CFA

Probability Trees and

Conditional Expectations

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Introduction
Expected Value
• Expected value (E(X)) represents the probability-weighted average of possible outcomes of a random
variable.
• Investors use expected values for forecasting returns, assessing financial variables, and making
investment decisions.
• Expected value contrasts with historical or sample mean, which is an equally weighted average of
observed values.
• The formula for calculating the expected value of a discrete random variable X is:
E(X) = P(X1)X1 + P(X2)X2 + ...+P(Xn)Xn = σ𝒏𝒊=𝟏 𝑷(𝑿𝒊)(𝑿𝒊)

(where X1 represents outcomes and P(X1) represents their probabilities)

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Introduction
Variance and Standard Deviation
• Variance measures the dispersion of outcomes around the expected value.
• The variance of a random variable X is calculated as
σ 2(X) = E[X − E(X)]2
• Variance is a non-negative value; higher variance indicates greater dispersion or risk.
• Standard deviation (σ) is the square root of variance and is in the same units as the random variable.

Standard deviation is easier to interpret than variance because it shares the same units as the random
variable.

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Example 1
BankCorp’s Earnings per Share, Part 1 2. What are the variance and standard deviation of
BankCorp’s EPS for the current fiscal year?
Probability EPS (USD)
Solution:
0.15 2.60
0.45 2.45 σ2(EPS) = P(2.60)[2.60 − E(EPS)]2 + P(2.45)[2.45 −
E(EPS)]2
0.24 2.20
0.16 2.00 + P(2.20)[2.20 − E(EPS)]2 + P(2.00)[2.00 − E(EPS)]2
1.00 σ2(EPS = 0.15 (2.60 − 2.34)2 + 0.45 (2.45 − 2.34)2 + 0.24
(2.20 − 2.34)2 + 0.16 (2.00 − 2.34)2
1. What is the expected value of Bank
Corp’s EPS for the current fiscal year? σ2(EPS = 0.01014 + 0.005445 + 0.004704 + 0.018496

Solution: σ2(EPS = 0.038785

E(EPS) = 0.15(USD2.60) + 0.45(USD 2.45) + Standard deviation = 0.038785

0.24(USD 2.20) + 0.16(USD 2.00) σ(EPS) = 0.196939
E(EPS) = USD2.3405
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Probability Trees And Conditional Expectations
Conditional Expected Values
• In investments, forecasts are often refined based on new information or events.
• Conditional expected values, denoted as E(X | S), are used when updating forecasts based on specific
events or scenarios (S).
• X can take on n distinct outcomes (X1, X2, ..., Xn), forming mutually exclusive and exhaustive events.
• The formula for calculating the conditional expected value of X given S is:

E(X | S) = P(X1 | S)X1 + P(X2 | S)X2 + ... + P(Xn | S)Xn.

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Probability Trees And Conditional Expectations
Total Probability Rule for Expected Value
• Similar to the total probability rule for expressing unconditional probabilities in terms of conditional
probabilities, there is a principle for expressing unconditional expected values using conditional expected
values.
• The formula for the total probability rule for expected value is given by
E(X) = E(X | S)P(S) + E(X | SC)P(SC),
(where SC represents the complement of scenario S)
• In the general case given below, the expected value of X is expressed as a weighted sum of conditional
expected values:
E(X) = E(X | S1)P(S1) + E(X | S2)P(S2) + ... + E(X | Sn)P(Sn).

• S1, S2, ..., Sn represent mutually exclusive and exhaustive scenarios or events.

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Example 2
BankCorp’s Earnings per Share, Part 2
• The earnings of BankCorp are sensitive to interest
A probability tree diagram
rates.
given represents the analysis.
• There is a 0.60 probability of BankCorp operating in a
declining interest rate environment in the current fiscal
year.
• There is a 0.40 probability of BankCorp operating in a
stable interest rate environment.
• In a declining interest rate environment:
1. Probability of EPS being USD2.60 is estimated at 0.25.
2. Probability of EPS being USD2.45 is estimated at 0.75.
• The probabilities are consistent with the overall
probability of a declining interest rate environment.

