability of at least two is given by (27 + 8 + 1)/225 =
16.00%.

20.2.3. C. True: 64.7%

Per Bayes, Pr(M|B) = Pr(B∩M)/Pr(B) = Pr(B|M)*Pr(M) / Pr(B) = 80.0% * 55.0% / (15.0%*40.0%

+ 30.0%*60.0% + 55.0%*80.0%) = 80.0% * 55.0% / 68.0% = 64.71%.

The bonus question is: If we observe the stock beats the index two months in a row, what is
the probability it is a momentum stock; i.e., what is Pr(Momentum | Two consecutive Beats)?

The answer is 72.73%. Per Bayes, P(M | 2B) = P(2B | M) * P(M) / P(2B) = 64.0% * 55.00% /
48.40% = 72.73%;
where P(2B) = (6%/15%)^2*15% + (18%/30%)^2*30% + (44%/55%)^2*55% = 48.40%,
and where P(2B | M) = P(B | M)^2 = (44%/55%)^2 = 64.0%

Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-2-more-

probabilities-and-bayes-rule.23259/

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P1.T2.708. Probability function fundamentals

Learning objectives: Calculate the probability of an event given a discrete probability
function.

708.1. Let f(x) represent a probability function (which is called a probability mass function,
p.m.f., for discrete random variables and a probability density function, p.d.f., for continuous
variables) and let F(x) represent the corresponding cumulative distribution function (CDF); in the
case of the continuous variable, F(X) is the integral (aka, anti-derivative) of the pdf. Each of the
following is true about these probability functions EXCEPT which is false?

a) The limits of a cumulative distribution function (CDF) must be zero and one; i.e., F(-∞) =
0 and F(+∞) = 1.0
b) For both discrete and random variables, the cumulative distribution function (CDF) is
necessarily an increasing function
c) In the case of a continuous random variable, we cannot talk about the probability of a
specific value occurring; e.g., Pr[R = +3.00%] is meaningless
d) Bayes Theorem can only be applied to discrete random variables, such that continuous
random variables must be transformed into their discrete equivalents

708.2. Consider a binomial distribution with a probability of each success, p = 0.050, and that
total number of trials, n = 30 trials. What is the inverse cumulative distribution function
associated with a probability of 25.0%?

a) Zero successes
b) One successes
c) Two successes
d) Three successes

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708.3. For a certain operational process, the frequency of major loss events during a one period
year varies from zero to 5.0 and is characterized by the following discrete probability mass
function (pmf) which is the exhaustive probability distribution and where (b) is a constant:

Which is nearest to the probability that next year LESS THAN two major loss events will
happen?

a) 5.3%
b) 22.6%
c) 63.3%
d) 75.0%

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Answers:

708.1. D. False. Bayes applies to both, although practicing applications are almost
always using simple discrete random variables.

In regard to (A), (B) and (C), each is TRUE.

 In regard to true (B), the discrete CDF is an increasing step function.
 In regard to true (C), we need to specify an interval; e.g., Pr[2.95% < R < 3.10%]

708.2. B. One success. Binomial Pr(X = 0 successes) = 21.46% and Pr(X = 1 success) =
33.89% such that Pr(X ≤ 1) = 21.46% + 33.89% = 55.35%, and the cumulative 25.0% falls at
one success; i.e., =BINOM.INV(30, 0.050, 0.250)

708.3. C. 63.3%. The sum of the pmf probabilities must be 100.0% such that 30*b = 1.0 or b =
1/30. Therefore the Pr [X < 2] = Pr[X ≤ 1] = Pr[X = 0] + Pr[X = 1] = 12/30 + 7/30 = 19/30 =
63.33%.

Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-708-probability-

function-fundamentals-miller-ch-2.10766/

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P1.T2.709. Joint probability matrices

Learning objectives: Define and calculate a conditional probability, and distinguish
between conditional and unconditional probabilities.

