LM03 Probability Concepts 2023 Level I Notes

LM03 Probability Concepts

1. Probability Concepts and Odds Ratios ........................................................................................................2

1.1 Probability, Expected Value, and Variance ........................................................................................2
2. Conditional and Joint Probability ..................................................................................................................3
3. Expected Value and Variance ..........................................................................................................................5
4. Portfolio Expected Return and Variance of Return ................................................................................8
5. Covariance Given a Joint Probability Function ..................................................................................... 10
6. Bayes’ Formula .................................................................................................................................................. 11
7. Principles of Counting ..................................................................................................................................... 12
Summary................................................................................................................................................................... 15

This document should be read in conjunction with the corresponding reading in the 2023 Level I
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
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LM03 Probability Concepts 2023 Level I Notes

1. Probability Concepts and Odds Ratios

Since many investment decisions are made in an environment of uncertainty, it is essential
for portfolio managers and investment managers to have a fundamental grasp of probability
concepts. In this reading, we will focus on:
• Definitions and rules related to probability
• Expected value and variance
• Covariance and correlation
1.1 Probability, Expected Value, and Variance
Fundamental Concepts
A random variable is an uncertain quantity/number. For example, when you roll a die, the
result is a random variable.
An outcome is the observed value of a random variable. For example, if you roll a 2, it is an
outcome.
An event can be a single outcome or a set of outcomes. For example, you can define an event
as rolling a 2 or rolling an even number.
Mutually exclusive events are events that cannot happen at the same time. For example,
rolling a 2 and rolling a 3 are examples of mutually exclusive events. They cannot happen at
the same time.
Exhaustive events are those that cover all possible outcomes. For example, ‘rolling an even
number’ or’ rolling an odd number’ are exhaustive events. They cover all possible outcomes.
The two defining properties of probability are:
• The probability of any event has to be between 0 and 1.
• The sum of the probabilities of mutually exclusive and exhaustive events is equal to
1.
Ways of Estimating Probability
The methods of estimating probabilities are:
• Empirical probability: Based on analyzing the frequency of an event’s occurrence in
the past.
• A priori probability: Based on formal reasoning and inspection rather than personal
judgment.
• Subjective probability: Informed guess based on personal judgment.
Empirical and a priori probabilities are often grouped as objective probabilities because they
do not vary from person to person.
Probability Stated as Odds
Odds for an event are defined as the probability of the event occurring to the probability of

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LM03 Probability Concepts 2023 Level I Notes

the event not occurring. Odds for E = P(E) / [1 – P(E)].

Given odds for E of “a to b”, the implied probability of E is a / (a + b).
Example
If the probability of an event is 0.2, what are the odds of it occurring? Alternatively, if the
odds are 1 to 4, what is the probability of this event?
Solution:
0.2
The odds of the event occurring are = 0.8 = 1/4. This is stated as odds of 1 to 4.
1 1
Given the odds, the probability of the event occurring is 1 + 4 = 5 = 0.20.

Odds against an event are defined as the probability of the event not occurring to the
probability of the event occurring. Odds against E = [1 – P(E)] / P(E).
Give odds against E of “a to b”, the implied probability of E is b / (a + b).
Example
If P(E) = 0.2, what are the odds against the event occurring? If the odds against an event are
4 to 1, what is the probability of the event?
Solution:
0.8 4
P(E) = 0.2 = 1. Hence the odds against E are 4 to 1.
1
Given the odds against an event, the probability of the event is 4 + 1 = 0.2

2. Conditional and Joint Probability

Conditional v/s Unconditional probabilities
Unconditional probability is the probability of an event occurring irrespective of the
occurrence of other events. It is denoted as P(A). Unconditional probability is also called
‘marginal’ probability.
Conditional probability is the probability of an event occurring given that another event has
occurred. It is denoted as P(A|B), which is the probability of event A given that event B has
occurred.
Joint Probability and Multiplication Rule
Multiplication rule is used to determine the joint probability of two events. It is expressed as:
P(AB) = P(A|B) P(B)
Rearranging the equation, we get the formula for computing conditional probabilities:
P(A|B) = P(AB) / P(B)