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Example 2
• We can find expected EPS given a declining and stable interest rate environment as follows:
Declining interest rate environment Stable interest rate environment
E(EPS | declining interest rate environment) E(EPS | stable interest rate environment)
= 0.25(USD2.60) + 0.75(USD2.45) = 0.60(USD2.20) + 0.40(USD2.00)
= USD2.4875 = USD2.12
Now using the total probability rule for expected value,
E(EPS) = E(EPS | declining interest rate environment)P(declining interest rate environment) + E(EPS | stable
interest rate environment)P(stable interest rate environment)
E(EPS) = USD2.4875(0.60) + USD2.12(0.40)
E(EPS) = USD2.3405 or about USD2.34.

• This amount is identical to the estimate of the expected value of EPS calculated directly from the
probability distribution in Example 1.
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Example 2
• We can also calculate the variance of EPS given each scenario:
Declining Interest Rate:
σ2(EPS|declining interest rate environment) = 0.25(USD2.60 − USD2.4875)2 + 0.75(USD2.45 − USD2.4875)2
σ2(EPS|declining interest rate environment) = 0.004219

Stable Interest Rate:

σ2(EPS | stable interest rate environment) = 0.60(USD2.20 − USD2.12)2 + 0.40(USD2.00 − USD2.12)2
σ2(EPS | stable interest rate environment) = 0.0096

• The above are conditional variances, the variance of EPS given a declining interest rate environment and
the variance of EPS given a stable interest rate environment.

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Example 3
BankCorp’s Earnings per Share, Part 3
• Continuing with the BankCorp example, you focus now Two scenarios for growth, pictured in the
on BankCorp’s cost structure. tree diagram
• One model, a simple linear regression model, you are
researching for BankCorp’s operating costs is 𝑌෠ = a + bX,
• where 𝑌෠ is a forecast of operating costs in millions of
US dollars and X is the number of branch offices; and 𝑌෠
represents the expected value of Y given X, or E(Y | X).
• You interpret the intercept a as fixed costs and b as
variable costs.
• You estimate the equation as follows: 𝑌෠ = 12.5 + 0.65X.
• BankCorp currently has 66 branch offices, and the
equation estimates operating costs as 12.5 + 0.65(66) =
USD55.4 million.
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Example 3
෡ = 12.5 +
1. Compute the forecasted operating costs given the different levels of operating costs, using 𝒀
0.65X. State the probability of each level of the number of branch offices.

Solution:

Operating Costs Probability

𝑌෠ = 12.5 + 0.65(125) = USD93.75 million 0.80(0.50) = 0.40
𝑌෠ = 12.5 + 0.65(100) = USD77.50 million 0.80(0.50) = 0.40
𝑌෠ = 12.5 + 0.65(80) = USD64.50 million 0.20(0.85) = 0.17
෠ 12.5 + 0.65(70) = USD58.00 million
𝑌= 0.20(0.15) = 0.03
1.00

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Example 3
2. Compute the expected value of operating costs under the high growth scenario. Also calculate the
expected value of operating costs under the low growth scenario.
Solution:
US dollar amounts are in millions.
E(operating costs|high growth) = 0.50(USD93.75) + 0.50(USD77.50) = USD85.625
E(operating costs|low growth) = 0.85(USD64.50) + 0.15(USD58.00) = USD63.525
3. Refer to the question in the initial box of the tree: What are BankCorp’s expected operating costs?
Solution:
US dollar amounts are in millions.
E(operating costs) = E(operating costs|high growth)P(high growth) + E(operatingcosts|low growth)P(low
growth)
= 85.625(0.80) + 63.525(0.20)
=USD81.205 million.
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Bayes' Formula And Updating Probability Estimates
• Bayes' formula is a rational method used in investment and business decision-making.
• It helps adjust viewpoints based on new knowledge and observations.
• Bayes’ formula makes use of the total probability rule: P(A) = σ𝑛 𝑃 (A ∩ Bn).
• Bayes' formula is often referred to as an "inverse probability" because it uses event occurrence to infer
the probability of the scenario that caused it.
• It reverses the "given that" information, updating beliefs concerning the causes of a new observation
based on the event occurrence.
P(Information | Event)
• Bayes' Formula is expressed as: P(Event | Information) = × P(Event)
P(Information)
• P(Information | Event) = Probability of the new information given event
• P(Information) = Unconditional probability of the new information
• P(Event)= Prior probability of event.