709.1. The following probability matrix gives the joint probabilities (the inner square represents
joint probabilities) of variable X which can assume one of three values {1, 2, 3} and variable Y
which can assume one of three values {1, 3, 5}:

Are the two variables independent?

a) No, because 20.0% * 35.0% does not equal 6.0%
b) No, because the upper diagonal is not a mirror of the lower diagonal
c) Yes, because the sum of joint probabilities is 100% which is equal to the sum of each
variable's unconditional probabilities
d) It cannot be determined with this information

709.2. The following joint probability matrix captures the relationship between Inflation (which
can be either Down, Steady or Up) and the Market (which can be either Bear, Range-bound, or
Bull):

About this joint probability matrix, each of the following statements is correct EXCEPT which is
false?
a) The unconditional probability of a Bear Market is 19.0%
b) The probability of a Bull Market conditional on Up Inflation is about 58.8%
c) The probability of a Down Inflation conditional on a Bear Market is about 21.4%
d) The joint probability of Up Inflation and Range-bound Market is 8.0%

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709.3. Below is a simplified one-year ratings transition matrix (aka, ratings migration matrix;
please note this is NOT a joint probability table). Given a bond's rating now, the matrix gives the
probability associated with the bond having a given rating at the end of the year. The rating of
'D' represents default.

What is the probability that a B-rated bond defaults over the next two (2) years; aka, two-year
cumulative default probability? (this question is inspired by Miller's EOC Question 2.9)1.

a) 1.960%
b) 3.410%
c) 5.910%
d) 6.410%

1
Michael Miller, Mathematics and Statistics for Financial Risk Management, 2nd Edition (Hoboken, NJ:
John Wiley & Sons, 2013)

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Answers:

709.1. A. Correct: No, because 20.0% * 35.0% does not equal 6.0%. Independence requires
that Pr(X)*Pr(Y) = P(X*Y) for all cells. These variables are almost uncorrelated: their correlation,
ρ = -0.08758.

See below three examples that illustrate the three key probability concepts: joint, unconditional,
and conditional:

709.2. C is incorrect. Instead, the probability of a Down Inflation conditional on a Bear

Market is given by 3.0%/19.0% = 15.79%. On the other hand, the probability of a Bear Market
conditional on Down Inflation is given by 3.0%/14.0% = 21.43%
 In regard to true (A), the unconditional probability of a Bear market is the sum of each
of its joint probabilities: 3.0% + 10.0% + 6.0% = 19.0% (already displayed outside the
matrix)
 In regard to true (B), the conditional probability Pr(Bull Market | Up Inflation) =
20.0%/34.0% = 58.8%
 In regard to true (D), the joint probability Pr(Up Inflation ∩ Range-bound Market) =
8.0% as already displayed (the inner square represents joint probabilities)

709.3. D. Correct: 6.410%. In the first year, the bond can remain at (B), migrate to (A) or (C) or
default; if the bond survives the first year, it can default according to its default probability at the
beginning of the year. Therefore the two-year cumulative default probability is given by
3.0%*1.0% + 86.0*3.0% + 8.0%*10.0% + 3.0%*100% = 6.41%.

Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-709-joint-

probability-matrices-miller-ch-2.11140/

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P1.T2.300. Probability functions (Miller)

AIMs: Describe the concept of probability.

300.1. Assume the probability density function (pdf) of a zero-coupon bond with a notional value
of $10.00 is given by f(x) = x/8 - 0.75 on the domain [6,10] where x is the price of the bond:

( )= − 0.75 . . 6≤ ≤ 10 where = bond price

8
What is the probability that the price of the bond is between $8.00 and $9.00?

a) 25.750%
b) 28.300%
c) 31.250%
d) 44.667%

300.2. Assume the probability density function (pdf) of a zero-coupon bond with a notional value
of $5.00 is given by f(x) = (3/125)*x^2 on the domain [0,5] where x is the price of the bond:

3
( )= . .0 ≤ ≤ 5 where = bond price
125
Although the mean of this distribution is $3.75, assume the expected final payoff is a return of
the full par of $5.00. If we apply the inverse cumulative distribution function and find the price of
the bond (i.e., the value of x) such that 5.0% of the distribution is less than or equal to (x), let
this price be represented by q(0.05); in other words, a 5% quantile function. If the 95.0% VaR is
given by -[q(0.05) - 5] or [5 - q(0.05)], which is nearest to this 95.0% VaR?

a) $1.379
b) $2.842
c) $2.704
d) $3.158

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300.3. Assume a loss severity given by (x) can be characterized by a probability density function
(pdf) on the domain [1, e^5]. For example, the minimum loss severity = $1 and the maximum
possible loss severity = exp(5) ~= $148.41. The pdf is given by f(x) = c/x as follows:

( )= . . 1≤ ≤ where = |loss severity|

What is the 95.0% value at risk (VaR); i.e., given that losses are expressed in positive values, at
what loss severity value (x) is only 5.0% of the distribution greater than (x)?

a) $54.42
b) $97.26
c) $115.58
d) $139.04

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Answers:

300.1. C. 31.250%
The anti-derivative is F(X) = x^2/16 - 0.75*x + c.
We can confirm it is a probability by evaluating it on the domain [x = 6, x = 10]
= 10^2/16 - 0.75*10 - 6^2/16 - 0.75*6 = -1.25 - (-2.25) = 1.0.
Probability [8 <= x <= 9] = [9^2/16 - 0.75*9] - [8^2/16 - 0.75*8]
= -1.68750 - (-2.000) = 31.250%

300.2. D. $3.158
As f(x) = 3/125*x^2, F(x) = 3/125*(1/3)*x^3 = p, such that:
p = F(x) = (3/125)*(1/3)*x^3 = x^3/125, solving for x:
x = (125*p)^(1/3) = 5*p^(1/3). For p = 5%, x = 5*5%^(1/3) = $1.8420.
As q(0.05) = $1.8420, 95% VaR = $5.00 - $1.8420 = $3.1580

300.3. C. $115.58
We need d/dx [ln(x)] = 1/x; see
http://en.wikipedia.org/wiki/Natural_logarithm#The_natural_logarithm_in_integration

if f(x) = c/x, then anti-derivative f'(x) = F(x) = c*ln(x) + a;

it must be the case that, under a probability function, F(e^5) = 1.0 such that 1.0 = c*ln(e^5) =
c*5, and therefore c = 1/5.
As F(x) = p = ln(x)/5, now solving for x:
p = ln(x)/5,
5p = ln(x), and taking exp() of both sides:
exp(5p) = x, such that for the 95% quantile function:
exp(5*0.950) = $115.58

Discuss in the forum here: http://www.bionicturtle.com/forum/threads/p1-t2-300-probability-

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P1.T2.301. Miller's probability matrix

AIMs: Calculate the probability of an event given a discrete probability function.
Distinguish between independent and mutually exclusive events. Define joint probability,
describe a probability matrix and calculate joint probabilities using probability matrices.

301.1. A random variable is given by the discrete probability function f(x) = P[X = x(i)] = a*X^3
such that x(i) is a member of {1, 2, 3} and (a) is a constant. That is, X has only three discrete
outcomes. What is the probability that X will be greater than its mean? (bonus: what is the
distribution's variance?)

( )= ∈ {1,2,3}

a) 45.8%
b) 50.0%
c) 62.3%
d) 75.0%

301.2. A credit asset has a principal value of $6.0 with probability of default (PD) of 3.0% and a
loss given default (LGD) characterized by the following continuous probability density function
(pdf): f(x) = x/18 such that 0 ≤ x ≤ $6. Let expected loss (EL) = E[PD*LGD]. If PD and LGD are
independent, what is the asset's expected loss? (note: why does independence matter?)

( )= 0≤ ≤6
18
a) $0.120
b) $0.282
c) $0.606
d) $1.125

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301.3. In analyzing a company, Analyst Sam prepared a probability matrix which is a joint (aka,
bivariate) probability mass function that characterizes two discrete variables, equity
performance versus a benchmark (over or under) and bond rating change.

The company's equity performance will result in one of three mutually exclusive outcomes:
under-perform, track the benchmark, or over-perform. The company's bond will either be
upgraded, downgraded, or remain unchanged.

Unfortunately, before Sam could share his probability matrix, he spilled coffee on it, and
unfortunately some cells are not visible.

Two questions: what is the joint Prob [equity over-performs, bond has no change]; and are the
two discrete variables independent?

a) 7.0%, yes
b) 12.0%, yes
c) 19.0%, no
d) 22.0%, no

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Answers:

301.1. D. 75.0%
Because it is a probability function, a*1^3 + a*2^3 + a*3^3 = 1.0; i.e., 1a + 8a + 27a = 1.0,
such that a = 1/36.
Mean = 1*(1/36) + 2*(8/36) + 3*(27/36) = 2.722.
The P [X > 2.2722] = P[X = 3] = (1/36)*3^3 = 27/36 = 75.0%
Bonus: Variance = (1 -2.722)^2*(1/36) + (2 -2.722)^2*(8/36) + (3 -2.722)^2*(27/36) = 0.2562,
with standard deviation = SQRT(0.2562) = 0.506135

301.2. A. $0.120
If PD and LGD are not independent, then E[PD*LGD] <> E(PD) * E(LGD); for example, if they
are positively correlated, then E[PD*LGD] > E(PD) * E(LGD).

For the E[LGD], we integrate the pdf: if f(x) = x/18 s.t. 0 < x < $6,
then F'(x) = (1/18)*(1/2)*x^2 = x^2/36
(note this satisfied the definition of a probability over the domain (0,6) as 6^2/36 = 1.0).

