AFM 323 Fall 2023

Quantitative Foundations for Finance

21 September 2023

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 Learning Objectives

 Linear functions of a random variable

 Standardizing a normal distribution

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 Important relationships
Linear Function of a Random Variable
 Let X be a discrete or continuous rv with and .

 Let a and b be some known constants.

 Define a new random variable Y to be a linear function of X:

a and b are known constants

Then the expected value or mean of Y is given by

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 Linear Function of a Random Variable

 But the expected value of a sum is a sum of expected values; so we

have

 Next, the expectation of a constant is constant itself; so we have

 And

 So, we see that expectations is a linear operator in the following

sense:

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 Linear Function of a Random Variable
 Next, consider

 But we know that

 Where
 (due to the definition of a variance)

 Var (b) =0 (since there is no uncertainty w.r.t a constant)

 ( there is no uncertainty between a rv and

a constant)

 So, we have

 Adding a constant to X does not affect its variance, and the effect of
multiplying X by the constant a simply increases the variance of X by
the square of a. 5
 Linear Function of a Random Variable

 A normal random variable has the special property that a linear

function of it is also a normal random variable.

 The following proposition establishes the result.

PROPOSITION. Let . Consider a linear function,

Y = aX + b as before.

Then where and .

 A linear function of a normal rv is also a normal rv.

REMARKS.
 The proof of the result relies on the change-of-variables formula for
determining pdf of a function of a random variable.
 Result may or may not hold for random variables whose distributions are
not normal. 6
 Standardizing a Normal Random Variable

 Standardizing a normal random variable with mean and

variance .

 Consider a normal rv X with nonzero mean and non-unity variance

 Then we can standardize the rv X, so that the resulting rv Z has 0

mean and unit variance, i.e. Z is a standard normal N(0,1) rv.

 We center X from its mean and scale by its SD:

 We can write the above as

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 Standardized Normal Random Variable

 Properties of Z as a standardized random variable

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 Standardizing a Normal Random Variable

 So we have

 i.e., we have

 Hence, standardization creates a new random variable, Z, with mean

= 0 and variance = 1.

 In addition, if X is normally distributed, then

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 What is the intuition of the standardized normal rv?

 Given, we “demean” the variable by its mean

to obtain a variable centered from its mean .

 We “scale” by the square root of the variance

to obtain .

 We denote this “standardized” variable as Z , i.e.

 A non-standard random variable X with mean and variance

can be created from a standard random variable via a linear

transformation:

This result is useful for financial modeling purposes as shown

below. 10
 Quantile of a general normal rv

 Let

 Let be the quantile of a N (0,1) rv.

 Then by definition of and the result that

we have

 This implies that the quantile of X for

is given by

where is the quantile of a N(0,1) rv Z.

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 Example

 Let X ~ N(2, 4).

 We want to find Pr (X>5)

 But we only know the probabilities associated with a

standard normal random variable Z ~ N(0, 1).

 We solve as follows:

 Pr (X>5) = Pr [ (X -2)/2 > (5-2)/2] = Pr (Z > 1.5) = 93%

93%

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 Takeaway

 A linear function of a normal rv is also a normal rv.

 Any random variable that has a normal distribution can be

standardized to create a new random variable, Z that has a
normal distribution with a mean = 0 and variance = 1

 See Excel example.

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