FRM Part 1

Book 2 – Quantitative Analysis

RANDOM VARIABLES
 Learning Objectives
After completing this reading you should be
able to:
 Describe and distinguish a probability mass function from a
cumulative distribution function and explain the relationship between
these two.
 Understand and apply the concept of a mathematical expectation of a
random variable.
 Describe the four common population moments.
 Explain the differences between a probability mass function and a
probability density function.
 Characterize the quantile function and quantile-based estimators.
 Explain the effect of a linear transformation of a random variable on the
mean, variance, standard deviation, skewness, kurtosis, median, and
interquartile range.
 Random Variables
 A random variable refers to any quantity with uncertain expected future
values.
 It can also be defined as a variable whose possible values are outcomes of
a random phenomenon.
o Example: the rate of return earned on a stock next year, the value at
risk of a portfolio, or the time of death of an insured in a life assurance
contract.
 An outcome refers to any possible value that a random variable can take.
o Example: A lottery ticket has two outcomes – a win or a loss; or
o The return earned by a mutual fund can take on any value around a
specific mean expectation.
 An event is a specified out outcome or a specified set of outcomes.
o For example, we could define event A as the event when the return
earned by a mutual fund is 10% or less, and event B as the event
when the return is more than 10%.
 Types of Random Variables (1/2)
A random variable can either be discrete or continuous.
 A discrete random variable is one that produces a set of distinct values. A
discrete random variable manifests:
o If the range of all possible values is a finite set, e.g., {1,2,3,4,5,6} in the
case of a six-sided die or,
o If the range of all possible values is a countably infinite set:e.g. {1,2,3,
... }
 For example, suppose we rolled a dice. The set of possible outcomes
would be: {1 2 3 4 5 6}
 Each of these outcomes would occur with a probability of 1/6 (16.7%).
0.20

0.15

0.10

0.05

0.00
1 2 3 4 5 6
 Types of Random Variables (2/2)
A random variable can either be discrete or continuous.
 A continuous random variable can assume any value along a given
interval of a number line.
 For instance, 𝑥 > 0, −∞ < 𝑥 < ∞ and 0 < 𝑥 < 1.
o Examples of continuous random variables are: Price of stock, amount
time is takes to run a marathon, etc.

 Thus it is not possible to talk about the probability of the random variable
assuming a particular value.
o Instead, we talk about the probability of the random variable assuming a
value within a given interval.
 Probability Function
A probability function explains how the total chance (which is 1) is distributed
amongst the possible values of X.
 There are two key properties of a probability function:
i. The probability for a particular value or range of values must be
between 0 and 1, i.e., 0 < p(x) < 1
ii. Sum of all probabilities must equal 1.

 There are two types of probability functions:

I. Probability mass function
II. Probability density function

 We are going to look at each of these in detail…

 Probability Mass Function
A probability mass function (PMF) is a probability function for discrete
random variables.
 It gives the probability that a random variable takes a particular value.

Example : Bernoulli Variable

 The graph of the Bernoulli PMF is shown below, assuming the p = success
= 0.7. Note that PMF is only defined for X=0,1.
 The PMF of a Bernoulli random variable X is given by

𝒇𝑿 𝒙 = 𝒑𝒙 𝟏 − 𝒑 𝟏−𝒙 , 𝑿 = 𝟎, 𝟏

0.7

0.3

0
0 1
 Probability Density Function
A probability density function (PDF) is a probability function for continuous
random variables.
 It gives the probability that a random variable takes a value within some
specified interval.
 Given a PDF f(x), we can determine the probability that x falls
between a and b:
𝒃
𝑷𝒓 𝒂 < 𝒙 ≤ 𝒃 = න 𝒇 𝒙 𝒅𝒙
𝒂
 The probability of the random variable assuming a value within some given
interval from a to b is defined to be the area under the graph of the
probability density function between a and b.
f (x) Uniform f (x) Normal f (x) Exponential

a b a b a xb1 x2
Cumulative Distribution Function
A cumulative distribution function (CDF), gives the probability that the
random variable X is less than or equal to x, for every value x, i.e.
𝑭(𝒙) = 𝑷(𝑿 ≤ 𝒙)
 Both discrete and continuous distributions have cumulative distributions.
 For instance, the CDF of the Bernoulli random variable is:

𝑃(𝑋 ≤ 0)
1.0
𝟎, 𝒙 < 𝟎
𝑭𝑿 𝒙 = ቐ𝟏 − 𝒑, 𝟎 ≤ 𝒙 < 𝟎 0.7
𝟏, 𝒙 > 𝟎
𝑃(𝑋 ≤ 0)
0.3
The graph shows the
cumulative Bernoulli 0
distribution with p = 0.7. 0 1
CDF for Continuous Variables
 To determine the CDF of a continuous random variable, its PDF is
integrated from its lower bound.
𝒂
𝑭 𝒂 =න 𝒇 𝒙 𝒅 𝒙 =𝑷𝑿≤𝒂
−∞

f (x)
Uniform f (x) Exponential

Normal
f (x)

a a x1 x2

a
 Relationship between CDF and PMF
with Discrete Random Variables
 The CDF can be represented as the sum of the PMF for all the values that
are less than or equal to x. Simply put:

𝑭𝑿 𝒙 = ෍ 𝒇𝑿 (𝒕)
𝒕𝝐𝑹 𝒙 ,𝒕≤𝒙
o Where R(x) is the range of realized values of X (X=x).

 On the other hand, PMF is equivalent to the difference between the

consecutive values of X. That is:

𝒇𝑿 𝒙 = 𝑭𝑿 𝒙 − 𝑭𝑿 𝒙 − 𝟏
 Expected Value (1/2)
The expected value of a random variable (denoted as E(X)) is the probability-
weighted average of the possible outcomes of the random variable.
 For a discrete random variable, the expected value is simply the sum of
the product of the value of the random variable and the probability assumed
by the corresponding random variable.
𝐧

𝐄 𝐗 = 𝐏 𝐗𝟏 𝐗𝟏 + 𝐏 𝐗𝟐 𝐗𝟐 + ⋯ + 𝐏 𝐗𝐧 𝐗𝐧 = ෍ 𝐏 𝐗𝐢 𝐗𝐢
𝐢=𝟏
 For a continuous random variable, the expected value is calculated by
integrating the product of the value of the random variable and the
probability assumed by the corresponding random variable.
∞

𝐄 𝐗 = න 𝐱𝐟(𝐱)𝐝𝐱
−∞
Example >>
 Expected Value (2/2)
Example
 There are 8 different positions with different values in a bank’s trading
book. Positions 1 to 3 are each worth $1m, 4 and 5 are worth $2m, and the
rest are worth $3m. Determine the mean portfolio value.
Solution
 The PDF can be represented as:
3
,𝑥 = 1
8
1
𝑓 𝑥 = ,𝑥 = 2
4
3
,𝑥 = 3
8
 Now,
3 1 3
𝐸 𝑋 = ෍ 𝑥𝑓(𝑋) = $1𝑚 × + $2𝑚 × + $3𝑚 × = $2𝑚
8 4 8
𝑥
 So, the mean value is $2m.
 Population Moments
Mean
 The mean is the first moment and given by:
𝝁 = 𝑬(𝑿)
o It is the average value of X.

Variance and Standard Deviation

 Variance is the second moment and presented as:
𝝈𝟐 = 𝑬 𝑿 − 𝑬 𝑿 𝟐 =𝑬 𝑿−𝝁 𝟐

o The variance measures the spread of the random variable from its
mean.

 The standard deviation (𝜎) is the square root of the variance.

o The standard deviation is more commonly quoted in the world of
finance because it is measured in the same units as X, while the
variance is in X-units squared.
 Skewness
 Skewness is the third moment of the distribution.
𝟑 𝟑
𝑬 𝑿−𝑬 𝑿 𝑿−𝝁
𝒔𝒌𝒆𝒘 𝑿 = =𝑬
𝝈𝟑 𝝈
o It measures the asymmetry of the distribution.
 Kurtosis
 Kurtosis is the degree fourth degree of the distribution.
𝟒 𝟒
𝑬 𝑿−𝑬 𝑿 𝑿−𝝁
𝑲𝒖𝒓𝒕 𝑿 = =𝑬
𝝈𝟒 𝝈
o It represents the peakedness of a distribution, usually taken in relation
to a normal distribution.