The mean of f(x) integrates xf(x) where xf(x) = x*x/18 = x^2/18, which integrates to 1/18*(x^3/3)
= x^3/54, so E[LGD] = 6^3/54 = $4.0.

is f(x) a pdf? only if the CDF = 1:

1 6
= = = = 1.0
18 18 2 36

The expected value (mean) of a continuous distribution is the integral of xf(x):

1 1 6
( )= ( ) = = = =
18 18 18 3 54

Therefore, the expected loss = E[PD * LGD] = 3.0%*$4.0 = $0.120.

301.3. C. 19.0%, no
Joint Prob[under-perform, upgrade] = 4%, such that marginal (aka, unconditional)
Prob[upgrade] = 4% + 8% + 11% = 23%.

The marginal (unconditional) Prob[no change] = 100% - 23% - 13% = 64%, and therefore:
Joint Prob[over-perform, no change] = 64% - 15% - 30% = 19.0%.

The variables are independent if and only if (iif) the joint probability is equal to the product of
marginal pmfs (pdfs);

In this case, joint Prob[over-perform, no change] = 19.0% but the product of marginals =
32%*64% = 20.48%; i.e., 19% <> Prob[over-perform]*Prob[no change]

Discuss in the forum here: http://www.bionicturtle.com/forum/threads/p1-t2-301-millers-

probability-matrix.6757/

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Probabilities (Stock & Watson Chapter 2)

P1.T2.201. Random variables
P1.T2.204. Joint, marginal, and conditional probability functions

P1.T2.201. Random variables

AIMS: Define random variables, and distinguish between continuous and discrete
random variables. Define the probability of an event. Define, calculate, and interpret the
mean, standard deviation, and variance of a random variable.

201.1. Which of the following is most likely to be characterized by a DISCRETE random

variable, and consequently, a discrete probability distribution (aka, probability mass function,
PMF) and/or a discrete CDF?

a) The future price of a stock under the lognormal assumption (geometric Brownian motion,
GBM) that underlies the Black-Scholes-Merton (BSM)
b) The extreme loss tail under extreme value theory (EVT; i.e., GEV or GPD)
c) The empirical losses under the simple historical simulation (HS) approach to value at
risk (VaR)
d) The sampling distribution of the sample variance

201.2. A model of the frequency of losses (L) per day, for a certain key operational process,
assumes the following discrete distribution: zero loss (events per day) with probability (p) =
20%; one loss with p = 30%; two losses with p = 30%; three losses with p = 10%; and four
losses with p = 10%. What are, respectively, the expected (average) number of loss events per
day, E(L), and the standard deviation of the number of loss events per day, StdDev(L)?

a) E(L) = 1.20 and StdDev(L) = 1.44

b) E(L) = 1.60 and StdDev(L) = 1.20
c) E(L) = 1.80 and StdDev(L) = 2.33
d) E(L) = 2.20 and StdDev(L) = 9.60

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201.3. A volatile portfolio produced the following daily returns over the prior five days (in
percentage terms, %, for convenience): +5.0, -3.0, +6.0, -1.0, +3.0. Although this is a tiny
sample, we have two ways to calculate the daily volatility. The first is to compute a technically
proper daily volatility as an unbiased sample standard deviation. The second, a common
practice for short-period/daily returns is to make two simplifying assumptions: assume the mean
return is zero since these are daily periods, and divide the sum of squared returns by (n) rather
than (n-1). For this sample of only five daily returns, what is respectively (i) the sample daily
volatility and (ii) the simplified daily volatility?

a) 1.65 (sample) and 2.55 (simplified)

b) 2.96 (sample) and 3.00 (simplified)
c) 4.11 (sample) and 3.65 (simplified)
d) 3.87 (sample) and 4.00 (simplified)

201.4. Consider the following five random variables:

 A standard normal random variable; no parameters needed.
 A student's t distribution with 10 degrees of freedom; df = 10.
 A Bernoulli variable that characterizes the probability of default (PD), where PD = 4%; p
= 0.040
 A Poisson distribution that characterizes the frequency of operational losses during the
day, where lambda = 5.0
 A binomial variable that characterizes the number of defaults in a basket credit default
swap (CDS) of 50 bonds, each with PD = 2%; n = 50, p = 2%
Which of the above has, respectively, the lowest value and highest value as its variance among
the set?

