Quantitative Methods: Basic Concepts

Reading 8. Probability Concepts

Learning Outcome Statements

h. calculate and interpret an unconditional probability using the total probability rule;

i. explain the use of conditional expectation in investment applications;

j. explain the use of a tree diagram to represent an investment problem;

CFA Curriculum, 2020, Volume 1

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Subject 5. The Total Probability Rule

If we have an event or scenario S, the event not-S, called the complement of S, is written SC. Note that P(S) + P(SC) = 1, as either S or not-S must occur.

The total probability rule explains the unconditional probability of an event in terms of probabilities conditional on the scenarios.

  • P(A) = P(A|S)P(S) + P(A|SC)P(SC)
  • P(A) = P(A|S1)P(S1) + P(A|S2)P(S2) + ... + P(A|Sn)P(Sn)

  • The first equation is just a special case of the second equation.
  • The second equation states the following: the probability of any event [P(A)] can be expressed as a weighted average of the probabilities of the event, given scenarios [terms such as P(A|S1)]; the weights applied to these conditional probabilities are the respective probabilities of the scenarios [terms such as P(A1 multiplying P(A|S1)], and the scenarios must be mutually exclusive and exhaustive.

Suppose there are two events:

  • Event A: IBM's revenue will increase.
  • Event B: the economy is going into an expansion. P(B) = 0.6, and therefore P(Bc) = 0.4.

The probability of an increase in IBM's revenue given an economic expansion is P(A|B) = 0.8.
The probability of an increase in IBM's revenue given no economic expansion is P(A|Bc) = 0.7.

Using the total probability rule, we can compute the probability of an increase in IBM's revenue: P(A) = P(A|B) x P(B) + P(A|Bc) x P(Bc) = 0.8 x 0.6 + 0.7 x 0.4 = 0.76.

Typical exam question

An analyst constructs the following probability table for the market and Company X's stock:

1. Compute the total probability of good performance for Company X's stock.

Here we are asked to find the total probability of good performance. This means we have to find the joint probability of one stock outcome. To do this we multiply and add.

We take Σ (probability of economic state x good conditional probability): Joint probability = (0.5 x 0.4) + (0.3 x 0.5) + (0.2 x 0.5) = 45%

2. Compute the probability of simultaneously realizing a bull economy and poor stock performance for Company X.

This question asks you to determine the probability of a specific branch. If we follow the branch and multiply the probabilities, we will arrive at the correct answer as follows.

Bull economy: 0.5
Poor stock: 0.3
Probability = 0.5 x 0.3 = 0.15 = 15%

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User Contributed Comments 5

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jackwez

an easy way to remember this is the fact that A|B is like A/B multipled by B equals A.... along the same lines as teh dupont questions...

wundac

thanks jack

mdejesus

Man... I can't remember these formulas at all. But I CAN make a mean tree diagram. Making a tree diagram seems to be more helpful for me :)

choas69

but u cant keep making trees in an exam bro

gyee2012

Realize the change in mutliplication between independent and dependent probability and you will be set