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Finance Head Secretary
FEBS, IIT Bhubaneswar FEBS, IIT Bhubaneswar
About FEBS
FEBS is IIT Bhubaneswar's society of finance, economics, and business. The community
is an agglomerate of enthusiastic people brought together by their love for finance,
economics, and business and their aspiration to spread the importance of financial
literacy in IIT Bhubaneswar. The prime motto of our society is to encourage the
development of financial literacy, economic thought, and business ideas. We aim to
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 Probability

Probability

Preliminaries

An experiment is a repeatable process that gives rise to several

outcomes.
An event is a collection (or set) of one or more outcomes.
A sample space is the set of all possible outcomes of an experiment,
often denoted Ω.

Probability Scale
Probability of an Event E occurring i.e. P(E) is less than or equal to 1 and
greater than or equal to 0.
0 ≤ P(E) ≤ 1

Probability of an Event
The probability of an event occurring is defined as:
P(E) = The number of ways the event can occur
Total number of outcomes

The Complimentary Event E′

An event E occurs or it does not. If E is the event then E′ is
the complimentary event, i.e. not E where

P(E’) = 1 − P(E)
 Probability

Conditional Probability
The probability of an event B may be different if you know that a
dependent event A has already occurred.

Example

Consider a school which has 100 students in its sixth form. 50 students
study mathematics, 29 study biology and 13 study both subjects. You walk
into a biology class and select a student at random. What is the probability
that this student also studies mathematics?

Mutually exclusive and Independent events

When events can not happen at the same time, i.e. no
outcomes in common, they are called mutually exclu- sive. If
this is the case, then
P(A ∩ B) = 0
and the addition rule becomes
P(A ∪ B) = P(A) + P(B)
When one event has no effect on another event, the two events are said to
be independent, i.e.
P(A|B) = P(A) and the multiplication rule becomes
P(A ∩ B) = P(A) × P(B)
 Probability

Random Variables
Notation
Random Variables X, Y, Z
Observed Variables x, y, z

Definition
Outcomes of experiments are not always numbers, e.g. two heads
appearing; picking an ace from a deck of cards. We need some way of
assigning real numbers to each random event. Random variables assign
numbers to events.
Thus a random variable (RV) X is a function which maps from the sample
space Ω to the number line.

Example
let X = the number facing up when a fair dice is rolled, or let X represent
the outcome of a coin toss, where

X = 1 if heads
0 if tails

Probability Distributions
When dealing with a discrete random variable we de- fine the probability
distribution using a probability mass function or simply a probability
function.

Example
The (RV) X is defined as’ the sum of scores shown by two fair six sided
dice’. Find the probability distribution of X
A sample space diagram for the experiment is:
 Probability

Continuous Distributions
As continuous random variables can take any value, i.e an infinite number
of values, we must define our probability distribution differently.
For a continuous RV the probability of getting a specific value is zero, i.e

P(X = x) = 0
 Probability

and so just as we go from bar charts to histograms when representing

discrete and continuous data, we must use a probability density function
(PDF) when describing the probability distribution of a continuous RV.

Expectation and Variance

The expectation or expected value of a random variable X is the mean μ
(measure of centre), i.e.
E(X) = μ

The variance of a random variables X is a measure of dispersion and is

labeled σ^2, i.e.
Var(X) = σ^2
 Probability

Continuous Random Variables

 Probability

If X and Y are random variables, then their covariance

is defined as:

Important Distributions

Binomial Distribution
A binomial distribution can be thought of as simply the probability of a
SUCCESS or FAILURE outcome in an experiment or survey that is
repeated multiple times. The binomial is a type of distribution that has two
possible outcomes (the prefix “bi” means two, or twice). For example, a
coin toss has only two possible outcomes: heads or tails and taking a test
could have two possible outcomes: pass or fail.
 Probability

Mean and Variance:

The mean of a binomial distribution is np, and the variance is np(1−p)

Poisson Distribution
The Poisson distribution is a discrete distribution where the random
variable X represents the number of events that occur ‘at random’ in any
interval. If X is to have a Poisson distribution then events must occur

• Singly, i.e. no chance of two events occurring at the same time

• Independently of each other
• Probability of an event occurring at all points in time is the same
We say X ∼ Po(λ).