a) Standard normal (lowest) and Bernoulli (highest)

b) Binomial (lowest) and Student's t (highest)
c) Bernoulli (lowest) and Poisson (highest)
d) Poisson (lowest) and Binomial (highest)

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Answers:

201.1. C. The empirical losses under the simple historical simulation (HS) approach to
value at risk (VaR). Historical simulation sorts actual losses (e.g., daily) which informs an
empirical and discrete distribution. Put another way, note that identifying the VaR is basically an
exercise in identifying the quantile based on a "counting-type" distribution of losses; e.g., -100, -
98, -97, .... -40. Another view is that in a discrete distribution the p(X = x) = f(x); contrast with a
continuous, where P(X = x) = dxf(x). In a simple historical simulation of 100 losses, the
probability of the worst loss, or any loss, is 1/100 = 1.0% = f(x).
(note: per Dowd, there are kernel methods to effectively transform a discrete empirical into a
continuous pdf, but this question says "simple" HS!)
 In regard to (A), lognormal is continuous.
 In regard to (B), EVT approaches are parametric continuous.
 In regard to (D), the sampling distribution of the sample variance is characterized by the
continuous chi-squared distribution; i.e., we use chi-square to test the significance of a
sample variance.

201.2. B. E(L) = 1.60 and StdDev(L) = 1.20

E(L) = 20%*0 + 30%*1 + 30%*2 + 10%*3 + 10%*4 = 1.6;
Variance(L) = (0 - 1.6)^2*20% + (1 - 1.6)^2*30% + (2 - 1.6)^2*30% + (3 - 1.6)^2*10% + (4 -
1.6)^2*10% = 1.44; Standard deviation (L) = SQRT(1.44) = 1.20.

Please note: as we are given ex-ante probabilities and not an empirical sample, there is no
application of sample variance concept here; i.e., as this is not a sample and our variance is not
an estimate (the value produced by an estimator), we do not need to divide the sum of squared
differences by (n-1).

201.3. D. 3.87 (sample) and 4.00 (simplified)

The average return = +2;
The sum of squared differences = (5-2)^2 + (-3-2)^2 + (6-2)^2 + (-1 - 2)^2 + (3-2)^2 = 60.
The sample variance = 60/(n-1) = 15, such that the sample standard deviation = SQRT(15) =
3.8730.

The simplified standard deviation = SQRT[(5^2 + -3^2 + 6^2 + -1^2 + 3^2)/5] = 4.0
While assuming that the mean = 0 is a simplifying assumption, the division by n=5 rather than
n=4 is to merely rely on a different but valid estimator (MLE rather than unbiased).

201.4. C. Bernoulli (lowest) and Poisson (highest)

In order:
 Bernoulli has variance = p(1-p) = 4%*96 = 0.0384
 Binomial has variance = p(1-p)n = 2%*98%*50 = 0.980
 Standard normal has, by definition, mean = 0 and variance = 1.0
 Student's t has variance = df/(df-2) = 10/8 = 1.25
 Poisson has lambda = variance = mean = 5 <-- easy to remember, yes?!
Discuss in the forum here: http://www.bionicturtle.com/forum/threads/p1-t2-201-random-
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P1.T2.204. Joint, marginal, and conditional probability functions

AIM: Describe Joint, marginal, and conditional probability functions

204.1. X and Y are discrete random variables with the following joint distribution; e.g., Pr (X = 4,
Y = 30) = 0.07.

What is the conditional standard deviation of Y given X = 7; i.e., Standard Deviation(Y) | X = 7?

a) 10.3
b) 14.7
c) 21.2
d) 29.4

204.2. Sally's commute (C) is either long (L) or short (S). While commuting, it either rains (R =
Y) or it does not (R = N). Today, the marginal (aka, unconditional) probability of no rain is 75%;
P(R = N) = 75%. The joint probability of rain and a short commute is 10%; i.e., P(R = Y, C = S)
= 10%. What is the probability of a short commute conditional on it being rainy, P (C = S | R =
Y)?
a) 10%
b) 25%
c) 40%
d) 68%

204.3. Economists predict the economy has a 40% of experiencing a recession in 2012;
marginal P(R) = 40% and therefore the marginal probability of no recession P(R') = 60%. Let
P(S) be the probability the S&P 500 index ends the year above 1400, such that P(S') is the
probability the index does not end the year above 1400. If there is a recession, the probability of
the index ending the year above 1400 is only 30%; P(S|R) = 30%. If there is not a recession, the
probability of the index ending above 1400 is 50%; P(S|R') = 50%. Bayes' Theorem tells us that
the conditional probability, P(R|S), is equal to the joint probability P(R,S) divided by the marginal
probability, P(S). At the end of the year, the index does end above 1400, such that we observe
(S) not (S'). What is the probability of a recession conditional on the index ending above 1400;
i.e., P(R|S)?
a) 12.0%
b) 28.6%
c) 40.0%
d) 42.0%

