Term
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Definition
-variable that can take on a countable number of values -each outcome has a specific probability of occurring, which can be measured |
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Term
Continuous Random Variable |
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Definition
-variable for which the number of possible outcomes cannot be counted (there are infinite possible outcomes) -probabilities cannot b attached to specific outcomes -ex) rate of return |
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Term
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Definition
-identifies the probability of each of the possible outcomes of a random variable |
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Term
Probability Function p(x) |
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Definition
-expresses the probability that 'X', the random variable takes on a specific value of 'x' -P(X=x) -discrete random variables |
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Term
Probability Density Function (pdf) |
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Definition
-used to determine the probability that the outcomes lies within a specified range of possible values -used to interpret the probability structure of CONTINUOUS random variables -f(x) |
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Term
Cumulative Distribution Function |
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Definition
-the probability that a random variable, X, takes on a value less than or equal to a specific value x -F(x) = P(X <(or = to) x) |
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Term
Possible outcomes of specified discrete random variable |
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Definition
-p(x) = 0 --> random variable cannot take particular value of x -p(x) > 0 --> specified value of x is present in the set of possible outcomes that the random variable can take -p(x) = 1 --> x is the only possible outcome |
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Term
Discrete Uniform Distribution |
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Definition
-distribution in which the probability of each of the possible outcomes is identical -ex) probability diet of outcomes from roll of a fair die |
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Term
Bernoulli Random Variable |
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Definition
-two possible outcomes -probability of success is always the same no matter how many times the trial is performed -P(1) = P(Y=1) = p P(0) = P(Y=0) = 1-p --> where Y is the random variable |
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Term
Binomial Random Variable (X) |
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Definition
-the number of successes (Y=1) from a Bernoulli trial that is carried out 'n' times -Probability of x success in n trials is given by: P(X=x) = nCx * (p)^x * (1-p)^(n-x) --> where p=probability of success on each trial -B(n,p) --> mean = np(1-p) |
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Term
Binomial Tree to describe stock price movements |
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Definition
-define two possible outcomes and the prob that each outcomes will occur -binomial tree is constructed by showing all possible combinations |
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Term
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Definition
-measure of how closely a portfolio's returns match the returns of the index to which it is benchmarked -Tracking Error = Gross return on portfolio - Total return on benchmark index |
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Term
Continuous Uniform Distribution |
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Definition
-defined over a range that spans between some lower limit 'a' and some upper limit 'b' -U(a,b) -probability of any outcome outside this interval is 0 -individual outcomes also have a probability of 0 --> P(X=x) = 0 -probability that random variable will take a value that falls between x1 and x2 that both lie within the range, a to b, is the proportion of the total area taken up by the range x1 to x2 |
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Term
Normal Distribution (Characteristics) |
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Definition
-bell shaped -symmetric --> median, mean and mode is the same -X~N(mean, var) -skewness = 0 -kurtosis = 3; excess kurtosis = 0 -linear combination of normally distributed random variables is also normally distributed --> if the returns on each stock in a portfolio are normally distributed the returns on the portfolio will also be normally distributed -tail on either side extends to infinity -total area/probability under curve = 1 -68% of all values will lie within +/- 1 st dev from the mean |
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Term
Multivariate Distribution |
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Definition
-specifies probabilities for a group of RELATED random variables -multivariate normal distribution for the return on a portfolio with n stocks is completely defined by: 1) mean returns on each n stock 2) variance of returns of each n stocks 3) pair-wise correlations. there will be n(n-1)/2 pairwise correlations in total |
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Term
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Definition
-describes the distribution of a SINGLE random variable |
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Term
Probability that a normally distributed random variable lies inside a given interval |
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Definition
-90% confidence interval for X is +/- 1.65 st dev -95% confidence interval for X is +/- 1.98 st dev -99% confidence interval for X is +/- 2.58 st dev |
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Term
Standard Normal Distribution |
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Definition
-X~(mean, var) --> Z~(0,1) |
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Term
How to standardize a random variable |
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Definition
-Z=(X - mean) / st dev ex) The probability that we'll observe a value smaller than 9.5 for X~N(5,1.5) is exactly that same as the probability that we'll observe a value smaller than 3 for Z~N(0,1) |
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Term
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Definition
-probability that a portfolio's return will fall below a particular target return over a given period |
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Term
Roy's Safety-First Criterion |
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Definition
=[E(Rp) - Rt] / st dev of portfolio -the optimal portfolio minimezs the probability that the return of the portfolio, Rp, falls below some minimum acceptable level, Rt -minimum acceptable level is called threshold level -essentially calculating z-score -the HIGHER SF ratio is preferred -higher the SF ratio the further to the left it will be on the prob distribution so probability will be less |
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Term
Lognormal Distribution (relationship w normal distribution) |
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Definition
-generated by the function e^x, where X is normally distributed -lne^x=x --> the logarithms of log normally distributed random variables are normally distributed -mathematic rule: e^x will always be positive -LOG IS NORMAL (phrase to remember) |
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Term
Lognormal Distribution (properties) |
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Definition
-skewed to the right -bounded by zero on the lowered -upper end is unbounded -useful to model distribution of asset prices bc asset prices never take negative values |
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Term
Continuously Compounded Rate |
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Definition
-continuously compounded rate is the stated rate where as effective annual rate is the effective return received over the year -(P1/P0)-1 = EAR -ln(EAR + 1) = continuously compounded rate OR ln(HPR + 1) = continuously compounded rate -(e^continuously compounded rate) - 1 = EAR |
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Term
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Definition
-generates random numbers and operator inputs to synthetically create probability distributions for variables -used to calculate expected values and dispersion measures for random variables which are then used for statistical inferences -for each of the risk factor inputs, analyst specifies the parameters of the probability distribution -based on all the information, computer will generate a output which represents the distribution of possible values for the security that you are analyzing |
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Term
Monte Carlo Simulation (Investment Applications) |
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Definition
-experiment with proposed policy before actually implementing it -provide a probability distribution to estimate investment risk -provide expected values of investments that can be difficult to price -to test models and investment tools and strategies -estimating the distribution of the return of a portfolio composed of assets that do NOT have normally distributed returns or that has assets w features such as embedded options, call features, and parameters that change w market conditions |
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Term
Monte Carlo Simulation (Limitations) |
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Definition
-Answers are as good as the assumptions and model used -does not provide cause-and-effect relationships |
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Term
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Definition
-uses historical data to generate the sets of realized random variables (as opposed to a random # generator as in Monte Carlo) -assumes random var dist in future depends on its past dist -advantage: distribution of risk factors does not need to be estimated |
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Term
Limitations of Historical Simulations |
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Definition
-risk factor that was not represented in historical data will not be considered in simulation -does not facilitate "what if" analysis if the "if" factor has not occurred in the past -assumes future will be similar to the past -does not provide cause-and-effect relationship information |
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