The Poisson distribution has probability function:

 Probability

It can be shown that:

E(X) = λ
Var(X) = λ

Mean and Variance

In Poisson distribution, the mean of the distribution is represented by λ.

For a Poisson Distribution, the mean and the variance are equal. It means
that E(X)=V(X) where E(X) is the expected value and V(X) is the variance
Example
Suppose there is a bakery on the corner of the street and on average 10
customers arrive at the bakery per hour. For this case, we can calculate
the probabilities of different numbers of customers arriving at the bakery at
any hour using the Poisson distribution
 Probability

Normal Distribution
The Normal distribution is a continuous distribution. This is the most
important distribution. If X is a random variable that follows the normal
distribution we say:
The Probability Density Function (PDF) of the normal or Gaussian
distribution is given by:

Where:
x is the variable
μ is the mean
σ is the standard deviation

The Normal distribution is symmetric and area under the graph equals 1,
i.e.
 Probability

The empirical rule, or the 68-95-99.7 rule, tells you where most of
your values lie in a normal distribution:

Around 68% of values are within 1 standard deviation from the

mean.
Around 95% of values are within 2 standard deviations from the
mean.
Around 99.8% of values are within 3 standard deviations from the
mean.

Mean and Standard Deviation

The mean determines where the peak of the curve is centered. Increasing
the mean moves the curve right, while decreasing it moves the curve left.
The standard deviation stretches or squeezes the curve. A small standard
deviation results in a narrow curve, while a large standard deviation leads
to a wide curve
 Probability

Exponential Distribution.
The exponential distribution is a probability distribution that describes the
time between events in a Poisson process, where events occur
continuously and independently at a constant average rate.

Probability Density Function (PDF):

Where:
• x is a non-negative random variable representing the time between
events.
• λ (lambda) is the rate parameter, also known as the rate of occurrence or
the inverse of the mean time between events. It
must be greater than zero (λ > 0)
 Probability

Mean of Exponential Distribution: The value of lambda is reciprocal of

the mean, similarly, the mean is the reciprocal of the lambda, written
as μ = 1 / λ.
Median of Exponential Distribution: Median can be determined as the
fraction of the natural value of log (2) by lambda, written as M = log (2)
/ λ.
Variance of Exponential Distribution: The variance is determined with
the help of the exponential distribution’s second moment and is
denoted as follows:
Var (x) = 1 / λ 2

The Chi Square Distribution

The Chi-squared( ) distribution is a continuous probability distribution that
is commonly used in statistical hypothesis testing and confidence interval
estimation, particularly in the context of testing the goodness of fit of an
observed dataset to an expected theoretical distribution.

Shape and Asymmetry:

As you've described, the Chi-squared distribution is asymmetric with a
minimum value of 0 and no maximum value. Its shape depends on the
degrees of freedom parameter (df ). For each degree of freedom, there
exists a different Chi-squared distribution. As the degrees of freedom
increase, the distribution becomes more spread out and skewed to the
right.

Where:

• x is a non-negative random variable.

• k is the degrees of freedom parameter. • Γ is the gamma function.
 Probability

Relationship with Normal Distribution:

The Chi-squared distribution emerges as the distribution of the sum of
squares of independent standard normal random variables. That is, if Z1,
Z2, Z3,...,Zk are independent standard normal random
variables(Z∼N(0,1)), then the random variable,

Follows a Chi-Squared Distribution with k degrees of freedom.

 Probability

Mean and Variance

The mean and variance of a chi-squared random variable χ2 with n
degrees of freedom are given by E(χ2) = n, and V(χ2) = 2n

Central Limit Theorem

The Central Limit Theorem (CLT) is a fundamental concept in statistics
that describes the behavior of the sum or average of a large number of
independent and identically distributed random variables. It states that
regardless of the original distribution of the individual random variables,
the sampling distribution of the sum or average tends to be approximately
normally distributed when the sample size is sufficiently large.