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Answers:

204.1. A. 10.3
E(Y|X=7) = 10*(0.05/0.32) + 20*(0.03/0.32) +30*(0.13/0.32) + 40*(0.11/0.32)= 29.375.
E(Y^2|X) = 10^2*(0.05/0.32) + 20^2*(0.03/0.32) +30^2*(0.13/0.32) + 40^2*(0.11/0.32)= 968.75

Variance(Y|X=7) = 968.75 - 29.375^2 = 105.8594.

StdDev(Y|X=7) = SQRT(105.8594) = 10.289.

204.2. C. 40%
The conditional probability Pr(C = S | R = Y ) = Pr(C = S, R = Y ) / Pr (R = Y).
The marginal probability of rain Pr (R = Y) = 1 - 75% = 25%; such that
The conditional probability Pr(C = S | R = Y ) = 10% / 25% = 40%.

204.3. B. 28.6%
According to Bayes, P(R|S) = P(R,S) / P(S). In this case,
P(R,S) = P(R)*P(S|R) = 40%*30% = 12%.
P(S) = P(R)*P(S|R) + P(R')*P(S|R') = 12% + 60%*50% = 12% + 30% = 42%. Such that,
P(R|S) = 12%/42% = 28.6%; i.e., the ex post knowledge of (S) decreases the conditional
probability of recession from its marginal probability of 40%.

Discuss in the forum here: http://www.bionicturtle.com/forum/threads/p1-t2-204-joint-marginal-

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Statistics (Gujarati’s Essentials of Econometrics)

P1.T2.59. Gujarati’s introduction to probabilities
P1.T2.60. Bayes Theorem
P1.T2.61. Statistical dependence
P1.T2.65. Variance and conditional expectations

P1.T2.59. Gujarati’s introduction to probabilities

AIM: Define the probability of an event. Describe the relative frequency or empirical
definition of probability. Describe and interpret the probability mass function, probability
density function, and cumulative density function for a random variable. Distinguish
between univariate and multivariate probability density functions.

59.1 If each outcome has an equal chance of occurring and the outcomes are mutually
exclusive, the P(outcome A) = number of outcomes favorable to A / total number of outcomes.
Which type of probability is this?
a) A priori
b) A posterior
c) Bayes Theorem
d) Relevant frequency

59.2 If a bank’s 99% daily value at risk (VaR) is determined by simple historical simulation (HS),
which probability is used?
a) Classical
b) A priori
c) Relative frequency (empirical)
d) Parametric (analytical)

59.3 Consider the statement: “Our bank’s 99% daily VaR is $1 million.” This reflects which
generic probability function?
a) PMF
b) PDF
c) CDF
d) None of the above

59.4 Consider the statement: Each SINGLE ROW of a credit migration (transition) matrix is itself
an empirical probability distribution.
a) True because the outcomes sum to 1.0 (100%)
b) True because the outcomes are exclusive
c) True because the probabilities are empirical
d) True because all of the above are true

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59.5 Which of the following necessarily implies a multivariate probability distribution (while the
others can imply a univariate probability distribution)?
a) Poisson to model frequency of an operational loss
b) Copula to model default dependence in a CDO/basket CDO
c) Binomial to model probability of defaults reaching mezzanine tranche in a basket CDS
where the credits are i.i.d.
d) Exponential to model (waiting) time until default for a single credit given hazard rate
(a.k.a., default intensity)

59.6 Bayes Theorem says that P(A|B) is given by:

a) Conditional (A|B) / Marginal (B)
b) Conditional (B|A) / Marginal (B)
c) Joint P(AB) / Marginal (A)
d) Joint P(AB) / Marginal (B)

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Answers:

59.1 A. (A priori)
We can deduce the probability prior to any experience; e.g., in the case of rolling a die, or
picking a card from a deck, we can imagine the odds without the need for running experiments
and collecting observations

59.2 C. (empirical)
Historical simulation calibrates confidence% VaR (e.g., 99%) based on the (1-confidence%;
e.g., 1%) worst loss experienced in the historical sample. This is the essence of an empirical
distribution.
 In regard to (A) and (B), which are the same, this is after (posterior) data is observed,
not before
 In regard to (D), there is no parametric/statistical distribution assumed. This is the key
ADVANTAGE of HS: it does not make an assumption about a (parametric) distribution
and therefore, arguably, lends itself more easily to heavy tails.

