Chapter 4 : Common

Probability Distributions
Department of Finance
 CHAPTER 4 LEARNING OUTCOMES
The candidate should be able to:
• Define a probability distribution and distinguish between discrete and continuous random variables and their
probability functions;
• Describe the set of possible outcomes of a specified discrete random variable;
• Explain the key properties of the normal distribution;
• Determine the probability that a normally distributed random variable lies inside a given interval;
• Define the standard normal distribution, explain how to standardize a random variable, and calculate and interpret
probabilities using the standard normal distribution;
• Define shortfall risk, calculate the safety-first ratio, and select an optimal portfolio using Roy’s safety-first criterion;
Characteristics of the Normal Distribution

The random variable

a specific value that the

random variable may take
 Characteristics of the Normal Distribution
• A probability distribution is a way of describing the likelihood or chance of
different possible outcomes in a given situation.
1. Coin Toss:
1. Possible outcomes: Heads or Tails.
2. Probability distribution: In a fair coin toss, the probability of getting Heads is 0.5, and the
probability of getting Tails is also 0.5. So, the probability distribution is {Heads: 0.5, Tails:
0.5}.
2. Six-sided Die Roll:
1. Possible outcomes: Rolling a 1, 2, 3, 4, 5, or 6.
2. Probability distribution: In a fair six-sided die, each number has an equal chance of 1/6. So,
the probability distribution is {1: 1/6, 2: 1/6, 3: 1/6, 4: 1/6, 5: 1/6, 6: 1/6}.

3. Concluding Remarks
In more complex situations, probability distributions are used to model uncertainties and risk
assessment in various fields, such as finance and Investments.
 Characteristics of the Normal Distribution
A probability function has two key properties
1. 0 ≤ p(x) ≤ 1, because probability is a number between 0 and 1.
• 0 means the event is impossible, and 1 means the event is certain or guaranteed.
• So, the probability can't be negative, and it can't be greater than 1.

2. The sum of the probabilities p(x) over all values of X equals 1.

• This property emphasises that if you consider all possible outcomes (values of
X) of an event, the total probability of any of those outcomes happening is 1.
• In other words, if something has to happen, there's a 100% chance that one of the
possible outcomes will occur.
• This reflects the idea that all possible outcomes are covered, and there's no room
for uncertainty beyond these outcomes.
 The role played by probability distributions
play in finance and investments
1. Modeling Uncertainties:
In finance and investments, uncertainties arise due to unpredictable market fluctuations,
economic changes, and unforeseen events. Probability distributions enable professionals to
model these uncertainties by assigning probabilities to potential outcomes, helping them make
informed decisions in the face of unpredictability.
2. Risk Assessment:
Probability distributions are crucial for risk assessment in finance. They help investors and
financial analysts estimate the probability of different investment outcomes, potential returns,
and potential losses. This information aids in constructing portfolios, managing risks, and
making strategic investment decisions.
3. Portfolio Management:
Investors often hold diverse portfolios comprising various assets with different risk-return
profiles. Probability distributions assist in analysing and optimising these portfolios by
considering the probabilities of different asset performances and their potential impact on the
overall portfolio.
THE NORMAL DISTRIBUTION

✔ Most extensively used probability

distribution
✔ The distribution is completely described by
its mean and variance/std. deviation
✔ Skew = 0, Kurtosis = 3 (Mean, Median and
Mode are all equal). Std. deviation of 1.0
✔ The random variable has an infinite
theoretical range: +∞ to -∞

✔ Central Limit Theorem: the sum and mean

of a large no. of independent random
variables is approximately normally
distributed.
 PROPERTIES OF THE NORMAL DISTRIBUTION
• The normal distribution- also known as the bell curve.

• It is a continuous probability distribution that is symmetrical around its

mean, meaning that most data points cluster around the central
average, and fewer values are found as you move away from the mean in
either direction.

• The normal distribution is defined by two parameters: the mean (μ)

and the standard deviation (σ). The mean represents the centre of the
distribution, while the standard deviation measures the spread or
dispersion of the data.
 The Empirical Rule
Having established that the normal distribution is the appropriate model for a variable of
interest, we can use it to make the following probability statements:
• Approximately 50 percent of all observations fall in the interval μ ± (2/3)σ.
• Approximately 68 percent of all observations fall in the interval μ ± σ.
• Approximately 95 percent of all observations fall in the interval μ ± 2σ.
• Approximately 99 percent of all observations fall in the interval μ ± 3σ.
 The Empirical Rule
1. Approximately 50 percent in μ ± (2/3)σ:
• Think of this as the middle part of the data. Imagine you have a bell-shaped curve
(normal distribution), and if you go two-thirds of the way in either direction from the
average (μ), you would cover about half (50%) of all the data.
2. Approximately 68 percent in μ ± σ:
• This is like the first statement but covers a wider range. If you go one standard
deviation (σ) away from the average in both directions, you capture a larger portion
of the data—around 68%.
3. Approximately 95 percent in μ ± 2σ:
• Now, we're widening the range even more. If you go two standard deviations away
from the average on both sides, you encompass an even larger portion of the data—
about 95% of it.
 The Empirical Rule
4. Approximately 99 percent in μ ± 3σ:
1. This is the widest range mentioned. Going three standard deviations away from the
average in both directions covers an extremely large proportion of the data—
approximately 99%.