 A distribution that’s more

peaked than normal is called
leptokurtic.
 A distribution that’s less
peaked than normal is called
platykurtic.
 A normal curve itself is called
mesokurtic, which is neither
too peaked nor too flat-
topped.
 Quantiles
 For a continuous variable X, the α-quartile of X is the smallest number m
such that:
𝑷𝒓 𝑿 < 𝒎 = 𝜶
o Where 𝛼𝜖[0,1]

 For instance, if X is a continuous random variable, the median is defined to

be the solution of:
𝒎
𝑷 𝑿 < 𝒎 = න 𝒇𝑿 𝒙 𝒅𝒙 = 𝟎. 𝟓
−∞
o Similarly, the lower and upper quartile is such that 𝑃 𝑋 < 𝑄1 = 0.25
and 𝑃 𝑋 < 𝑄3 = 0.75.

 The interquartile range (IQR), which is an alternative measure of spread. It

is given by:
𝑰𝑸𝑹 = 𝑸𝟑 − 𝑸𝟏
 Mode
 The mode measures the common tendency, that is, the location of the
most observed value of a random variable.
o In case of continuous random variable, the mode is represented by the
highest point in the PDF.
 Random variables can be unimodal if there’s just one mode, bimodal if
there are two modes, or multimodal if there are more than two modes.

Unimodal Bimodal
4.5 4.5
4 4
3.5 3.5
3 3
2.5 2.5
2 2
1.5 1.5
1 1
0.5 0.5
0 0
1 2 3 4 5 6 1 2 3 4 5 6
Standardizing Random Variables
 When 𝑋 has mean 𝜇 and standard deviation σ, a standardized version of
𝑋 can be constructed.

 A z-score which is the standard version of X, indicates distance from the

mean in standard deviation units. Formula:
𝑿− 𝝁
𝒛=
𝛔
o Converting to standard or z-scores does not change the shape of the
distribution.

 We will learn more about z-scores in future chapters.

 Linear Transformation of
Random Variables (1/2)
 A linear transformation is a change to a variable characterized by one or
more of the major math operations:
o adding a constant to the variable,
o subtracting a constant from the variable,
o multiplying the variable by a constant,
o and/or dividing the variable by a constant.

 Transformation results in the formation of a new random variable.

o Linear transformation is informed by the fact that many variables used in
finance and risk management do not have a natural scale.

Example >>
 Linear Transformation of
Random Variables (2/2)
Example
 Suppose your salary is 𝜶 dollars per year, and you are entitled to a bonus
of 𝜷 dollars for every dollar of sales you successfully bring in.
o Let x be what you sell in a certain year.
 How much in total do you make?
Solution
 We can linearly transform the sales variable X into a new variable Y that
represents the total amount made.

Y = 𝛼 + 𝛽x

Total amount Shift Scale

made (new constant constant
variable)
How does Linear Transformation
Affect Moments?
 If 𝑌 = 𝛼 + 𝛽𝑥 where α and β constants, the mean of Y is given by:
𝑬 𝒀 = 𝑬 𝜶 + 𝜷𝒙 = 𝜶 + 𝜷𝑬(𝑿)
 The variance is given by:
𝑽𝒂𝒓 𝒀 = 𝑽𝒂𝒓 𝜶 + 𝜷𝒙 = 𝜷𝟐 𝑽𝒂𝒓 𝑿 = 𝜷𝟐 𝝈𝟐
 The shift parameter α does not affect the variance.
o Variance is a measure of spread from the mean; adding 𝛼 does not
change the spread but merely shifts the distribution to the left or to the
right.
 The standard deviation of Y is given by:
𝜷𝟐 𝝈𝟐 = |𝜷|𝝈
 If β is positive, then the skewness and kurtosis of 𝑌 are identical to the
skewness and kurtosis of X.
 If β is negative, there is no effect on kurtosis, and the skewness has the
same magnitude but the opposite sign.
 Book 2 – Quantitative Analysis

RANDOM VARIABLES
Learning Objectives Recap
 Describe and distinguish a probability mass function from a
cumulative distribution function and explain the relationship between
these two.
 Understand and apply the concept of a mathematical expectation of a
random variable.
 Describe the four common population moments.
 Explain the differences between a probability mass function and a
probability density function.
 Characterize the quantile function and quantile-based estimators.
 Explain the effect of a linear transformation of a random variable on the
mean, variance, standard deviation, skewness, kurtosis, median, and
interquartile range.