59.3 C. (VaR is a CDF quantile)

In this case, the statement is equivalent to “1% of the time, we expect to lose at least $1 million;”
i.e., P[ ABS(loss) >= $1 million] =1% is the same as P[x loss <= -$1million] = 1%, which is a
CDF

59.4 D. (all of the above are true)

Each single row contains exclusive probabilities that a credit/obligor will end the period with a
certain rating; the probabilities sum to 1.0 and are empirical.

59.5 B. (copula is multivariate)

A copula is a function that “joins” marginal distributions together, using the function to
incorporate the dependence, into a multivariate probability function.
 In regard to (C), the i.i.d. assumption is key to the binomial and enables the univariate
distribution: If i.i.d. applies, the all defaults are characterized by the same, single
variable, P[default] which is a Bernoulli. The collection of i.i.d Bernoullis (each with the
same p = ?) is a binomial.

59.6 D. Joint P(AB) / Marginal (B)

P(A|B) = P(B|A)P(A) / P(B) = P(AB)/P(B) = joint(AB)/marginal(B)

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t2-59-

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P1.T2.60. Bayes Theorem

AIM: Define Bayes’ theorem and apply Bayes’ formula to determine the probability of an
event.

60.1 A bank develops a new 99% confidence value at risk (VaR) model. Assume there is a 50%
chance the model is good and a 50% chance the model is bad (bad = not good). A good 99%
VaR model produces an exception (a loss in excess of VaR) 1% of the time. The bad VaR
model will produce an exception 3% of the time. If we observe an exception, what is the
probability the model is good?

a) 1.0%
b) 25.0%
c) 50.0%
d) 66.7%

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Answer:

60.1 B (25%)
Let P(G) = unconditional probability that model is good = 50%
Let P’(G) = unconditional probability that model is bad = 50%
Let P(E|G) probability of exception conditional on good model = 1%, such that
Let P(E’|G) probability of no exception conditional on good model = 99%
Let P(E|G’) probability of exception conditional on bad model = 3%, such that
Let P(E’|G) probability of no exception conditional on bad model = 97%
Bayes says the probability of good model conditional on observed exception is given by
P(G|E) = P(GE)/P(E) = (50%*1%)/[(50%*1%)+(50%*3%)] = 25%

Cross-reference: Here are four (4) more Bayes’ Theorem practice questions:
http://www.bionicturtle.com/forum/threads/question-35-probability-quantitative.2128

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t2-60-bayes-

theorem.3609/

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P1.T2.61. Statistical dependence

AIMs: Describe marginal and conditional probability functions. Explain the difference
between statistical independence and statistical dependence.
61.1 It is popular to characterize loss given default (LGD) with a beta distribution due to its
flexibility. If LGD has a mean of 75% under the assumption of a beta PDF, which type of
probability function is this?
a) Marginal
b) Unconditional
c) Conditional
d) Joint

61.2 An analyst screens for stocks using a technical screen and a fundamental screen among
the universe of 15,000 US publicly traded companies. The marginal (unconditional) probability
of a stock meeting the technical screen is 10%; i.e., P[pass technical screen] = 10%. The
probability of a stock meeting the fundamental screen conditional on meeting the technical
screen is 30%; i.e., P [pass fundamental screen | passed the technical screen] = 30%. What is
the JOINT probability that a stock passes both screens?
a) 1.0%
b) 3.0%
c) 12.0%
d) 15.0%

61.3 Add the following to the above assumptions: The probability that a stock passes the
fundamental screen conditional on failing the technical screen is 5.0%; i.e., P[pass fundamental
screen | fail technical screen] = 5.0%. If we observe that a stock passed the fundamental
screen, what is the posterior probability that the stock passed the technical screen?
a) 10%
b) 20%
c) 30%
d) 40%

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61.4 If expected loss (EL) is the product of the probability of default (PD) and loss given default
(LGD), what is the condition that must be satisfied in order for PD and LGD to be statistically
independent (note that both PD and LGD are probability functions. PD is Bernoulli PMF and
LGD may be use different distribution but also falls within [0,1])?
a) EL = PD*E(LGD) always
b) EL = PD*E(LGD) at least some of the time
c) EL = PD*E(LGD) + COV(PD,LGD) always
d) EL = PD*E(LGD) + COV(PD,LGD) at least some of the time

