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f ( x) P (1 P)
x
( n x)
n! /( x!(n x)!)
E ( x ) x
f ( x) xdx
x xi / n
i 1
Geometric Mean
For positive numbers only
Better than arithmetic mean when used for
(gross) returns
Geometric Arithmetic
n
G( x) ( xi )
i 1
1/ n
s ( xi x ) 2 / n
2
x
i 1
Covariance
A Measure of how much two variables
move together
n
cov( x, y ) ( x x)( y y ) / n
i 1
Correlation
A scaled measure of how much two
variables move together
-1 1
cov( x, y ) /( s x s y )
20
15
Each point represents a year.
Linear (Each point represents a year.)
10
0
-10
-5
10
15
20
25
Distributions
Normal distribution (Gaussian) (bell-shaped
curve)
Fat-tailed distribution common in finance
Normal Distribution
Norm al Distribution w ith Zero Mean
0.45
0.4
0.35
0.3
0.25
f(x)
Standard Dev. = 3
Standard Dev. = 1
0.2
0.15
0.1
0.05
0
-15
-10
-5
0
Return (x)
10
15
f(x)
0.25
Normal Distribution
Cauchy Distribution
0.2
0.15
0.1
0.05
0
-15
-10
-5
0
Return x
10
15
Expected Utility
Pascals Conjecture
St. Petersburg Paradox, Bernoulli: Toss coin
until you get a head, k tosses, win 2(k-1)
coins.
With log utility, a win after k periods is
worth ln(2k-1)
E(U ) prob( x xi )U ( xi )
i 1
PDV xt /(1 r ) t
t 1
Consol PDV x / r
11 /(1 r )T
r
Insurance Annuities
Life annuities: Pay a stream of income until a
person dies.
Uncertainty faced by insurer is termination
date T