Concluding Remarks
• In essence, these statements above describe how much of your data falls
within certain distances from the average in a normal distribution.
• The further away you go from the average, the less data you include.
• These percentages are based on the assumption that the data follows a
normal distribution pattern.
Translation to the Standard Normal Distribution

• Any normal distribution (with any mean and standard deviation

combination) can be transformed into the standard normal
distribution (z)
• Also known as the “z” distribution
• Translate from x to the standard normal (the “z” distribution) by
subtracting the mean of x and dividing by its standard deviation:
 Translation to the Standard Normal Distribution

Example: If x is distributed normally with mean of 100 and standard

deviation of 50, the z value for x = 250 is

This says that x = 250 is three standard deviations (3 increments of

50 units) above the mean of 100.
Translation to the Standard Normal Distribution

Note that the distribution is the same, only the scale has changed. We
can express the problem in original units (x) or in standardized units (z)
Cumulative Probabilities for a Standard Normal
Distribution
The Standard Normal table
gives the probability from the
mean (zero) up to a desired
value for z

To find the probability that a standard

normal variable is less than or equal
to 0.24, for example, locate the row
that contains 0.20, look at the 0.04
column, and find the entry 0.5948.
Thus, P(Z ≤ 0.24) = 0.5948 or 59.48
percent.
 The Standard Normal Table
The column gives the value of z to the
second decimal point

The row shows

the value of z
to the first
decimal point

The value within the table

gives the probability from z =
0 up to the desired z value
 The Standard Normal Table
The relations below are helpful for using tables for x ≥ 0, as well as in other uses:

For a non-negative number x, use N(x) from the table. Note that for the probability to the right of x, we
have P(Z ≥ x) = 1.0 − N(x).

For a negative number −x, N(−x) = 1.0 − N(x): Find N(x) and subtract it from 1. All the area under
the normal curve to the left of x is N(x). The balance, 1.0 − N(x), is the area and probability to
the right of x. By the symmetry of the normal distribution around its mean, the area and the
probability to the right of x are equal to the area and the probability to the left of −x, N(−x).

For the probability to the right of −x, P(Z ≥ −x) = N(x).

Probabilities for a Common Stock Portfolio: Example
•
Probabilities for a Common Stock Portfolio: Example
2) What is the probability that portfolio return will be between 12 percent and 20 percent? In other words, what
is P(12% ≤ Portfolio return ≤ 20%)?
Solution to 2: P(12% ≤ Portfolio return ≤ 20%) = N(Z corresponding to 20%) − N(Z corresponding to 12%). For the
first term, Z = (20% − 12%)/22% = 0.36 approximately, and N(0.36) = 0.6406 (as in Solution 1).
To get the second term immediately, note that 12 percent is the mean, and for the normal distribution 50 percent
of the probability lies on either side of the mean. Therefore, N(Z corresponding to 12%) must equal 50 percent.
So P(12% ≤ Portfolio return ≤ 20%) = 0.6406 − 0.50 = 0.1406 or approximately 14 percent.
3) You can buy a one-year T-bill that yields 5.5 percent. This yield is effectively a one-year risk-free interest rate.
What is the probability that your portfolio’s return will be equal to or less than the risk-free rate?
Solution to 3: If X is portfolio return, then we want to find P(Portfolio return ≤ 5.5%).
First, subtract the portfolio mean 5.5% − 12%
Second, divide by the standard deviation of portfolio return (5.5% − 12%)/22%] = P(Z ≤ −0.295455) =
N(−0.295455).
Third, as we pointed out earlier, N(−x) = 1 − N(x). Rounding −0.29545 to −0.30 for use with the excerpted table,
we have N(−0.30) = 1 − N(0.30) = 1 − 0.6179 = 0.3821, roughly 38 percent. The probability that your portfolio will
underperform the one-year risk-free rate is about 38 percent.
APPLICATIONS OF THE NORMAL DISTRIBUTION

•
APPLICATIONS OF THE NORMAL DISTRIBUTION

The safety-first optimal portfolio maximizes the safety-first ratio (SFRatio):

SFRatio=[ E(RP) - RL ] / sP

Where E(RP) − RL is the distance from the mean return to the shortfall level. Dividing
this distance by σP gives the distance in units of standard deviation.

There are two steps in choosing among portfolios using Roy’s criterion (assuming
normality):
1) Calculate each portfolio’s SFRatio.
2) Choose the portfolio with the highest SFRatio.
APPLICATIONS OF THE NORMAL DISTRIBUTION

From std normal distr table

APPLICATIONS OF THE NORMAL DISTRIBUTION

(a) Compute RL
(b) Choose the Optimal Allocation that satisfies the client’s need
(c) What is the probability that the return on the safety-first portfolio will be less than RL?

(a) R30k/R800k = 3.75%

(b) SFRatio A = (25 – 3.75)/27 = 0.787037
SFRatio B = (11 – 3.75)/8 = 0.90625 (Optimal!!!)
SFRatio C = (14 – 3.75)/20 = 0.5125
(c) Z of 3.75% = (0.0375 – 0.11 )/0.08 = -0.91
N(0.91) = 0.8186 N(-0.91) = 1 – 0.8186 = 18.14%