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Example 4
Assume a hypothetical large-cap stock index has 500 member firms, of which 100 are technology firms, and
60 of these had returns of >10 percent, and 40 had returns of ≤10 percent. Of the 400 non-technology firms
in the index, 100 had returns of >10 percent, and 300 had returns of ≤10 percent.

Summary of Returns for Tech and Non-Tech Firms in Hypothetical Large-Cap Equity Index

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Example 4
What is the probability a firm is a tech firm given that it has a return of >10 percent or P(tech | R > 10%)?
Looking at the frequencies in the table, we can see many empirical probabilities, such as the following:
• P(tech) = 100 / 500 = 0.20,
• P(non-tech) = 400 / 500 = 0.80,
• P(R > 10% | tech) = 60 / 100 = 0.60,
• P(R > 10% | non-tech) = 100 / 400 = 0.25,
• P(R > 10%) = 160 / 500 = 0.32,
• P(tech | R > 10%) = 60/ 160 = 0.375.

Now in the next slide, let us use Bayes’ formula to find the probability that a firm has a return of >10
percent P(R > 10%) and then the probability that a firm with a return of >10 percent is a tech firm, P(tech
| R > 10%).

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Example 5
Probability that a firm has a return of >10 percent
P(R > 10%) = P(R > 10% | tech) × P(tech) + P(R > 10% | non-tech) × P(non-tech)
P(R > 10%) = 0.60 × 0.20 + 0.25 × 0.80
P(R > 10%) = 0.32.

Probability that a firm with a return of >10 percent is a tech firm

𝑃(𝑅 > 10%|𝑡𝑒𝑐ℎ) × 𝑃(𝑡𝑒𝑐ℎ)
P(tech|R > 10%) = • Users of Bayesian statistics do not consider
𝑃(𝑅 > 10%)
probabilities (or likelihoods) to be known with
0.60×0.20 certainty but believe that these should be
P(tech|R > 10%) =
0.32 subject to modification whenever new
information becomes available.
P(tech|R > 10%) = 0.375.
• Our beliefs or probabilities are continually
updated as new information arrives over time.

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Example 6
Suppose you are an investor in the stock ofnDriveMed, Inc. DriveMed is preparing to release last quarter’s EPS
result, and you are interested in which of these three events happened:
1. Last quarter’s EPS exceeded the consensus EPS estimate,
2. Last quarter’s EPS exactly met the consensus EPS estimate,
3. Last quarter’s EPS fell short of the consensus EPS estimate.
• Prior probabilities:
1. P(EPS exceeded consensus) = 0.45
2. P(EPS met consensus) = 0.30
3. P(EPS fell short of consensus) = 0.25
• New Information and Likelihoods:
1. DriveMed announces an expansion indicating increased sales demand.

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Example 6
• Investor assesses conditional probabilities (likelihoods) of DriveMed expanding given each of the three
scenarios:
1. P(DriveMed expands | EPS exceeded consensus) = 0.75
2. P(DriveMed expands | EPS met consensus) = 0.20
3. P(DriveMed expands | EPS fell short of consensus) = 0.05
• Conditional probabilities of an observation (here: DriveMed expands) are sometimes referred to as
likelihoods.
• Next, you combine these conditional probabilities or likelihoods with your prior probabilities to get the
unconditional probability for DriveMed expanding, P(DriveMed expands), as follows:
• P(DriveMed expands)= P(DriveMed expands|EPS exceeded consensus) × P(EPS exceeded consensus) +
P(DriveMed expands|EPS met consensus) × P(EPS met consensus) +P(DriveMed expands|EPS fell short
of consensus) × P(EPS fell short of consensus)
• P(DriveMed expands)= 0.75(0.45) + 0.20(0.30) + 0.05(0.25) = 0.41, or 41%.

