Mid-Term Exam on Probability Concepts, Due on Oct 10.

All work is to be done on an individual basis with no discussions with anyone else, fellow
class member or otherwise. I will be happy to try to answer questions, however. Show
enough work to justify your answers and simplify expressions and compute numerical
answers where possible. Good luck!

1. Find the probability density function of Y=eX when X is normally distributed with
parameters  and 2. The random variable Y is said to have a lognormal distribution (since
log(Y) has a normal distribution) with parameters  and 2.

2. Suppose that A, B, and C are uncorrelated random variables with means 1, 2, and 3 and
standard deviations 1, 2, and 3, respectively. If X = A + B and Y = B + C, what is the
correlation of X and Y?

3. Let X be a normal random variable with parameters =0 and 2=1 and let I, independent of
X, be such that P{I=1}=0.5=P{I=0}.
 X if I = 1
Now define Y by Y =  .
− X if I = 0
In words, Y is equally likely to equal either X or –X.
a) Are X and Y independent?
b) Are I and Y independent?
c) Show that Y is normal with mean 0 and variance 1.
d) Find Cov(X,Y).

4. (Introduction to portfolio choice theory.) Denote by X and Y the (random) returns from
projects 1 and 2, respectively, and let X and Y be jointly normally distributed: X is normally
distributed with mean 1 and standard deviation 1, Y is normally distributed with mean 2
and standard deviation 2, and Cor(X,Y)=. Consider the return from a joint project a1X+a2Y,
when the amount a1 is invested in project 1 and the amount a2 is invested in project 2.
a) What is the distribution of a1X+a2Y?
b) Suppose that an investor wants to meet a “target” return . Therefore, she needs to
choose a1 and a2 such that E[a1X+a2Y]=. Suppose that the investor is risk averse. Then, among
all possible investments that yield return , the investor prefers an investment that has the
minimal variance. In other words, the investor’s problem is to find a1 and a2 such that
1) E[a1X+a2Y]=,
2) for all b1 and b2, such that E[b1X+b2Y]=, Var(a1X+a2Y)<Var(b1X+b2Y).
Find these optimal a1 and a2.

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5. In a survey, some of the questions concern sensitive issues (e.g., income, drug use, sexual
experiences). As a result, some respondents do not answer the questions truthfully. Suppose
that 30% of the members of a particular population had incomes over $100,000 last year. A
random sample of n = 10 members of this population is taken, and each person in the sample is
asked “Was your income over $100,000 last year?” If a person really had an income over
$100,000, the probability that he or she will give a truthful answer to this question is 0.7. If a
person’s income was not over $100,000, the probability that he or she will give a truthful
answer is 0.9.
(a) Find the probability distribution of X, the number of people in the sample who had
incomes over $100,000 last year.
(b) Find the probability distribution of Y, the number of “yes” answers to the question in the
sample of size 10.
(c) Find the probability distribution of T, the number of truthful answers from the 10
respondents.
(d) Given the answer “Yes, my income was over $100,000,” what is the probability that the
income of this person was, indeed, over $100,000? Similarly, given the answer “No, my income
was not over $100,000,” what is the probability that the income of this person was, indeed,
below $100,000?

6. The number of oil tankers arriving at a certain refinery each day has a Poisson distribution
with parameter λ = 1.5. Present port facilities can service three tankers a day. If more than
three tankers arrive in a day, the tankers in excess of three must be sent to another port.
(a) On a given day, what is the probability of having to send tankers away?
(b) How much must present facilities be increased to permit handling all arriving tankers on
approximately 90 percent of the days?
(c) What is the expected number of tankers arriving per day?
(d) What is the most probable number of tankers arriving daily?
(e) What is the expected number of tankers serviced daily?
(f) What is the expected number of tankers turned away daily?

7. Exercise 78 of Chapter 7 of the Ross book (p. 389), slightly modified. Two envelopes, each
containing a check, are placed in front of you. You are to choose one of the envelopes, open it,
and see the amount of the check. At this point you can either accept that amount or you can
exchange it for the check in the unopened envelope. What should you do? Is it possible to
devise a strategy that does better than just accepting the first envelope?
Let A and B, A<B, denote the (unknown) amounts of the checks, and note that the strategy that
randomly selects an envelope and always accepts its check has an expected return of (A+B)/2.
Consider the following strategy: Let F(x) be any strictly increasing distribution function.
Randomly choose an envelope and open it. If the discovered check has value x then accept it
with probability F(x), and with probability 1-F(x) exchange it.

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 a) Show that if you employ the latter strategy, then your expected return is greater than
(A+B)/2. Hint: Condition on whether the first envelope has value A or B.
Now consider the strategy that fixes a value x (a priori), and then accepts the first check if its
value is greater than x and exchanges it otherwise.
b) Show that for any x, the expected return under the x-strategy is always at least (A+B)/2,
and that it is strictly larger than (A+B)/2 if x lies between A and B.
c) Let X be a continuous random variable on the whole real line with cdf F(x), and
consider the following strategy: Generate the value of X, and if X=x then employ the x-
strategy of part (b). Show that the expected return under this strategy is greater than
(A+B)/2. Compare it with the expected return from part (a).
d) Consider the following paradoxical/cyclical reasoning, for the same situation, but when
you know in advance that one of the envelopes has twice as much money as the other:
“Suppose I choose first envelope. Suppose it has $100. Then the other has either $200 or
$50, with equal probabilities (since I had a 50-50 chance to select this particular
envelope out of the two). Then the expected amount of money in the second envelope is
($200+$50)/2=$125, so it looks like I have to take the second envelope. Now, without
opening it, I apply the same reasoning: the second envelope has either $50 or $200. Then
the first envelope has either ($25, $100) with equal chances, or ($100, $400) with equal
chances, which yield $156.25 in expectation. First, it looks like I have to take the first
envelope then. Second, it seems that if I apply this reasoning n times, the expected
amount in an envelope, which I consider right now, becomes $100*(1.25)n. That’s
weird!” In other words, the paradox is in: 1) The other envelope always looks more
attractive (since the expected sum of money there is 1.25 times greater); 2) By switching
back and forth, the expected sum of money in any envelope goes to infinity. Can you
find a flaw in these arguments (resolve the paradox)? Do solutions (a)-(c) help?