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LM03 Probability Concepts 2023 Level I Notes

Example
P(interest rates will decrease) = P(D) = 40%
P(stock price increases) = P(S)
P(stock price will increase given interest rates decrease) = P(S|D) = 70%
Compute probability of a stock price increase and an interest rate decrease.
Solution:
P(SD) = P(S|D) x P(D) = 0.7 x 0.4 = 0.28 = 28%
Addition Rule for Probabilities
Addition rule is used to determine the probability that at least one of the events will occur. It
is expressed as:
P(A or B) = P(A) + P(B) – P(AB)
P(AB) represents the joint probability that both A and B will occur. It is subtracted from the
sum of the unconditional probabilities: P(A) + P(B), to avoid double counting.
If the two events are mutually exclusive, the joint probability: P(AB) is zero and the
probability that either A or B will occur is simply the sum of the unconditional probabilities
for each event:
P(A or B) = P(A) + P(B)
Example
P(price of A increases) = P(A) = 0.5
P(price of B increases) = P(B) = 0.7
P(price of A and B increases) = P(AB) = 0.3
Compute the probability that the price of stock A or the price of stock B increases.
Solution
P(A or B) = 0.5 + 0.7 – 0.3 = 0.9
Independent and Dependent Events
If the occurrence of one event does not influence the occurrence of the other event, then the
two events are called independent events.
i.e. P(A|B) = P(A) or P(B|A) = P(B)
Multiplication rule for independent events: P(AB) = P(A) P(B)
Addition rule for independent events: P(A or B) = P(A) + P(B) – P(AB). (The addition rule
does not change.)
If the probability of an event is affected by the occurrence of another event, then it is called a

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LM03 Probability Concepts 2023 Level I Notes

dependent event.
Total Probability Rule
The total probability rule is used to calculate the unconditional probability of an event, given
conditional probabilities.
In investment analysis, we often formulate a set of mutually exclusive and exhaustive
scenarios and then estimate the probability of a particular event. For example, let’s say that
we have two scenarios S and non-S that are mutually exclusive and exhaustive.
According to the total probability rule, the probability of any event P(A) can be expressed as:
P(A) = P(AS) + P(ASC)
Using the multiplication rule we get,
P(A) = P(A|S) P(S) + P(A|SC) P(SC)
If we have more than two scenarios, we can generalize this equation to:
P(A) = P(AS1) + P(AS2) +… + P(ASn) = P(A|S1) P(S1) + P(A|S2) P(S2) + … + P(A|Sn) P(Sn)
3. Expected Value and Variance
Expected Value of a Random Variable
The expected value of a random variable can be defined as the probability-weighted average
of the possible outcomes of the random variable. For a random variable X, the expected value
of X is denoted as E(X) and is calculated as:
n

E(X) = ∑ P(Xi ) Xi
i=1

where:
Xi = One of n possible outcomes of the random variable X
P(Xi) = Probability of Xi
Variance of a Random Variable
The expected value is our forecast, but we cannot count on the individual forecast being
realized. This is why we need to measure the risk we face. Variance and standard deviation
are examples of how we can measure this risk. The variance of a random variable is the
probability-weighted sum of the squared differences between each possible outcome and the
expected value of the random variable. It is expressed as:
n
2 (X)
σ = ∑ P(X) [X − E(X)]2
i=1

Variance is a number greater than or equal to 0 because it is the sum of squared terms. If
variance is 0, there is no dispersion or risk. The outcome is certain and the quantity X is not

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LM03 Probability Concepts 2023 Level I Notes

random at all. Standard deviation is the positive square root of variance.

