READING NO.

9
COMMON PROBABILITY
DISTRIBUTIONS

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Institute. The following is the source for these materials: “CFA® Program Curriculum
Level I Volume 1”
READING NO. 9
COMMON PROBABILITY DISTRIBUTIONS
 LOS 9a: Define a probability distribution and distinguish between discrete and continuous random variables and
their probability functions.

 LOS 9b: Describe the set of possible outcomes of a specified discrete random variable.

 LOS 9c: Interpret a cumulative distribution function.

 LOS 9d: Calculate and interpret probabilities for a random variable, given its cumulative distribution function.

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

 LOS 9f: Calculate and interpret probabilities given the discrete uniform and the binomial distribution functions.

 LOS 9g: Construct a binomial tree to describe stock price movement.

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 The probability distribution, denoted p(x), of a random variable identifies the probability of each of the
possible outcomes of a random variable.
It has following two properties:
 The sum of the probabilities of all possible outcomes equals 1.
 The probability of a given outcome will be between 0 to 1, where 0 implies outcome is not possible and 1 implies, it is
only possible outcome.

Probability distribution are of two ways:

 Discrete random variable
 Discrete uniform distribution is one in which the probability of each of the possible outcome is identical. Probability of each
outcome is equal to
 Discrete non-uniform distribution
 Continuous random variable
 Continuous uniform distribution is one where the probability of X occurring in a possible range is the length of the range
relative to the total of all possible values.
 Continuous non-uniform distribution: For example – Normal distribution.

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A cumulative distribution function (cdf), or distribution function, expresses the probability that a random variable, X, takes on a
value less than or equal to a specific value, x. It is the sum of the probabilities of all outcomes that are less than or equal to the
specified value, x. A cdf is denoted by F(x) = P(X ≤ x).
[Example: Probability Functions and Cumulative Distribution Functions] The set of possible values that a random variable, X,
can take is given by: X = (5,10,15,20). The probability function for the random variable is given as: p(x) = x/50. Calculate the
following probabilities:
• p (5)
• p (15)
• p (17)
• F (10)
• F (20)

[Example: Discrete Uniform Distribution] For a roll of a fair die:

• Calculate the probability that the outcome is less than or equal to 2.
• Calculate the probability that the outcome is greater than 2 but less than or equal to 5.

[Example: Continuous Uniform Distribution] X is a uniformly distributed continuous random variable that cannot take values
lower than 2 or greater than 10. Calculate the probability that X will fall between 5 and 7.

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 A binominal distribution is a distribution that has only 2 possible outcomes which are
labelled “success” and “failure.” Further, these two outcomes are mutually exclusive and
collectively exhaustive.
 The probability of x successes in n trials is given by:

P(X=x) =
 The expected value of a binomial random variable (X) is given by: E(x) = n × p
 The variance of a binomial random variable is given by: n × p ×(l−p)

• [Example: Binomial Distribution] A door-to-door salesman visits 7 houses every day.

The probability of making a sale to any customer is 0.4.
• Compute the probability of making exactly 3 sales on a given day.
• Calculate the expected value of a sale every day.

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Binomial trees may be drawn to illustrate possible stock price movements. Binomial
stock price models are extensively used in option pricing.
• [Example: Binomial trees] Stock price $100, the probability of a rise in price is constant
through the periods and is given as 0.4, stock prices can rise by 10%. Prepare a two-
binominal tree.

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  LOS 9.i: Explain the key properties of the normal distribution.

LOS 9.k: Determine the probability that a normally distributed random variable lies inside a given interval.
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.
Normal distribution has following properties:
 It is completely described by its mean and variance.
 It is symmetric about the mean (skewness = 0).
 Kurtosis = 3.
 Any linear combination of jointly, normally distributed random variables is also normally distributed.

 The standard normal probability distribution has a mean of 0 and a standard deviation of 1.
 A normally distributed random variable X can be standardized as: Z score =

 Confidence interval:
 90%: μ ± 1.65 standard deviations.
 95%: μ ± 1.96 standard deviations.
 99%: μ ± 2.58 standard deviations.

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• [Example: Confidence Interval]: The average return of a stock is 12% per year and the
standard deviation of annual returns is 3%. If returns are approximately normal, calculate
the following:
• Probability of return less than or equal to 16.95%?
• Probability of return less than or equal to 7.05%?
• Probability of return greater than or equal to 7.05%?
• Probability of return between 7.05% to 16.95%?
• Confidence interval for 90% return?

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 LOS 9.m: Define shortfall risk, calculate the safety-first ratio, and select an optimal portfolio using Roy’s
safety-first criterion.
Safety-first ratio =
 Shortfall risk is the probability that a portfolio's value or return, E(RP), will fall below a particular
target return (RT) over a given period.
Portfolios with higher SF Ratios are preferred to those that have a lower SF ratio; higher SF Ratio
portfolios have a lower probability of not meeting their target returns.
• [Example: Using Roy's Safety-First Criterion to Select the Optimal Portfolio] An investor has $1,000
dollars to invest. His minimum acceptable portfolio value at the end of the year is $1,050. He is
considering two portfolios, A and B. Portfolio A has an expected return of 8% and a standard deviation
of 10%, while Portfolio B has an expected return of 12% and a standard deviation of 15%. Using Roy's
safety-first criterion select the optimal portfolio, and calculate the probability that the portfolio’s return
will fall short of its target.

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 LOS 9.n: Explain the relationship between normal and lognormal distributions and why the
lognormal distribution is used to model asset prices.
The lognormal distribution is generated by the function , where x is normally distributed.
Three important features differentiate the lognormal distribution from the normal
distribution:
 It is bounded by zero on the lower end.
 The upper end of its range is unbounded.
 It is skewed to the right (positively skewed).

The lognormal distribution is frequently used to model the distribution of asset prices
because it is bounded on the left by zero.

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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.
Continuous compounding vs discrete compounding
• [Example: Continuously Compounded Returns] A stock that was purchased for $65 one
year ago was sold for $86 today. What was the continuously compounded return on this
investment?

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 LOS 9.j: Distinguish between a univariate and a multivariate distribution and explain the
role of correlation in the multivariate normal distribution.
Univariate distribution: single random variable
Multivariate distribution: for more than one random variable. Following inputs would be
required:
 Mean returns of individual stocks
 Variance of the individual stocks
 Pairwise correlation

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LOS 9.p: Explain Monte Carlo simulation and describe its applications and limitations.
LOS 9.q: Compare Monte Carlo simulation and historical simulation.
Monte Carlo simulation is a technique used to understand the impact of risk. It is used to
model security prices based on risk factors. It gives the distribution of the expected value
of the security as output.

Limitations:
 Not an analytical method but a statistical one. Analytical methods, when available, provide
more insight into cause-and-effect relationships.
 Complex and will provide answers that no better that assumptions.

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