61.5 Which is most accurate condition for the statistical independence of two variables (X) and
(Y)?
a) Their correlation is zero: COV(X,Y) = 0
b) Their covariance is zero: rho(X,Y) =0
c) marginal P(X)*marginal P(Y) = marginal P(X)*P(Y|X) = marginal P(Y)*P(X|Y)
d) P(X|Y) = Joint (X,Y)/marginal (X)

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Answers:

61.1 C. (conditional)
LGD = E [loss | default]; i.e., expected loss conditional on a default
… the beta PDF is not particularly relevant

61.2 B (3.0%)
Joint (T,F) = marginal (T)*conditional (F|T) = marginal (F) * conditional (T|F).
In this case, 10% marginal * 30% conditional = 3.0% joint

61.3 D (40%)
P(T) = 10% and P(T’) = 90%; i.e., marginal or unconditional probabilities
P[F|T] = 30% and P[F|T’] = 5%; i.e., conditional probabilities
According to Bayes’ Theorem, P[T|F] = joint(T,F)/marginal(F) = 3%/(10%*30%+90%*5%) =
40.0%

61.4 A. EL = PD*E(LGD) always

Two variables (X) and (Y) are statistically independent if and only if their joint PMF/PDF is equal
to the product of their marginal PMF/PDFs, for ALL COMBINATIONS of (X) and (Y) values.

61.5. C. marginal P(X)*marginal P(Y) = marginal P(X)*P(Y|X) = marginal P(Y)*P(X|Y)

Independence holds if and only if the product of marginals is equal to the joint probability. Both
P(X)*P(Y|X) and marginal P(Y)*P(X|Y) are equivalent to Joint (X,Y).
 In regard to (A) and (B), independence implies correlation() and covariance are zero.
However, these are measures of linear dependence which is a narrow measure of
dependence (e.g., copulas can handle non-linear dependencies) such that the
CONVERSE is not true.
 In regard to (D), this is simply a true statement regardless of independence

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t2-61-statistical-

dependence.3612/

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P1.T2.65. Variance and conditional expectations

AIMs: Define, calculate and interpret the mean and variance of a set of random variables.
Describe the difference between conditional and unconditional expectation.
65.1 Assume a two-asset portfolio where the weight of the first asset is (w) and the weight of the
second asset is (1-w). The first asset has return volatility of 10%, the second asset has return
volatility of 20%, and their returns have a correlation of +0.25. Take the first derivative of the
formula for portfolio variance to find the weight of the first asset that produces the minimum
variance portfolio; i.e., the local minimum is where the first derivative with respect to (w) is equal
to zero. What is the weight (w) that produces the minimum variance portfolio?
a) 50.0%
b) 67.5%
c) 75.0%
d) 87.5%

65.2 Three of the following concepts imply a conditional expectation or probability. Which one is
the exception and implies an unconditional expectation?
a) Expected shortfall
b) GARCH(1,1)
c) P(AB) / P (A | B)
d) Hazard rate (a.k.a., default intensity)

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Answers:

65.1. D. 87.5%
Portfolio variance (V) = 10%^2*w^2 + 20%^2*(1-w)^2 + 2*w*(1-w)*10%*20%*0.25, such that
V = 0.01*w^2 + 0.04*(1-w)^2 + 0.01*w*(1-w),
V = 0.01w^2 + 0.04 - 0.08w + 0.04w^2 + 0.01w - 0.01w^2,
V = 0.04w^2 - 0.07w + 0.04.
First derivative with respect to (w) gives:
dV/dw = 0.08w - 0.07, and set that equal to zero for local minimum such that
0 = 0.08w - 0.07 and w = 7/8 = 0.875 or 87.5%
And we can check: For w = 87.5%, portfolio volatility = SQRT (portfolio variance) = 9.683%,
which is the minimum variance portfolio.

65.2 C. P(AB) / P (A | B)
Conditional P (A | B) = joint P(AB) / unconditional P (B), such that:
Unconditional P(B) = joint P(AB) / Conditional P (A|B)
 In regard to (A), expected shortfall (aka, conditional tail loss) is a conditional: E (L | L >
VaR).
 In regard to (B), the “C” in GARCH(1,1) refers to conditional as this process modes a
conditional variance.
 In regard to (D), hazard rate is a conditional probability of default: P(D) | survival
through previous periods.

Discuss in forum here: https://www.bionicturtle.com/forum/threads/l1-t2-65-variance-and-

conditional-expectations.3633/

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