We can calculate the expected value and variance of a random variable using a financial
calculator as shown below:
Example
A project’s cash flow for the upcoming year depends on the state of the economy, as shown
in the table below. What is the variance of the cash flow? What is the standard deviation?
State of Economy Probability Cash Flow
Good 0.3 50
Average 0.5 40
Weak 0.2 20
Solution:
Using a financial calculator:
Keystrokes Explanation Display
[2nd] [DATA] Enters data entry mode
[2nd] [CLR WRK] Clears data register X01
50 [ENTER] 1st possible value of random variable X01 = 50
[↓] 30 [ENTER] Probability of 30% for X01 Y01 = 30
[↓] 40 [ENTER] 2nd possible value of random variable X02 = 40
[↓] 50 [ENTER] Probability of 50% for X02 Y02 = 50
[↓] 20 [ENTER] 3rd possible value of random variable X03 = 20
[↓] 20 [ENTER] Probability of 20% for X03 Y03 = 20
[2nd] [STAT] Puts calculator into stats mode
[2nd] [SET] Press repeatedly till you see  1-V
[↓] Total number of entries N = 100
[↓] Expected value of random variable X = 39
[↓] Sample standard deviation Sx = 10.49
[↓] Population standard deviation σx = 10.44
We can then square the population standard deviation of 10.44 to get the variance i.e. 10.44 2
= 109.00
Total Probability Rule for Expected Value
Just like the total probability rule states unconditional probabilities in terms of conditional
probabilities, the total probability rule for expected values states unconditional expected

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LM03 Probability Concepts 2023 Level I Notes

values in terms of conditional expected values.

E(X|S) = P(X1|S) X1 + P(X2|S) X2 + … + P(Xn|S) Xn
Instructor’s Note
Notice that this formula is exactly similar to the total probability rule formula.
P(A) = P(A|S1) P(S1) + P(A|S2) P(S2) + … + P(A|Sn) P(Sn)

Example
What is the expected price of a stock at the end of the current period given the following
information: probability that interest rates will decline = 0.4. If interest rates decline there is
a 75% chance that stock price will be $100 versus a 25% chance that the stock price will be
$90. If interest rates do not decline there is a 50% chance that the stock price will be $80
versus a 50% chance that stock price will be $70.
Solution:
We can plot the probabilities using a tree diagram.

Consider the first node (top right). It refers to the probability that the stock price will be
$100 given a decline in interest rates. We can calculate the probability of that happening by
multiplying the probability of a decline in interest rates (0.4) by the probability of the stock
price being $100 if that happens (0.75). This gives us a conditional probability of 0.30. In
short, it is the joint probability of the stock price being $100 given a decline in interest rates.
Similarly, probabilities are calculated for each of the other three nodes. We can then
calculate:
E(Price│decline in interest rates) = 0.75 ($100) + 0.25 ($90) = $97.50
E(Price│no decline in interest rates) = 0.50 ($80) + 0.50 ($70) = $75.00
Now we use the total probability rule for expected value of stock price at the end of the
current period:

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LM03 Probability Concepts 2023 Level I Notes

E(Price) = E(Price│decline in interest rates) P(decline in interest rates) + E(Price│no decline

in interest rates) P(no decline in interest rates)
E(Price) = $97.50 (0.40) + $75.00 (0.60)
E(Price) = $84.00
4. Portfolio Expected Return and Variance of Return
Expected Return
A portfolio’s expected return can be calculated as:
E(R P ) = w1 E(R1 ) + w2 E(R 2 ) + … + wn E(R n )
where:
wn = portfolio weight of nth security in the portfolio
Rn = expected return of nth security in the portfolio
n = number of securities in the portfolio
We will discuss portfolio expected return and variance of return using a two-stock portfolio.
Example
40% of the portfolio is invested in Stock A and 60% is invested in Stock B. As shown in the
table below, the expected return of each stock depends on the economic scenario.
Scenario P(Scenario) Expected returns of A Expected returns of B
Recession 0.25 2% 4%
Normal 0.50 8% 10%
Boom 0.25 12% 16%
This information can also be presented as a joint probability function of A’s and B’s returns:
RB = 4% RB = 10% RB = 16%
RA = 2% 0.25 0 0
RA = 8% 0 0.50 0
RA = 12% 0 0 0.25
Row 1 and Column 1 represent the returns of A and B respectively. The other cells contain
probabilities. Calculate the expected return of A and B.
Solution:
Given the data presented above:
The expected return of A is: 0.25 x 2 + 0.50 x 8 + 0.25 x 12 = 7.5%.
The expected return of B is: 0.25 x 4 + 0.50 x 10 + 0.25 x 16 = 10%.
Expected return of the portfolio = weight of A in the portfolio x expected return of A + weight
of stock B in the portfolio x expected return of B = 0.4 x 7.5 + 0.6 x 10 = 9%
The expected portfolio return is 9%. As the term implies, this is the expected return. The