Assumptions:

Sum or Average of Random Variables: The CLT primarily focuses on

the sum or average of a large number of random variables. It asserts that
the distribution of the sum or average approaches a normal distribution as
the sample size increases, regardless of the original distribution of the
individual variables.
Resulting Normal Distribution: According to the CLT, the shape of the
resulting normal distribution depends on the original distribution's shape.
However, as the sample size increases, the resulting distribution tends to
more closely resemble a normal distribution, regardless of the original
distribution's shape (binomial, uniform, exponential, etc.).
 Probability

Brownian Motion

Definition
Brownian motion, named after the botanist Robert Brown, refers to the
random movement of particles suspended in a fluid. In the context of
finance, Brownian motion is used to model the random movement of
asset prices over time. It forms the basis of the geometric Brownian
motion model, which is used in the Black-Scholes option pricing model
and other financial derivatives. This model assumes that the logarithm of
asset prices follows a Brownian motion, and it has been influential in the
development of modern financial theory and the pricing of financial
instruments.

Literal Brownian motion is the random-looking motion of microscopic

particles in water from the jostling of water molecules.

Mathematical Brownian motion is a mathematical model for literal

Brownian motion. It can be used to analyse many random or random-
seeming processes.

Financial asset returns are often modelled as geometric Brownian motion.

This means the logarithm of the asset price is assumed to follow a one-
dimensional Brownian motion process.

One way to think about this process is to start with a random walk model in
which a coin is flipped every second, heads the stock ticks up 0.02%, tails
it ticks down 0.02%. Then imagine the interval and price move gets
shorter, the coin is flipped one hundred times per second, and the stock
ticks up or down 0.002%; then the coin is flipped 10,000 times per second
and the stock ticks up or down 0.0002%. If you keep going until the coin is
flipped infinitely often, you have Brownian motion.
 Probability

Properties of a Brownian Motion

Continuity: Brownian motion is the continuous time-limit of the discrete
time random walk. It thus has no discontinuities and is non-
differentiable everywhere.
Finite: The time increments are scaled with the square root of the
times steps such that the Brownian motion is finite and non-zero
always.
Normality: Brownian motion is normally distributed with zero mean and
non-zero standard deviation.
Martingale and Markov Property: Martingale property states that the
conditional expectation of the future value of a stochastic process
depends on the current value, given information about previous
events. The Markov property instead focuses on the ‘no memory’
theory that the expected future value of a stochastic process does not
depend on any past values except the current value. Brownian motion
follows both these properties.
 Probability

Application

1. Stock Market Analysis: Brownian motion is used in mathematical

finance to model the stock price movement. The random walk hypothesis,
based on Brownian motion, assumes that stock prices follow a continuous-
time stochastic process, and changes in prices are random and
independent of past prices. It forms the foundation of the famous Black-
Scholes-Merton option pricing model.

2. Option Pricing: Brownian motion is central to the development of option

pricing theory. The Black-Scholes-Merton model, which assumes
geometric Brownian motion for stock prices, allows for the valuation of
options based on their underlying asset's volatility and other factors.

3. Risk Management: Brownian motion helps in risk assessment and

management by modelling the behaviour of financial variables such as
asset prices, interest rates, and exchange rates. It provides a framework
for estimating the probability of extreme events and simulating various
scenarios to analyse the impact of market fluctuations on investment
portfolios.

4. Random Walk Hypothesis: The concept of Brownian motion underlies

the random walk hypothesis, which suggests that stock prices and other
financial variables evolve randomly and cannot be predicted based on
past movements. This hypothesis has implications for efficient market
theories and forms the basis for many statistical models used in finance.

5. Monte Carlo Simulations: Brownian motion is employed in Monte Carlo

simulations, a powerful technique used to generate random variables and
model uncertainty in finance. By simulating multiple possible future paths
of financial variables, Monte Carlo methods help in pricing complex
derivatives, estimating value at risk (VaR), and conducting stress tests.