Quantitative Methods

Probability Trees and Conditional

Expectations

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 Intro and Exam Focus

• Discrete probability distribution: calculating mean and

standard deviation

• Using conditional probabilities in probability trees

• Bayes’ formula

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Expected Value of Discrete Probability Distribution:

CFA Institute Example
Expected value: E(X) = ΣP(xi)xi
Probability Distribution: BankCorp’s EPS

P(xi) EPS $ (xi) P(xi)xi

0.15 2.60 0.39

0.45 2.45 1.1025
0.24 2.20 0.528
0.16 2.00 0.32
1 E(X) =
-2

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 Variance of a Discrete Probability Distribution

Much quicker
on the BAII+
Variance: σ2X = ΣP(xi)[xi – E(X)]2

P(xi) EPS $ (xi) P(xi)xi P(xi)[xi –E(X)]2

0.15 2.60 0.39
0.45 2.45 1.1025 0.005445
0.24 2.20 0.528 0.004704
0.16 2.00 0.32 0.018496
1 E(X) = 2.34 = σ2

Standard deviation: square root of σ2 = -4

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Dependent/Independent Events
Independent events: occurrence of one event does not change the probability
of other event
P(A|B) = P(A)
Example: flipping a fair coin: P(3 heads) = 0.5 × 0.5 × 0.5 = 0.53 = 0.125
Dependent events: knowing the outcome of one event changes the probability
of another event occurring
P(A|B) ≠ P(A)
Example: picking cards from a pack without replacement
P(2 aces) = (4 / 52) × (3 / 51) = 0.0045

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 Probability Trees: Example
• P (interest rate increase) = P(I) = 70%
• P (recession | increase) = P(R|I) = 60%
• P (recession | no increase) = P(R|IC) = 20%
What is the (unconditional) probability of recession?

P(R) = [P(R|I) × P(I)] + [P(R|IC) × P(IC)]

= P(RI) + P(RIC)
= + =
-1

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Probability Trees (cont.)

Unconditional Conditional Joint
probabilities probabilities probabilities
0.60 Recession 0.42
Interest rate
0.70 increase
No 0.48
0.40 0.28
recession Unconditional
probability
0.30 No interest 0.20 Recession 0.06
rate increase
No 0.24
0.80 recession -4

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 Probability Tree: CFA Institute Example
BankCorp’s Earnings Per Share Part 2:
• Probability of declining interest environment = 0.60
• Probability of stable interest environment = 0.40
• In a declining interest environment, there is 25% probability a company’s EPS
will be $2.60, and a 75% probability EPS will be $2.45.
• In a stable interest environment, there is 60% probability a company’s EPS will
be $2.20, and a 40% probability EPS will be $2.00
Calculate:
• The expected EPS of the company, E(EPS)
• The conditional expected EPS given a declining interest environment
• The conditional variance of EPS in a declining interest environment

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Probability Trees (cont.)

Unconditional Conditional Joint
Expected EPS
probabilities probabilities probabilities
0.25
EPS = $2.60 0.15 0.39
declining
0.60 interest
environment EPS = $2.45 0.45 1.1025
0.75
EV =
0.40 stable 0.60 EPS = $2.20 0.24 0.528
interest
environment
0.40 EPS = $2.00 0.16 0.32
-5

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 Probability Tree: Solution
Expected EPS = $2.34
= 0.15($2.60) + 0.45($2.45) + 0.24($2.20) + 0.16($2.00)

Conditional expectations of EPS:

E(EPS) | Declining interest rates = + =
E(EPS) | Stable interest rates = + =

Expected EPS = + =
-3

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Conditional Variances: Solution

Condition Xi P(Xi) P(Xi)Xi (Xi – X)2 P(X i )(Xi – X)2

Declining $2.60 0.25 0.65
interest rates $2.45 0.75 1.8375 0.001406 0.001055
X = 2.4875 σ = 2