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LM03 Probability Concepts 2023 Level I Notes

actual return will vary around 9%. The amount of variability is measured by the variance. In
order to determine the variance of return, we must first calculate the covariance.
Covariance
Covariance tells us how movements in a random variable vary with movements in another
random variable, whereas variance tells us how a random variable varies with itself. Assume
there are two random variables Ri and Rj. The forward-looking, population covariance
between Ri and Rj (used to measure how they move together) is given by:
Cov (R i , R j ) = E ([R i – ER i ][ R j – ER j ])
where:
ERi = expected return for variable Ri
ERj = expected return for variable Rj
If the random variables are returns, the units of both forward-looking covariance and
historical variance would be returns squared.
The sample covariance between two random variables Ri and Rj is the average value of the
product of the deviations of observations on two random variables from their sample means.
It is calculated as follows:
n
  Ri,t  Ri R j,t  R j  n  1
Cov Ri , R j 
i 1

Unlike the population covariance, the sample covariance is based on historical data set. This
reading focuses on covariance in a forward-looking sense.
Example
Continuing with our previous example, calculate the covariance of returns between A and B.
Solution:
Say Ri represents the return on A and Rj represents the return on B, we have already
calculated the expected returns of A and B as 7.5% and 10% respectively. The covariance of
returns is:
E [(Ri – 7.5) (Rj – 10)]
= 0.25(2% - 7.5%)(4% - 10%) + 0.5(8% - 7.5%)(10% - 10%) + 0.25(12% - 7.5%)(16% -
10%)
= 0.000825 + 0 + 0.000675 = 0.0015
Correlation
The problem with covariance is that it can vary from negative infinity to positive infinity
which makes it difficult to interpret. To address this problem, we use another measure called
correlation. Correlation is a standardized measure of the linear relationship between two

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LM03 Probability Concepts 2023 Level I Notes

variables with values ranging between -1 and +1.

 A correlation of 0 (uncorrelated variables) indicates an absence of any linear
(straight-line) relationship between the variables.
 A correlation of +1 indicates a perfect positive relationship.
 A correlation of -1 indicates a perfect negative relationship.
It is computed as:
ρ(R i , R j ) = Cov(R i , R j )/σ(R i ) σ(R j )
The above correlation measure is forward-looking as it is calculated by dividing the forward-
looking covariance by the product of forward-looking standard deviations.

Historical or sample correlation = Historical or sample covariance between two variables /

(Sample standard deviation of variable Ri * Sample standard deviation of variable Rj)
We will now apply this formula to calculate the correlation between the returns of A and B
from our example. We have already shown that the covariance of returns is 0.0015. In order
to calculate the correlation, we need the standard deviation of A and B. Using a financial
calculator, we can determine that the standard deviation of A is 0.0357 and the standard
Cov(A,B)
deviation of B is 0.0424. The correlation, ρ(A, B) = σ(A)σ(B) = 0.0015/(0.0357 x 0.0424) =
0.99.
The correlation of 0.99 (almost 1) implies a very strong positive relationship between the
returns of A and B. This is more meaningful than the covariance number of 0.0015 which
tells us that there is a positive relationship between the returns of A and B but does not give
a sense for the strength of the relationship.
5. Covariance Given a Joint Probability Function
Given two random variables Ri and Rj, the covariance between Ri and Rj is given by:
Cov(Ri, Rj) = E[(Ri – ERi) (Rj – ERj)]
where:
ERi = expected return for variable Ri
ERj = expected return for variable Rj
Definition of Independence for Random Variables. Two random variables X and Y are
independent if and only if P(X,Y) = P(X)P(Y).
For example, given independence, P(5,6) = P(5)P(6). Joint probabilities are obtained by
multiplying the individual probabilities. Independence is a stronger property than
uncorrelatedness because correlation addresses only linear relationships.
The following condition holds for independent random variables and, therefore, also holds
for uncorrelated random variables.