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Example 6
• P(EPS" " exceeded" " consensus│DriveMed" " expands):
𝑃(𝐷𝑟𝑖𝑣𝑒𝑀𝑒𝑑 𝑒𝑥𝑝𝑎𝑛𝑑𝑠|𝐸𝑃𝑆 𝑒𝑥𝑐𝑒𝑒𝑑𝑒𝑑 𝑐𝑜𝑛𝑠𝑒𝑛𝑠𝑢𝑠)
= × P(DriveMed expands)
P(DriveMed expands)
0.75
• P(EPS" " exceeded" " consensus│DriveMed" " expands) = × (0.45)
0.41

• P(EPS" " exceeded" " consensus│DriveMed" " expands) = 0.823171 or 82.3%

Interpretation:
• Prior to the announcement, the probability of DriveMed beating consensus expectations was 45%.
• After considering the announcement, the updated probability increases to approximately 82.3%.
• This updated probability is called the posterior probability, reflecting the impact of new information on
prior beliefs.

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Example 7
Inferring Whether DriveMed’s EPS Met Consensus EPS
• You are still an investor in DriveMed stock.
• Prior probabilities:
1. P(EPS exceeded consensus) = 0.45,
2. P(EPS met consensus) = 0.30,
3. P(EPS fell short of consensus) = 0.25.
• You also have the following conditional probabilities:
1. P(DriveMed expands | EPS exceeded consensus) = 0.75
2. P(DriveMed expands | EPS met consensus) = 0.20
3. P(DriveMed expands | EPS fell short of consensus) = 0.05

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Example 7
1. What is your estimate of the probability P(EPS exceeded consensus |DriveMed expands)?

• P(DriveMed expands) = 0.75(0.45) +0.20(0.30) + 0.05(0.25) = 0.41, or 41 percent.

• The probability P(DriveMed expands | EPS met consensus) is given as 0.20.
• The prior probability P(EPS met consensus) is given as 0.30.
• Now, apply Bayes' formula:
𝑃(𝐷𝑟𝑖𝑣𝑒𝑀𝑒𝑑 𝑒𝑥𝑝𝑎𝑛𝑑𝑠|𝐸𝑃𝑆 𝑒𝑥𝑐𝑒𝑒𝑑𝑒𝑑 𝑐𝑜𝑛𝑠𝑒𝑛𝑠𝑢𝑠)
P(EPS met consensus | DriveMed expands)= × P(DriveMedexpands)
P(DriveMed expands)
0.20
• P(EPS met consensus | DriveMed expands)= × 0.30
0.41

• P(EPS met consensus | DriveMed expands)= 0.146341 = 14.63%

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Example 7
2. Update your prior probability that DriveMed’s EPS fell short of consensus.
• P(DriveMed expands) was already calculated as 41 percent. Recall that P(DriveMed expands | EPS fell
short of consensus) = 0.05 and P(EPS fell short of consensus) = 0.25 are givens.
• Now, apply Bayes' formula:
0.05
• P(EPS fell short of consensus|DriveMed expands) = × 0.25
0.41

• P(EPS fell short of consensus|DriveMed expands) = 0.030488

3. Show that the three updated probabilities sum to 1. (Carry each probability to four decimal places.)
The sum of the three updated probabilities = 0.8232 + 0.1463 + 0.0305 = 1.000

• Whether we are talking about conditional or unconditional probabilities, whenever we have a complete
set of distinct possible events or outcomes, the probabilities must sum to 1.
• This calculation serves to check your work.

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Example 7
Suppose, because of lack of prior beliefs about whether DriveMed would meet consensus, you updated on
the basis of prior probabilities that all three possibilities were equally likely: P(EPS exceeded consensus) =
P(EPS met consensus) = P(EPS fell short of consensus) = 1/3.
Solution:
P(DriveMed expands) = 0.75(1/3) + 0.20(1/3) + 0.05(1/3) =1/3
Now, apply Bayes' formula:
𝟎.𝟕𝟓
P(EPS exceeded consensus | DriveMed expands) = × 1/3 = 0.75, or 75%
𝟏/𝟑

• When all three possibilities were equally likely (diffuse priors), the updated probability that DriveMed's
last quarter's EPS exceeded consensus, given the expansion announcement, is 75%.
• This probability matches the conditional probability of DriveMed expanding given that EPS exceeded
consensus, which is also 75%.
• In this case, the prior probabilities don't influence the updated probability because they are equal for all
scenarios. The updated probability is solely determined by the information provided.
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