Stable $2.20 0.60 1.32 0.0064 0.00384

interest rates $2.00 0.40 0.80 0.0144 0.00576
X= 2.12 σ2 =

-5

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 Bayes’ Formula: CFA Institute Example
Given the following probability tree, what is the probability that a
randomly selected firm that has returns > 10% was also a tech stock?
0.60
Return > 10% 0.12
0.20 Tech firm of all firms
0.40 Return ≤ 10% 0.08 had earnings
>10%

0.80 Non-tech 0.25 Return > 10% 0.20

firm
= or
0.75 Return ≤ 10% 0.60
-4

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Bayes’ Formula
“Prior probability”

P(AB) P(B | A)×P(A) 0.12

P(A |B) = = = = 0.375 or 37.5%
P(B) P(B) 0.32

“Posterior probability”

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 Solutions

Expected Value of Discrete Probability Distribution:

CFA Institute Example
Expected value: E(X) = ΣP(xi)xi
Probability Distribution: BankCorp’s EPS

P(xi) EPS $ (xi) P(xi)xi

0.15 2.60 0.39

0.45 2.45 1.1025
0.24 2.20 0.528
0.16 2.00 0.32
1 E(X) = 2.34
-2

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 Variance of a Discrete Probability Distribution

Much quicker
on the BAII+
Variance: σ2X = ΣP(xi)[xi – E(X)]2

P(xi) EPS $ (xi) P(xi)xi P(xi)[xi –E(X)]2

0.15 2.60 0.39 0.01014
0.45 2.45 1.1025 0.005445
0.24 2.20 0.528 0.004704
0.16 2.00 0.32 0.018496
1 E(X) = 2.34 0.038785 = σ2

Standard deviation: square root of σ2 = $0.1969 -4

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Probability Trees: Example

• P (interest rate increase) = P(I) = 70%
• P (recession | increase) = P(R|I) = 60%
• P (recession | no increase) = P(R|IC) = 20%
What is the (unconditional) probability of recession?

P(R) = [P(R|I) × P(I)] + [P(R|IC) × P(IC)]

= P(RI) + P(RIC)
= [0.60 × 0.70] + [0.20 × 0.30] = 48%
-1

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 Probability Trees (cont.)
Unconditional Conditional Joint
Expected EPS
probabilities probabilities probabilities
0.25
EPS = $2.60 0.15 0.39
declining
0.60 interest
environment EPS = $2.45 0.45 1.1025
0.75
EV = 2.34
0.40 stable 0.60 EPS = $2.20 0.24 0.528
interest
environment
0.40 EPS = $2.00 0.16 0.32
-5

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Probability Tree: Solution

Expected EPS = $2.34
= 0.15($2.60) + 0.45($2.45) + 0.24($2.20) + 0.16($2.00)

Conditional expectations of EPS:

E(EPS) | Declining interest rates = 0.25($2.60) + 0.75($2.45) = $2.4875
E(EPS) | Stable interest rates = 0.60($2.20) + 0.40($2.00) = $2.12

Expected EPS = 0.60($2.4875) + 0.40($2.12) = $2.34

-3

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 Conditional Variances: Solution

Condition Xi P(Xi) P(Xi)Xi (Xi – X)2 P(X i )(Xi – X)2

Declining $2.60 0.25 0.65 0.012656 0.003164
interest rates $2.45 0.75 1.8375 0.001406 0.001055
X = 2.4875 σ2 = 0.004219

Stable $2.20 0.60 1.32 0.0064 0.00384

interest rates $2.00 0.40 0.80 0.0144 0.00576
X= 2.12 σ2 = 0.0096

-5

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Bayes’ Formula: CFA Institute Example

Given the following probability tree, what is the probability that a
randomly selected firm that has returns > 10% was also a tech stock?
0.60
Return > 10% 0.12
0.20 Tech firm 32% of all firms
0.40 Return ≤ 10% 0.08 had earnings
>10%

0.80 Non-tech 0.25 Return > 10% 0.20

firm 0.12
= 0.375 or 37.5%
0.32
0.75 Return ≤ 10% 0.60
-4

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