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LM03 Probability Concepts 2023 Level I Notes

Multiplication Rule for Expected Value of the Product of Uncorrelated Random

Variables.
The expected value of the product of uncorrelated random variables is the product of their
expected values.
E(XY) = E(X)E(Y) if X and Y are uncorrelated.
Many financial variables, such as revenue (price times quantity), are the product of random
quantities.
Variance of returns
Once we know the covariance, we can calculate the variance of a portfolio using this formula:
σ2 (R P ) = w12 σ12 (R1 ) + w22 σ22 (R 2 ) + 2w1 w2 Cov (R1 R 2 )
Example
Continuing with our example, the variance of the portfolio is
 Weight of the first asset, w1 = 0.40
 Weight of the second asset, w2 = 0.60
 Standard deviation of first asset = 0.0357
 Standard deviation of second asset = 0.0424
 Covariance between the two assets = 0.0015
Variance of the portfolio = 0.42 x 0.03572 + 0.62 x 0.04242 + 2 x 0.4 x 0.6 x 0.0015 = 0.00157
Standard deviation of the portfolio = √0.00157 = 0.0396
6. Bayes’ Formula
Bayes’ formula is a rational method for updating or adjusting the probability of an event
based on new information. According to Bayes’ formula, the updated probability of an event
given new information is:
P(Information│Event)
P(Event│Information) = × P(Event)
P(Information)
Example
Consider a factory that has three assembly lines. The percentage of output produced at each
assembly line is as follows: Line A = 45%, Line B = 35%, Line C = 20%. The output defective
from each line is estimated to be 3%, 5%, and 4%, respectively. Given that the product is
defective, what is the probability that it came from Line C?
Solution:
When dealing with questions related to Bayes’ formula, the first step is to reproduce the
information in probability notation:

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LM03 Probability Concepts 2023 Level I Notes

P(Line A) = 0.45; P(Not Line A) = 0.55

P(Line B) = 0.35; P(Not Line B) = 0.65
P(Line C) = 0.20; P(Not Line C) = 0.80
P(Defective | Line A) = 0.03, P(Defective | Line B) = 0.05, P(Defective | Line C) = 0.04
P(Defective) = 0.45 x 0.03 + 0.35 x 0.05 + 0.20 x 0.04 = 0.039
Next write down the Bayes formula:
P(Information│Event)
P(Event│Information) = x P(Event)
P(Information)
We then have to distinguish between the event and the information and plug the relevant
values into the formula. In this case, the information is that the product is defective. Hence,
the formula can be written as:
[P(Defective | Line C) ∗ P(Line C)] 0.04 ∗ 0.20
P(Line C | Defective) = = = 20.51%
P(Defective) 0.039

7. Principles of Counting
In counting, enumeration (counting the outcomes one by one) is the most basic resource.
This process is difficult and is prone to error. We will discuss shortcuts and principles of
counting, which make the process easier.
Multiplication Rule of Counting
The first of these principles is the multiplication rule. It states that ‘if one task can be done in
n1 ways, and a second task, given the first, can be done in n2 ways, and a third task, given the
first two tasks, can be done in n3 ways and so on for k tasks, then the number of ways the k
tasks can be done is (n1) (n2) (n3)… (nk). So the multiplication rule for counting can be
expressed as:
Number of ways of doing k tasks = n1 x n2 x n3 … nk
where:
n1 = number of ways of doing the first task,
n2 = number of ways of doing the second task and so on
Example
Consider a simple example. Suppose we have three steps in an investment decision process.
The first step can be done in 2 ways, the second step can be done in 4 ways and the third in 3
ways. In how many ways can the investment decision be made?
Solution:
Following the multiplication rule, there are (2) (4) (3) = 24 ways of making the investment

