Notes of CFA Level1 READING 10: COMMON PROBABILITY DISTRIBUTIONS

MODULE 10.1: UNIFORM AND BINOMIAL DISTRIBUTIONS 

The Binomial Distribution 二项分布

Expected Value and Variance of a Binomial Random Variable 

expected value of X = E(X) = np 

variance of X = np(1 − p)

A binomial tree is constructed by showing all the possible combinations of up-moves and down-moves over a number of successive periods. 

MODULE 10.2: NORMAL DISTRIBUTIONS

 if the return of each stock in a portfolio is normally distributed, the return on the portfolio will also be normally distributed.

Using asset returns as our random variables, the multivariate normal distribution for the returns on n assets can be completely defined by the following three sets of parameters:

• n means of the n series of returns (μ1, μ2, …, μn).
• n variances of the n series of returns
• 0.5n(n − 1) pair-wise correlations. 

confidence interval 置信区间 of normal distribution

 The three confidence intervals of most interest are given by:

• The 90% confidence interval for X is X − 1.65s to X + 1.65s.
• The 95% confidence interval for X is X − 1.96s to X + 1.96s.
• The 99% confidence interval for X is X − 2.58s to X + 2.58s.

MODULE 10.3: LOGNORMAL DISTRIBUTION, SIMULATIONS 

Define shortfall risk, calculate the safety-first ratio, and select an optimal portfolio using Roy’s safety-first criterion.

Shortfall risk is the probability that a portfolio value or return will fall below a particular (target) value or return over a given time period. 

Roy’s safety-first criterion states that the optimal portfolio minimizes the probability that the return of the portfolio falls below some minimum acceptable level. This minimum acceptable level is called the threshold level. Symbolically, Roy’s safety-first criterion can be stated as:

minimize P(Rp < RL)    where: Rp = portfolio return, RL = threshold level return

If portfolio returns are normally distributed, then Roy’s safety-first criterion can be stated as: 

maximize the SFRatio, where SFRatio =.

 the Sharpe ratio:

When the threshold level is the risk-free rate of return, the SFRatio is also the Sharpe ratio. 

(例子见P216 Kaplan Notes）

The lognormal distribution is generated by the function e^x, where x is normally distributed. 

• The lognormal distribution is skewed to the right.
• The lognormal distribution is bounded from below by zero so that it is useful for modeling asset prices which never take negative values. 

Discretely compounded returns 

For a stated rate of 10%, semiannual compounding results in an effective yield of

 Daily or even hourly compounding will produce still larger effective yields. The limit of this exercise, as the compounding periods get shorter and shorter, is called continuous compounding. 

The effective annual rate, based on continuous compounding for a stated annual rate of Rcc, can be calculated from the formula: effective annual rate =

 The continuously compounded rate of return is:

 In general, the holding period return after T years, when the annual continuously compounded rate is Rcc, is given by:

Monte Carlo simulation  is a technique based on the repeated generation of one or more risk factors that affect security values, in order to generate a distribution of security values. For each of the risk factors, the analyst must specify the parameters of the probability distribution that the risk factor is assumed to follow. A computer is then used to generate random values for each risk factor based on its assumed probability distributions. Each set of randomly generated risk factors is used with a pricing model to value the security. 

 The simulation procedure would be to:

•  Specify the probability distributions of stock prices and of the relevant interest rate, as well as the parameters (mean, variance, possibly skewness) of the distributions.
• Randomly generate values for both stock prices and interest rates.
• Value the options for each pair of risk factor values.
• After many iterations, calculate the mean option value and use that as your estimate of the option’s value.