Lesson 4 of 14 · All lessons in this module
  1. Random variables: PMF, PDF and CDF
  2. Expected value, variance and standard deviationVideo lesson
  3. Variance and covariance shortcuts, and the law of large numbers
  4. Discrete distributions: uniform, binomial and Poisson
  5. Continuous uniform and normal distributions, and simulating random draws
  6. Log-normal and logistic distributions, and the moments of key distributions
  7. Integrated cases: reading probabilities and moments from a return model
  8. Conditional probability and probability trees
  9. Conditional expected values and variancesVideo lesson
  10. Covariance from a joint probability function
  11. Joint, marginal and conditional distributions as information arrives
  12. Bayes' formula: updating a probability with new informationVideo lesson
  13. Bayes in practice: diffuse priors, missing inputs and screening tests
  14. Integrated cases: a tree with model forecasts and a Bayes update

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Lesson 4 of 14 · 15 min

Discrete distributions: uniform, binomial and Poisson

Three discrete distributions do most of the work in finance: the uniform for equally likely outcomes, the binomial for counting successes in a fixed number of yes/no trials, and the Poisson for counting rare events in a period.

In short

  • Discrete uniform: n equally likely outcomes, each with probability 1/n. For consecutive integers from a to b, mean (a+b)/2(a+b)/2 and variance [(b−a+1)2−1]/12[(b-a+1)^2-1]/12.
  • Bernoulli: one trial, success with probability p. Binomial: the number of successes in n independent Bernoulli trials, with mean np and variance np(1 − p).
  • The binomial model of stock prices moves the price up by a factor u or down by d each step, so after i ups and j downs S=S0uidjS = S_0 u^i d^j.
  • With large n and both np and n(1 − p) above 5, a binomial is well approximated by the normal N(np, np(1−p))N(np,\, np(1-p)).
  • Poisson: the number of events in an interval when events arrive independently at a constant rate λ. Mean = variance = λ; skewness 1/λ1/\sqrt{\lambda}.
  • In default-intensity models P(no default by t)=e−λtP(\text{no default by } t) = e^{-\lambda t}, P(default by t)=1−e−λtP(\text{default by } t) = 1 - e^{-\lambda t}, and the expected time to default is 1/λ1/\lambda.

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