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LM03 Probability Concepts 2023 Level I Notes

decision.
Notice that there are three groupings in this problem. From each group, only one step can be
selected.
Factorial
Another counting principle relates to the assignment of members of a group to an equal
number of positions. The number of ways we can assign every member of a group of size n to
n slots is n! (read as n factorial) = n (n - 1) (n - 2) (n - 3) … 1. By convention, 0! = 1. The
difference between the multiplication rule and factorial is that there is only one group in a
factorial. It involves arranging the set of items within the group and the order in which the
items are arranged matters. The formula is:
Number of ways of assigning group of size n to n tasks = n!
Example
There are five equity analysts covering five emerging countries. In how many ways can the
countries be assigned to the analysts?
Solution:
The total number of ways the assignments can be made = 5! = 120
Labeling
Labeling refers to the number of ways that n items can be labelled with k different labels
with n, of the first type, n of the second type, and so on. This can be expressed as:
Number of ways in which n items can be labelled using k labels =
n!
[(n1 !)(n2 !) … (nk !)]
Example
A portfolio consists of eight stocks. The goal is to designate four of the stocks as "long-term
holds," three of the stocks as "short-term holds," and one stock a "sell." How many ways can
these labels be assigned to the eight stocks?
Solution:
Notice that there are eight items (stocks) that are to be labelled in three different ways.
8!
= 280
4! × 3! × 1!
Combination
A special case of the labelling is the combination formula. It is the number of ways to choose
r objects from a total of n objects, when the order in which the r objects are listed does not
matter. This can be expressed as:

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LM03 Probability Concepts 2023 Level I Notes

[n Cr ] = n! / [(n − r)! r!]

where:
n = number of objects
r = number of objects chosen from n objects
[n Cr = number of ways to choose r objects from n objects where order does not matter
Example
A portfolio manager wants to eliminate four stocks from a portfolio that consists of six
stocks. How many ways can the four stocks be sold when the order of the sale is NOT
important?
Solution:
Using the formula for combination, we get the number of ways the four stocks can be sold
= 6! / [(6 – 4)! 4!] = 15.
Permutation
Permutation is the number of ways to choose r objects from a total of n objects, when the
order in which the r objects are listed does matter. It is expressed as:
n!
[n Pr =
(n − r)!
where:
n = number of objects
r = number of objects chosen from n objects
Example
Assume that in a portfolio of eight stocks, we decide to sell three stocks. How many ways can
we choose three of the eight to sell if the order of sale does matter?
Solution:
Using the formula for permutation, we can find the number of ways to sell three of the eight
stocks where order matters:
8!
= 336
(8 – 3)!

Instructor’s Note: given a problem, use the following pointers to identify the correct
counting method to apply.
 Factorial: if there is one group of size n and n items/tasks to be assigned, number of
ways = n!
 Labeling: used when there are three or more labels. Each item/member of a group must
be applied a label.

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LM03 Probability Concepts 2023 Level I Notes

 Combination: used when there are two groups of a certain size, say n and r. Use
combination when the order of choosing r objects from n objects does NOT matter.
 Permutation: used when there are two groups of a certain size, say n and r. Use
permutation when the order of choosing r objects from n objects does matter.
 Combination and permutation functions are available on the financial calculator and
should be used rather than the formula.

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LM03 Probability Concepts 2023 Level I Notes

Summary
LO: Define a random variable, an outcome, and an event.
 A random variable is an uncertain quantity/number.
 An outcome is the observed value of a random variable.
 An event can be a single outcome or a set of outcomes.
LO: Identify the two defining properties of probability, including mutually exclusive
and exhaustive events, and compare and contrast empirical, subjective, and a priori
probabilities;.
The two defining properties of a probability are:
 The probability of any event E is a number between 0 and 1: 0 ≤ P(E) ≤ 1.
 The sum of the probabilities of any set of mutually exclusive and exhaustive events
equals 1.
Mutually exclusive events are events that cannot happen at the same time. Exhaustive events
are those that include all possible outcomes.
The methods of estimating probabilities are:
 Empirical probability: Based on analyzing the frequency of an event’s occurrence in
the past.
 A priori probability: Based on formal reasoning and inspection rather than personal
judgment.
 Subjective probability: Informed guess based on personal judgment.
LO: Describe the probability of an event in terms of odds for and against the event.
Odds for E = P(E) / [1 – P(E)].
Odds against E = [1 – P(E)] / P(E).
LO: Calculate and interpret conditional probabilities.
Unconditional probability (marginal probability) is the probability of an event occurring
irrespective of the occurrence of other events. It is denoted as P(A).
Conditional probability is the probability of an event occurring given that another event has
occurred. It is denoted as P(A|B), which is the probability of event A given that event B has
occurred.
LO: Demonstrate the application of the multiplication and addition rules for
probability.
Multiplication rule is used to determine the joint probability of two events. It is expressed as:
P(AB) = P(A|B) P(B)
Addition rule is used to determine the probability that at least one of the events will occur. It

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LM03 Probability Concepts 2023 Level I Notes

is expressed as:
P(A or B) = P(A) + P(B) – P(AB)
The total probability rule is used to calculate the unconditional probability of an event, given
conditional probabilities. It is expressed as:
P(A) = P(A|S1) P(S1) + P(A|S2) P(S2) + … + P(A|Sn) P(Sn)
LO: Compare and contrast dependent and independent events.
If the occurrence of one event does not influence the occurrence of the other event, then the
events are called independent events.
i.e. P(A|B) = P(A) or P(B|A) = P(B)
If the probability of an event is affected by the occurrence of another event then it is called a
dependent event.
LO: Calculate and interpret an unconditional probability using the total probability
rule.
Using the total probability rule the unconditional probability of A can be computed as:
P(A) = P(A|S1) P(S1) + P(A|S2) P(S2) + … + P(A|Sn) P(Sn)
Where S1, S2 .. Sn are mutually exclusive and exhaustive events.
LO: Calculate and interpret the expected value, variance, and standard deviation of
random variables.
The expected value of a random variable can be defined as the probability-weighted average
of the possible outcomes of the random variable.
n

E(X) = ∑ P(Xi ) Xi
i=1

The variance of a random variable is the probability-weighted sum of the squared

differences between each possible outcome and the expected value of the random variable.
n
2 (X)
σ = ∑ P(X) [X − E(X)]2
i=1

The square root of variance will give us the standard deviation.

LO: Explain the use of conditional expectation in investment applications.
The expected value is heavily used in investment applications e.g. forecasting EPS of a
company, estimating rewards of alternative investments, etc. When you refine your
expectations or forecasts, you are typically making adjustments based on new information
or events; this is actually the use of conditional expected values.

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LM03 Probability Concepts 2023 Level I Notes

LO: Interpret a probability tree and demonstrate its application to investment

problems.
The tree diagram in an investment problem can help plot the probabilities of various
outcomes and depict expected values based on the paths chosen and selection made at each
node. For example:

LO: Calculate and interpret the expected value, variance, standard deviation,
covariances, and correlations of portfolio returns.
The formula for calculating the expected portfolio return is:
E(RP) = w1 E(R1) + w2 E(R2) + … + wn E(Rn)
Variance can be computed as:
σ2 (R P ) = w12 σ12 (R1 ) + w22 σ22 (R 2 ) + 2w1 w2 Cov(R1 R 2 )
LO: Calculate and interpret the covariances of portfolio returns using the joint
probability function.
Given two random variables Ri and Rj, the covariance between Ri and Rj is given by:
Cov(Ri, Rj) = E[(Ri – ERi) (Rj – ERj)]
where:
ERi = expected return for variable Ri
ERj = expected return for variable Rj
LO: Calculate and interpret an updated probability using Bayes’ formula.
Bayes’ formula is a rational method for updating or adjusting the probability of an event
based on new information. According to Bayes’ formula, the updated probability of an event
given new information is:

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LM03 Probability Concepts 2023 Level I Notes

P(Information│Event)
P(Event│Information) = × P(Event)
P(Information)
LO: Identify the most appropriate method to solve a particular counting problem and
analyze counting problems using factorial, combination, and permutation concepts.
The number of ways we can assign every member of a group of size n to n slots is n!
n!
Number of ways in which n items can be labelled using k labels = [(n
1 !)(n2 !)…(nk !)]

The combination formula gives the number of ways to choose r objects from a total of n
objects, when the order in which the r objects are listed does not matter.
𝑛 n n!
𝐶𝑟 = ( ) =
r (n − r)! r!
The permutation formula gives the number of ways to choose r objects from a total of n
objects, when the order in which the r objects are listed does matter.
𝑛 n!
Pr =
(n − r)!

© IFT. All rights reserved 19